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Before I get into the crux of my argument, I want to start by stating that I have the utmost respect for the writings of James Kostohryz. I have been reading his work for many years now and generally agree with the cautionary macroeconomic perspective he brings to the SA community, though I won't necessary always agree with everything he has to offer. While James and I would certainly agree that now is probably not the time to go blindly chasing after equity returns we've seen in the market, I don't think investors need to necessarily preoccupy themselves with the potential formation of the market bubble James sees brewing in his latest article.

Current Market Risk

There should be little argument that the uncharted economic territory we are navigating has upped the risk ante for investors near- and intermediate-term. If you are not spooked or at least questioning what kind of landing we are in for upon exiting QE, you apparently have some Nostradamus-like ability I am lacking. For those of you familiar with aviation, I would liken the current situation to a severe crosswind runway approach, with the pilot, in this case the Fed, forced to "crab" the plane sideways at various angles on final to compensate for perpendicular wind pressure on the plane. That maneuver, in addition to the normal descent path the plane is forced to take, can be an unnerving experience for both pilot and passenger alike.

Within the body of his latest article, "A Bubble Continues to Form In The Stock Market," James stated the following with regard to broad market pricing:

I would characterize valuations as starting to become only slightly stretched.

I have no qualms with this assertion. In fact, I think it's spot on. However, I think it prudent to consider why valuations might be higher than average at the moment. I believe the following list offers rationale for why broad equity pricing measured by the S&P 500 Index has run up over the past two years with little substantial or lengthy resistance:

  1. Moderate valuations at the onset
  2. Better forward risk-adjusted return perception relative to bonds
  3. Better yields relative to bonds and risk-free alternatives
  4. Return chasing or "train leaving the station" mentality
  5. An assumed soft landing coming out of QE

With the exception of #4 above, I think these are some pretty logical explanations as to why investors have shifted monies into equities over the past two years. Despite the macroeconomic headwinds and obvious choppy financial air, corporations, by and large, continue to grow earnings, return dividends, and provide guidance that hasn't provided for a massive "doomsday" scenario. Will a "bubble" scenario ultimately unfold given the "pathologies" that James contends are lurking in the economic and monetary systems? Perhaps, but it could be years before that occurs, or on the other hand, if the pathologies wane over time, it may never occur.

(click to enlarge)

Blowing Bubbles

While I think that James's thesis regarding a brewing bubble holds merit, I continue to lack understanding of what exactly constitutes a bubble. It is generally accepted that technology and Internet stocks were in a bubble back in the late 90s, until they began to deflate in early 2000. The Ciscos (CSCO), Microsofts (MSFT), and Intels (INTC) of the world still trade substantially lower than they did then. Now, they are typically considered value stocks, quite a far cry from the stratospheric valuations they were once given. For one to be predictive of an asset bubble, I think one needs to define the outcome along with the prediction. In other words, "I see the market crumbling X percent after the bubble forms."

To be blunt, I really dislike the ambiguous connotation of the word bubble. In addition to James's prediction about a broad market bubble, I continue to read commentary regarding dividend and bond bubbles. While I catch the drift that these assets may be collectively considered "expensive" via a variety of metrics or analytical methods, I still find application of the word "bubble" to overpriced assets rather opaque and sensationalistic. But maybe I'm just too old-fashioned.

Earlier in the year, I wrote an article that cautioned investors about selectively growing asset prices in the equity REIT sector, but never referred to the space as being in a bubble. As we know, REITs subsequently sold off swiftly and quickly, with many down as much as 25-30% in a very short span. With hindsight, were some REITs, a small but growing contingent of the equity market, in a bubble? In ensuing REIT articles I've never referred to the recent sell off as such, but would I would have been accurate to do so?

While this is somewhat a discussion of semantics, I feel it is important, because investors tend to get scared when they hear or read about bubbles. I'm not big on scare tactics when they're not necessary.

Getting Past A Bubble

Meanwhile, I think part of the agitation I get from reading about bubbles goes to the bottom up approach that I take with my investing, versus the top down approach that others utilize. I dislike phrases such as "REITs are wonderful" or "the economy stinks" because from an individual security perspective I see little overriding investment value in the commentary.

This is not to say that the macroeconomic outlook has no bearing on my portfolio strategy - it certainly does - but it takes a subordinate position to a focus on stock valuation and fundamentals. While obviously portfolio strategy is a very personal undertaking, I'm more inclined to tweak asset allocation and security selection as the macroeconomic underpinnings dictate, rather than make big market bets based on economic assumptions that may or may not ultimately flow through to the securities markets.

I'm of the opinion that more risk-adjusted investment value can be gained by slowly migrating a portfolio away from perceived individual security, sector, or asset-type risk, than by trying to position for a future economic scenario that may or may not come to fruition. Without being overly specific, this might be accomplished by decreasing equity allocation, lowering bond maturity, increasing exposure to non-correlated assets and cash, or increasing option activity through protective puts or covered call writing.

At the conclusion of James's article, he suggests that aggressive traders try to cherry pick the top of the upcoming bubble or that other investors "wait this out," presumably in cash. Given the fact that I agree that risk is increasing but that we may or may not (probably not) be headed for some sort of market bubble, I think the best option for most investors not inclined to market time is a middle-of-the-road stance that provides for continued exposure to the Fed punchbowl, but hedges risk with the several options I suggested above.

The more 'bubblish' equity pricing becomes in relation to actual growth, the more conservative and 'hedge heavy' a portfolio should become. This way, you don't have to try to predict a "top" and similarly don't have to guess when a "bottom" is in.


While this is a time for careful consideration of one's portfolio positioning, I don't think it's a time to necessarily be scared out of one's wits either. Unless one is stubborn enough to believe that stocks rise indefinitely and valuation is irrelevant like many did during the tech bubble over a decade ago, I don't think there's reason to fear this market if you approach it sensibly. Be mindful of the potential for a market sell off, but don't obsess over it.


Source: Bursting The 'Bubble' Mentality


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