Conventional wisdom: bubbles should only be in champagne and in a bath, not in asset holdings.
My opinion: asset bubbles are awesome* when you own the asset in question. Irrational exuberance represents unearned returns or returns that have been pulled to the present from the future because a herd of investors are overly optimistic about the asset’s prospects. The best thing that can happen to an investor is to have time accelerated for investment purposes.
The asterisk: Asset bubbles are only awesome if you sell the asset and redeploy the proceeds into a different asset that isn’t as bubbly. You’ll look like a sucker in the short-term when all your friends are bragging about the killing they’re making in the bubbilicious asset, but it’ll work out for you over the long-term.
The key is to figure out when things are in a bubble. It’s easy in hindsight, but it’s difficult to do when it’s happening. You have your own emotions working against you: “At this rate, I’ll be rich!” so you don’t want to get off the train, and you also have the additional distraction of the drumbeat of pundits saying “This time it’s different!”
How to spot an asset bubble
Historical data is a good guide to identifying asset bubbles, but that requires access to the data, the time and ability to crunch the numbers, and an understanding of the historical context and macro factors that guide the historical range.
An easier way is to divest the holding, or at the minimum rebalance your portfolio, whenever a given asset hits the upper 3-standard deviation 200-day Bollinger band. Gold at the end of 2011 is a good recent mainstream example where a major asset class tagged its upper 3-standard deviation Bollinger band and then failed from there. Bitcoin of course is another example, but that one sets the new gold standard for irrational exuberance.
The chart below shows how exceptional Bitcoin has been over the past two years. I set it up with two, three, and four-standard deviation 200-day Bollinger bands. The upper 2-standard deviation 200-day Bollinger band is the limit of normal trading for the vast majority of market regimes. Bitcoin broke the mold as it has not only repeatedly tagged its 3-standard deviation 200-day Bollinger band but also tagged its 4-standard deviation 200-day Bollinger band. Bitcoin is the first time in my experience I’ve ever seen an asset do that (short of a takeover offer at a significant premium).
You’ll notice that every time bitcoin tagged its three (and four)-standard deviation Bollinger band it pulled back or consolidated.
If you find yourself in the enviable situation where you bought an asset and then held on as it ripped higher before ultimately tagging its 3-standard deviation 200-day upper Bollinger band, you have two prudent options:
- Sell the position and hunt for the next opportunity. 9 times out of 10 this is the correct response because price usually tanks from here.
- If you’re a true believer in the asset in question (#HODL), the next best thing is to sell enough to get back your original investment plus 10 or 20 percent (to cover the cost of capital and all that), and then let the remaining portion ride. In this scenario you lock in a profit but still get to participate in any additional upside.
If you look at the chart below, which represents a proxy for the global stock market, price is getting close to the 3-standard deviation 200-day Bollinger band.
Just something to think about.