Why a Stock Market Bubble Doesn't Scare Us

The media's been giving a lot of attention to a three-word phrase that strikes fear in the hearts of investors: stock market bubble.

Jeremey Grantham of GMO Asset management thinks we are in a bubble and a stock market crash is inevitable. Grantham points at what he calls "extreme overvaluation, explosive price increases, frenzied issuance, and hysterically speculative investor behavior."

He could be right. After all, market indexes are at or near record highs, some stocks have gone on incredible runs over the last year (e.g. Tesla's 700% surge), and we've seen reckless speculating send GameStop to over $400 a share.

But even Mr. Grantham admits his valuation-based calls are not precise in timing, and he can be months or even years early.

Hedge fund manager Mark Rusko told CNBC that he thinks we are in a bubble much like 1999. He also pointed out that this does not mean we are going to have a massive crash. We could, but no law of market physics says we must have a crash because stocks are historically overvalued and speculation is increasing.

In other words, we might see a stock market crash and we might not. Helpful, right?

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Here's the thing: Whether we're in a stock market bubble or not, your strategy is likely to be the same. Investing in stocks carries some risk, and a crash, while infrequent in reality, is always possible. There is always the possibility that some geopolitical or economic event can cause a swift, sudden move down in stock prices.

A market bubble is just one more risk to consider.

Investors know time in the market beats timing the market every time. Pulling your money out of stocks and heading for the hills at the first sign of a bubble or instability could mean missing out on growing your money.

Let's take a look at why stocks could continue to power higher despite warnings of bubbles and crashes. Then we'll show you some common-sense ways to manage your risk so you can keep reaping the gains of this rally without worry.

Why Stocks Keep Going Up

It may seem like market fundamentals are out of whack. The Shiller P/E ratio is more than double its average, topping even its reading before the 1929 market crash with only the runup to the dot-com bubble showing a higher reading.

That sure sounds ominous. But the same thing could've been written in 2017.

Let's say you had an index fund tracking the Nasdaq, like Invesco QQQ Trust (NASDAQ: QQQ), saw market crash warning signs like the Shiller P/E ratio popping, and decided to pull your money out of the market. You would've missed out on a 171% gain between Jan. 1, 2017, and today. That includes last year's pandemic crash.

You see, even if the people calling for a market bubble are right, stocks can continue rallying far longer than expected, and they can recover from even the worst downturns in a flash.

And if you miss out on these potential gains, you may regret it. That's as true today as it was then.

In fact, there are a number of reasons for a huge move higher in the stock markets right now despite high valuations:

  • We are going to see another $1.9 trillion stimulus package to support the economy.
  • The vaccine rollout should improve with most of us vaccinated before summer.
  • The Biden administration and the Democratic Congress will likely pass a massive infrastructure program that could spur growth in related businesses.
  • The Fed is not going to budge on interest rates. It has changed policy to let things run hot to get us through to the other side of the pandemic.

So, what can we do to protect ourselves from a crash and remain in the market so we do not miss a continued move higher?

How to Protect Your Money from a Market Bubble Popping

First, we can use a trailing stop on our stocks.

A stop-loss order is one that tells our broker to sell our shares if the stock declines to a certain level.

A trailing stop just means that we are moving our stop loss order up as the stock price goes higher.

This means if a stock you own suddenly plummets, you'll sell before losses get too big. Then you can take your cash and buy back in when things settle.

Second, use a tail hedging strategy.

A tail hedging strategy uses options. You buy way out of the money put options on the S&P 500.

Not a little out of the money. We are talking way out of the money. You probably want to go to strike prices as much as 40% and even 50% lower than the index's current level.

Go out about three months and buy puts that trade for no more than $0.50 or so.

Only buy a handful. Don't put more than a percent or two of your portfolio's value into a tail hedge strategy. You are buying insurance, nothing more.

If the market falls, the explosion of volatility will cause those options to explode in value, offsetting much, if not all, of the decline in your portfolio.

Lastly, if that sounds too complicated, then you can always place a portion of your assets into a tail risk ETF line like the Cambria Tail Risk ETF (BATS: TAIL).

There are reasons for stocks to crash.

There are just as many for stocks to explode higher.

Pick the protection strategy that best fits your risk profile and personality, and enjoy the ride.

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