How to Time a Bubble Before I start, some apologies, followed by some warnings. This newsletter will be shorter than most, as I still have Covid curves dancing in front of my eyes. Also, be aware that I am going to make use of overlay charts, some of the most heinous examples of chart crime ever invented, and that I am going to dive into the question of how to time a bubble. Timing a bubble is a) dangerous and b) impossible but c) incredibly lucrative if you happen to do it correctly. It is seldom a good idea. But for many in the professional money management industry there may now be little alternative. There are plenty of differences between the current situation and the great bubble that burst in 2000. Perhaps most significantly, there is still a gusher of liquidity at present, while in 2000 the Federal Reserve was withdrawing liquidity after the world's computer systems had managed to navigate the "Y2K" problem successfully. There are also rather more evident risks now than there were then; the world is a more dangerous place than it was 20 years ago, and the risks from the Covid-19 pandemic continue to be skewed to the downside. What we do have in common with 2000 is an exceptional rise in tech stocks, accompanied by evidence of utter insanity at the margins. When investors bought the stock of companies that had not yet even made revenues, let alone profits, 20 years ago, now they are prepared to hand money straight over to companies in bankruptcy, facing the virtual certainty that it will all immediately be paid to creditors. Then as now, conventional valuation metrics have ceased to matter. If tech stocks were bothered by valuations, they would have sold off a long time ago. And also, oddly like 2000, there are large swathes of the market that are unaffected by the mania. In extremis, a bubble can always get even more expensive. The critical metrics to watch are "technical" ones, concerning the move in the market itself. In a bubble, you aren't investing in a company; you are instead placing a bet on the collective behavior of other investors. That behavior reveals itself in chart patterns, rather than in balance sheets and valuations. Some of history's most famous bubbles look surprisingly similar. Here are the two biggest equity market bubbles that I have had to cover — in Nasdaq technology stocks, peaking in March 2000, and in the Shanghai Composite A-share index, peaking in October 2007. I have normalized it so that the two markets peak at 100. And the similarities, particularly at the business end as the bubbles burst, are extraordinarily close:  Both hit a peak, fell, rose again, nearly returned to the peak but failed to get there, and then tanked in epic fashion. Now, continuing with the chart crime, here is the final ramp up in the Nasdaq 20 years ago, compared with this year. The recent peak on June 10 is aligned with the peak from 2000 — obviously a critical question is whether this one proves to be the peak. But again, the similarity isn't totally imaginary:  So, have we seen the top? I have no idea. But I do want to report on the approach suggested by Anatole Kaletsky, a former colleague and a co-founder of Gavekal Economics. You can find his note on this here. He draws many parallels between the two situations, and then shows that back then, investors were greatly influenced by how the market performed compared to previous highs. If it broke through an earlier high, that was taken as a license to buy. That happened in the fall of 1999. Speculation increased dramatically. When it failed to do so, forming the "double top" you can see in March 2000, it tanked. This happened again later in the year, as is visible in the first chart — and again, a failure to take out an earlier peak led to a huge sell-off. The possible outcomes look binary. This is Kaletsky's conclusion, which I endorse in its entirety: Last Wednesday, the Nasdaq composite exceeded by 2% its pre-Covid-19 high of 9817, set on February 19, but then fell back sharply. If the Nasdaq now rebounds above last week's 10,000 level, history suggests that the bull market will resume—and many more intrinsically worthless companies will soar to unimaginable heights. If, on the other hand, the outbreak of madness on Nasdaq turns out to mark a double top, the post-Covid equity bubble could deflate very quickly and the next big event for investors could be a test of the March lows. Which will it be? I have no idea, but I am pretty sure that market psychology, rather than monetary policy or economic data, will decide the answer. Many readers will dislike the notion that I am admitting to having "no idea" what will happen next, and quoting approvingly a commentator who also has no idea. So let's try to be a little more prescriptive. Ultimately when we hedge, we hedge against the possibility that we are wrong. If we are very, very clever we will need that hedge a little less than half the time. And if we wrongly believe that there isn't a bubble, thankfully it isn't too expensive to hedge the risk that we are wrong. Retail investors pouring into the market at present like small-cap value stocks, even if they appear objectively terrible. They are small and illiquid companies that had been sold down, so a lot of bad news is already in the price. (This still doesn't give you much protection on the downside, as a lot of companies could easily go bust, but at least it might help you deal with the cognitive dissonance of buying terrible companies during a bubble). In the event that the bubble has many months to run, such stocks could go up an awful lot. That means you don't need too big a holding of small-cap value companies to save the rest of your portfolio. If the Nasdaq does make another high in the next few days, and avoids a repeat of the 2000 "double top," it probably makes sense to hold your nose and put a sliver of money into small-cap value (and be ready to sell it when a double top shows up). If that top holds, it would be unwise to unload much in the way of stocks. You could be right. I could be crazy. But it just might be a lunatic who is driving prices at present. It pays to be careful. Survival Tips I am hoping to bring you an analysis of the conflict between China and India, the world's two most populous nations, that has seen bloodshed and death in Ladakh this week. It is a fascinating issue, but it needs to wait. For now, can I suggest looking at a few of the images and websites I am linking in this sentence? I was lucky enough to visit Ladakh, as a student with a pack on my back, more than 30 years ago. It is the most painfully beautiful place I have ever visited, a high and desolate plateau in the Himalaya abutting Tibet that is of almost no practical use to anyone. The Dalai Lama's summer palace in exile is there, and it is the intellectual and artistic center of Tibetan Buddhism. The monks in Ladakh's many monasteries take an inclusive attitude, and happily show off their treasures to visitors. I remember visiting one monastery that, according to the guidebook, had frescoes more than a thousand years old; and the monks told us to look at the one they had finished the previous year which was much better. It is an intensely beautiful tradition that has continued to develop and enrich itself, almost undisturbed, for a millennium. It seems a very cruel joke that Ladakh, of all places, is now at the crux of a geopolitical conflict. If you need a rest from the cares of investment bubbles and pandemics, try delving into the images and artworks of the fragile and endangered landscape of Ladakh. Like Bloomberg's Points of Return? Subscribe for unlimited access to trusted, data-based journalism in 120 countries around the world and gain expert analysis from exclusive daily newsletters, The Bloomberg Open and The Bloomberg Close. | 
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