I believe we face one of the biggest market bubbles seen in decades – one that is widespread, with the potential to impact long-duration bonds, high price-to-earnings stocks, Bitcoin and the ‘innovative’ sectors the most.
The eventuality of a major bear market hinges mostly on liquidity, as well as a host of bubble characteristics being displayed in portions of the market, including increased leverage, market democratisation, issuance and turnover. However, attractive returns are up for grabs outside of bubble assets.
In a bubble environment, investors become myopic. They believe the universe of attractive investment opportunities is small and growth can be found only in a few select sectors. It is exactly that narrow-mindedness that presents opportunities, as investors ignore the broad range of potential investments outside the bubble.
Today’s bubbles are following that precedent. Investors are focusing on technology, innovation, disruption, cryptocurrencies, and housing – but very little else. They seem enamoured with vacations to outer space and electric vehicles yet ignore the dire need for improving US logistical and electrical infrastructure.
Ironically, many equity markets around the world not known as hotbeds of innovation and disruption are outperforming Nasdaq so far during 2021. Our guess is most investors are completely unaware of the fundamentals supporting these markets’ outperformance.
Sectors are starved
Bubbles misallocate capital within the economy. Investors often extrapolate shorter-term price momentum for longer-term potential returns. But bubble sectors attract too much capital, which actually lowers future returns. Essentially, too much capital chases too few ideas. The overcapitalisation of bubble sectors means non-bubble sectors become relatively starved for capital and ultimately provide better long-term returns.
The romantic futuristic stories that often fuel bubbles may indeed come true within the economy, but that does not mean bubble assets outperform. Bubble asset valuations often discount potential returns far into the future. If you had bought the Nasdaq 100 Index in December 1999 – still months before the bubble burst – it would have taken 14 years to simply break even.
The energy sector at that time was probably the sector most starved for capital. As the tech bubble deflated, capital naturally flowed to assets with higher rates of return, and the S&P 500 Energy sector tripled over the same 14-year period during which tech investors only broke even.
The flow of capital to outer space-related stocks is perhaps today’s most stark misallocation of capital within the equity market. As the basic rules of investment suggest, too much capital is indeed hindering returns. There are significant and potentially long-lasting logistical problems here on earth that reflect significant under-investment much like the 1980s/90s energy sector. For example, despite all the hoopla about Star Trek-like ventures, earthbound logistics companies have been significantly outperforming space stocks during the recovery from the pandemic.
Never time a bubble
Some investors discount concerns about the current set of bubbles because no one truly knows when the bubbles will burst. Without precise timing, they prefer to stay invested in bubble assets for fear of missing out on further momentum.
However, our research shows you could invest in non-bubble assets without the knowledge of a bubble’s peak and still get better long-term returns. The data suggests not knowing when a bubble will burst justifies diversification away from the bubble rather than myopically focusing on bubble assets and potentially missing returns.
If we compare the returns of small cap value, financials, and energy to the Nasdaq 100 – the ‘real’ technology companies – this seems clear. The other assets outperformed the Nasdaq 100 even when investors bought several years early before the bubble popped. This strongly supports our notion that return on investment is highest when capital is scarce.
The misallocation of capital toward the technology sector during the bubble hindered returns for years to come, so much so that it did not matter if investors mistimed the absolute peak of the bubble. In most cases, investors’ returns were superior in the other assets even if they missed the entire technology bubble.
A comparison of the returns of the MSCI Emerging Markets Index against the Nasdaq 100 from December 31, 1998, indicates the performance of emerging markets shows similar results. If you had invested in emerging markets you would have underperformed during the bubble period, but emerging markets ultimately outperformed in the long run. In addition, analysis suggests the rotation from Nasdaq to other parts of the world may be well under way.
Small and mid-caps favourable
Bubbles build on the combination of liquidity and hype, and the current set of bubbles in long-duration assets has had plenty of both. While hype and stories are fun, our portfolios are built on fundamentals. Whereas consensus is focused on technology, innovation, disruption, cryptocurrencies, and the like, we will continue to follow our process that right now argues there awaits a world of opportunity outside of bubble assets.
Specifically, our portfolio has plenty of weight behind small and mid-cap equities in developed economies throughout Europe and select parts of Asia. While many investors talk about stocks being undervalued in these locations, few have highlighted the increasingly strong fundamentals of these companies.
It is vital investors do not overlook this market sweet spot, as cheap assets with strong fundamentals well outside of bubble territory is a more than attractive combination.
Richard Bernstein is chief investment officer at Richard Bernstein Advisors. The views expressed above are his own and should not be taken as investment advice.