- Talk of bubbly AI valuations is hitting markets as investors await Nvidia’s results
- It’s easy to lose sight of the risk of under-investing in a stock market bubble
- Some stats from the Dotcom era highlight the challenges facing investors
- 5 tips for investors worried about a stock market bubble.
Laith Khalaf, head of investment analysis at AJ Bell:
“Talk of a stock market bubble is everywhere right now, and for good reason. Valuations in the US stock market are sky high and the enormous technology companies sitting atop the S&P 500 are venturing into an unpredictable AI future, burning through tens of billions of shareholder dollars in their quest not to be left buried in a digital junkyard alongside DVD players, MiniDiscs and fax machines.
“No-one should need reminding of what a bubble bursting can do to your wealth. An investor in the S&P 500 in March 2000 saw a £10,000 investment wither to just £6,000 over the next three years. An investor in the tech-orientated NASDAQ 100 would have been left holding under £3,000 at the end of that period (source: FE).
“It’s hard to pinpoint precisely how much of this dire period for stock market returns can be laid at the door of the Dotcom bubble bursting, seeing as the fallout was exacerbated in 2001 by the World Trade Centre attacks and the Enron scandal. But one way or the other, the first few years of the millennium were undoubtedly a brutal wake-up call for investors.
Dotcom boomed before the bust
“What is perhaps easy to lose sight of after a bubble has burst, is how long and strong the preceding boom was. The table below shows returns from the S&P 500 in the late 1990s. These figures show that even if you believe we are in a bubble, the question of where we are in the expansionary stage really matters to portfolio returns.
Source: FE
“As early as December 1996, the Fed Chairman Alan Greenspan was warning about irrational exuberance in US stocks. Investors who had taken that as a signal to step away from the punch bowl would have missed out on some intoxicating returns over the next three years. Worse still, after watching stocks continue to soar, they might have got sucked back into the market just at the point the bubble was about to burst.
“FOMO might be a recent verbal configuration, but it’s an age-old sentiment. When FOMO is widespread, it can drive the market further and further into the stratosphere, leaving those left behind insolvent, if they are leveraged; unemployed, if they manage money; or exasperated, if they are a private investor.
The risk of under-investing
“The Alphabet CEO, Sundar Pichai, said last year that the risk of under-investing in AI is dramatically greater than the risk of over-investing. For a technology company which stands to be left behind if it doesn’t compete in the AI arms race, he has a valid point.
“But his words provide food for thought for stock market investors as well. Looking back to the Dotcom boom and bust, there were risks to both over-investing and under-investing, and they are more finely balanced than you might think. That is by no means to underplay the risk of being exposed to frothy assets during a bubble, but the cost of not participating in the upside also needs to be considered.
“The table below shows returns up to the end of 2005 based on a number of different purchase dates, from both the S&P 500 and the typical money market fund. With hindsight, the numbers show that investing in the market in December 1994, 1995, 1996 and 1997 was still preferable to investing in a money market fund, if you held on until the end of 2005, despite the market crash that was coming. Investing in the money market fund was the better course of action in December 1998 and 1999, in the later stages of the bubble.
Source: AJ Bell and FE, total return in GBP from S&P 500 and IA Standard Money Market fund sector average, periods 31st December to 31st December
“There is of course no definitive way to say if we are in a bubble, though the consensus now seems to be that we are. If that’s true, it still doesn’t tell us where we are in the bubble, and whether there may be a further substantial leg in equity market returns to come. As Howard Marks of Oaktree Capital is wont to say- being too far ahead of your time is indistinguishable from being wrong. So where does all this leave investors who are being bombarded with a torrent of bubble warnings and are concerned about their investments?.
5 tips for investors worried about a stock market bubble
“Here are five ideas which can help investors mitigate risk while maintaining stock market exposure.
1. Use regular savings
“Use regular savings to commit fresh funds to the market. Doing so leads to a smoother journey and mitigates the risk to your portfolio of a sharp market correction. This is most effective for those who are early on in their savings plan and whose new monthly contributions are relatively large compared to the assets they have built up. The longer a regular savings plan goes on, the less effective it becomes at mitigating market drawdowns. Some investors may also not be investing money in the market, for instance if they are drawing down their pension, in which case there are other levers that can be pulled.
2. Think about your asset allocation
“You don’t have to invest 100% in shares, you can diversify your portfolio by investing in other assets like bonds, money market funds and gold. Bonds and money market funds are now offering much higher yields than they were in the days of ultra-low interest rates, so you don’t have to entirely give up on returns by adding these to your portfolio. Gold is often seen as a safe haven, but it is volatile, and has been on its own tremendous bull run. Nonetheless it dances to its own tune and may provide some further diversification from shares, though it should only form a small part of your overall portfolio, effectively acting as a bit of insurance against other assets doing badly.
3. Consider multi-asset funds
“Multi-asset funds come in various risk profiles ranging from conservative to aggressive. Investors can therefore pick one which matches up with their own risk preferences, and adjust their risk as their personal circumstances change. These funds invest in shares, bonds, cash, and sometimes gold, property, infrastructure, and other alternative assets too. They’re a one stop shop and useful for investors who want someone else to take care of portfolio management for them.
4. Take stock of your stock exposure
“Within the equity side of your portfolio, make sure you know where your exposure is, and that you’re comfortable with it. In the context of a possible AI bubble this means taking special care to assess your holdings in US technology stocks. These might be found in high levels in unexpected places, such as an S&P tracker, where 38% of the portfolio is currently held in the Mag Seven plus Broadcom. This high concentration leaches across into global trackers funds which will tend to have over 70% invested in the US stock market. These stocks have likely done your portfolio a wonder of good in the last few years, but as a result may now make up a bigger part of your overall wealth and might be due a trim.
5. Be measured with portfolio changes
“If you decide to make changes to your investments, be measured in your approach. One of the liberating things about running a portfolio is you don’t have to take binary directional bets, such as being all in on the tech sector, or all out. You can weight your portfolio to fit a more nuanced view of the world.”
