How Would You React if You Knew a Bubble Was Forming?

Mark Hulbert looks at bulls’ worries that certain sectors may be overvalued, even bubbling.
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Would you stay invested in the stock market if you believed a bubble was about to pop?

Believe it or not, many of you would. And it is worth exploring the quirks of our nature that lead us to engage in such self-destructive behavior.

This is not just a hypothetical exercise, of course. There has been a distinct shift in attitude in recent weeks among many bulls who previously went to great lengths to argue that stocks weren’t overvalued. Many have now given up trying, and openly concede that at least certain sectors of the stock market (if not the overall market itself) have become not just overvalued but entered bubble territory.

Can you say Tesla  (TSLA) - Get Report? Bitcoin? GameStop  (GME) - Get Report?

This is reminiscent of the months leading up to the top of the Internet bubble in March 2000. That also was when the bulls gave up trying to justify stocks’ valuations yet nevertheless remained in the stock market. The stock market “wanted to go higher,” they in effect said, and who were they to stand in the way?

Their behavior reminds me of a joke Warren Buffett recounted a number of years ago: An oil man dies and is told by St. Peter that while he deserves to get into heaven, there is no more room since there are already too many oil men there. The oil man asks if it’s OK for him to try to convince some of the oil men already in heaven to go to hell, thereby opening up a spot for him, and St. Peter agrees. The oil man finds a convention of oil men in heaven and yells to them that oil’s been discovered in hell. Pretty soon there was a steady stream of them headed straight to hell, surprisingly with our newly dead oil man following fast on their heels. When asked why he was turning down a spot in heaven, the oil man replied that, you never know, the rumor about the oil discovery just might be true.

FOMO

Why would investors so willingly play Russian Roulette with their portfolios? One big part of the answer is that, for many if not most investors, losing money is not the worst possible outcome. Instead, psychologists tell us, even worse is the possibility that others might be getting rich while they are out of the market.

Losing money is tolerable, in other words, so long as most everyone else is losing too. What’s intolerable is the fear of missing out.

This fear is especially evident at times like now, when certain stocks and sectors are soaring. As Jeremy Grantham, co-founder of the investment firm GMO, recently pointed out in a letter to clients, “when price rises are very rapid..., impatience is followed by anxiety and envy… [T]here is nothing more supremely irritating than watching your neighbors get rich.” The consequence, as the great British economist and philosopher John Maynard Keynes foresaw a century ago, is that we would rather “fail conventionally than… succeed unconventionally.”

The current market therefore invites all of us to engage in honest self-reflection on the reasons why were invest. Is it, really and truly, to support long-term wealth creation? If so, then FOMO should not even be a secondary or even tertiary concern.

First to Leave the Party?

While you are engaging in that self-reflection, it’s also important to recognize the unrealistic belief you (at least implicitly) have if you are acting on FOMO: That you can be the first to leave the party when it has come to an end.

This is unrealistic for any of a number of reasons. Not everyone can be at the front of the line, of course. But it’s also unrealistic because it’s almost certain you will not recognize the party’s end on the day (or week, or month) when it occurs. On the contrary, when the party comes to an end you will be exuberant -- wanting to put more money in the market rather than pull anything out.

Consider the average recommended equity exposure levels among the nearly 100 stock market timers we monitor on a regular basis. This average is what’s represented by the Hulbert Stock Newsletter Sentiment Index, or HSNSI. The HSNSI was 58 percentage points higher at the top of the Internet bubble than it was at the bottom of the bear market that ensued after its popping.

This difference was even more dramatic among those market timers who focused on the Nasdaq stock market (as represented by the Hulbert Nasdaq Newsletter Sentiment index, or HNNSI). This average at the October 2002 bear market bottom was 145 percentage points lower than it was at the March 2000 top of the Internet bubble. (This greater-than-100-point drop reflected the average timer shifting from being bullish to being bearish.)

These drops in exposure levels are just the opposite of what would help us navigate bull market tops, of course. It would be far more helpful if market timers would have higher exposure levels at market bottoms than at market tops.

That they do not confirms the wisdom of Warren Buffett’s classic comment that our job is to be fearful when others are greedy and greedy when others are fearful. And right now, the sentiment pendulum has swung far closer to the greed end of the spectrum, especially among market timers who focus on the Nasdaq market: The HNNSI currently is higher than 94% of all daily readings since 2000.