Last year, Research Affiliates founder Rob Arnott and two co-authors called out what they saw as market bubbles.
Fifteen months later, the authors are claiming most of these those predictions were “spot-on.”
In a new paper from Research Affiliates, Arnott and co-authors Bradford Cornell and Shane Shepherd gave themselves a scorecard for bubble predictions made publicly in April 2018. Their calls included parts of the technology sector, Tesla, Bitcoin, and other cryptocurrencies.
They identified these assets using a formal definition developed for spotting bubbles as they happen, as opposed to after the fact.
“Too often, pundits identify bubbles much like the National Bureau of Economic Research identifies recessions: only in hindsight, typically years after the fact, which offers no actionable opportunity for investors in real time,” they wrote.
In the new paper, Arnott, Cornell, and Shepherd argue that all bubbles have two characteristics. “First, the asset or asset class offers little chance of a positive risk premium relative to bonds or cash, using a generally accepted valuation model with a plausible projection of expected cash flows,” they wrote. “Second, the marginal buyer of the asset or asset class disregards valuation models, presumably buying based on a popular narrative and expecting to resell the asset to someone else at a higher future price — and as if the market will tell them when to sell!”
The key word here, the authors noted, is “plausible.” As they argued in the paper, “the growth required to justify a stock’s current price needs only be implausible, not impossible.”
Using this definition, Arnott and his co-authors claimed in April 2018 that Tesla, for instance, was a bubble asset because its price was “arguably fair” under a best-case scenario: “if most cars are powered by electricity in 10 years, if most of these cars are made by Tesla, if Tesla can make those cars with sufficient margin and quality control and can service the cars properly, and if Tesla can raise additional capital sufficient to cover a $3 billion annual cash drain and another billion to service its debt.”
Since the paper was posted on April 2, 2018, the electric carmaker’s share price has fallen from $252.48 to $238.60 at market close on Thursday, with a lot of ups and downs in between.
“It turns out we were not wrong about Tesla, just a few months early,” the authors wrote. “Timing the top of a bubble is an exercise in futility.”
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Bitcoin and other cryptocurrencies were also among their previous calls. In the new paper, they noted that the universe of cryptocurrencies fell from a peak market capitalization of $828 billion in early January 2018 to $125 billion at the end of the year. In the first half of this year, however, Bitcoin has recovered by 187 percent. But the authors asserted that “based on our definition, plenty of bubble indications remain.”
As for technology stocks, Arnott and his co-authors pointed to the collapse in the fourth quarter and subsequent recovery in the early part of 2019. “Such rebounds are not an uncommon occurrence as a bubble unwinds,” they argued, noting that the NASDQ recovered from a 36 percent plunge in the spring of 2000 immediately before the tech bubble burst. In particular, Arnott and his co-authors pointed to Netflix, Tencent, and Twitter as possibly inflated assets, while arguing that the high valuations of Microsoft and Apple could be justified.
“Our recommendation 15 months ago was to reduce exposure to bubble assets; avoid cap-weighted index funds, which inherently overweight bubble assets; seek exposure to anti-bubble assets or markets that are implausibly cheap; and invest in value-based smart beta strategies, especially in Europe and the emerging markets,” Arnott, Cornell, and Shepherd wrote. “These still apply.”