What to Do When You’ve Spotted a Bubble
Yes, you could short it — but what if you’re a few years early?
Suppose you’ve found an asset you believe is overvalued. Maybe it’s a currency, a bond, a commodity, a stock, a sector, whatever.
What, exactly, should you do with this information?
Let’s assume you’re smart. Your thesis is correct, it’s overpriced, some day the price will correct, and lots of people will get hurt. But for the asset to be overpriced, somebody has to disagree with you.
So what do you do when you spot a bubble? This is an incredibly broad question, but it’s a question all investors in public markets have to ask. There are three basic schools of thought:
The brave, stupid, and intellectually consistent approach
You could just short it.
Sometimes, that works.
Sometimes it doesn’t, though. During the housing bubble, one manager wrote up a very compelling case for why subprime debt would end badly. The subtitle of it was “A Home Without Equity Is Just a Rental With Debt.” Anyone armed with that information would have been unsurprised by what happened from 2007 through 2009.
Here’s the problem: the title right above that subtitle was “Housing In the New Millennium,” because the write-up was from 2001. If you’d read the essay then, you might have done the obvious thing and shorted a homebuilder like Toll Brothers, which, at the time, traded at about $9 per share. TOL peaked in mid-2005 at about $57 per share.
Other homebuilders had similar performance. Bank stocks also took a long time to break down.
Of course, prices did eventually collapse, but shorting a basket of homebuilding stocks would have been unsatisfactory to an average investor and a fireable offense to a professional.
Normally, the quote people cite in situations like this is from Keynes, who apocryphally said, “Markets can remain irrational longer than you can remain solvent.” But a more apt quote is, “A bull market climbs a wall of worry.” The risk of a housing downturn is the risk a homebuilding investor is…