How to make the most of an investment bubble

You may have seen an article recently about the head of the Dutch central bank, Klaas Knot, who is also a governor on the European Central Bank, saying that "the picture resembles that of the period before the financial crisis", that we are "about to witness a brutal collapse in asset prices". He talked about overvaluation (the S&P 500 is hitting all-time highs), a low level of volatility (the VIX just hit a record low), and the risk that investment sentiment could turn very quickly if the US raises interest rates more aggressively than the market expects. He said the "risk of sharp market corrections is real".

Meanwhile Wolfgang Schauble, the German finance minister, also talks about a risk of "new bubbles" as a result of a decade of quantitative easing and the trillions of dollars central banks have pumped into the financial markets through the bond markets.

The ASX200 has hardly risen this year and is trading on a price-earnings ratio of just below 16x which is only marginally above the long-term average of around 15x. No bubble here. The US on the other hand has seen the S&P 500 up 12.5 per cent this year, the NASDAQ up 20.5 per cent and the S&P500 has moved from a price-earnings ratio of 18x to 23x in the last couple of years. Think about that. It means that share prices have risen 27 per cent more than earnings since early 2015.

Now I own a couple of businesses and I have to tell you, if someone wanted to come and pay me 23x post-tax earnings for either of them I would retire a squillionaire. Yet this is the average, repeat, average, valuation of $US22.97 trillion worth of US stocks in the S&P 500.

But before you rush to the doors on the back of Knot's comments you should understand that central bankers are perhaps the most conservative market commentators in existence. Prudence is their job, and all we are seeing is the first level of many markets' Chicken Little commentators, who are paid to do so, turning chicken. That is their role. On top of that let me make a few unconventional observations about stock-market bubbles.

The best market performance comes before a bubble. We should never fear a bubble, we should welcome them, encourage them even. They are rare, fantastic, twice-in-a-lifetime opportunities. If you spend those moments sitting on the sidelines wagging your finger at everyone else's stupidity you are missing the point.

What you can achieve in a few months or years ahead of a bubble bursting is what makes the stock market worthwhile in the long-term. All that time spent managing small returns over many years is marking time, waiting for this moment. And please understand, that long-term average return everybody is quoting includes bubbles. You will never achieve the long-term average unless you participate. Those long-term averages include the whole bubble, not a chickening out when things are a bit overvalued. To sit it out at the first sign of a bubble is lunacy.

When it comes to bubbles the obvious concern is the risk of a crash. Let me give you a few pointers on managing that possibility. The first is that you should never try to predict the top of a bubble. You are not that smart. You have to let it run. You only call the top of a bubble after the market starts to dump, not before.

When the end comes it will come fast so you have to be ready, watching, finger on trigger. Vigilance is King. By the time you read about the end of a bubble in the research, in the media, or on CNBC, it will be too late. You have to spot it earlier. I had a member once whose golden rule of trading was that if the US market ever fell 3 per cent in a day, sell half of everything, and if it did it again, sell the rest.

Also understand that no one will ever tell you to sell. The finance industry works very hard to get you into financial products, so they will never tell you to get out. That decision has to be yours and yours alone.

Not sure when to sell? Of course you're not. At some points in the market there is no science, no fundamental basis for anything, there is just your guts. Go with them, they are a distillation of your state of mind which is a distillation of everything happening around you. If you are worried, sell. And if you are awake at night thinking you should have sold yesterday, sell tomorrow.

Above all, be willing to do the one thing that the majority of puritanical value-based investors never do, which is to sell. The first day you see the market down 3 per cent you have to react not debate. An ability to sell is the most important element of risk management.

We are not in bubble territory yet, so relax. But when you see the market up 50 per cent in less than a year, get this article off the fridge.

Marcus Padley is the author of the daily stock market newsletter Marcus Today. For a free trial of the Marcus Today newsletter please go to www.marcustoday.com.au.

This story How to make the most of an investment bubble first appeared on The Sydney Morning Herald.