Investors should keep away from bubble assets such as US technology stocks, bitcoin and Elon Musk’s Tesla and seek out the ‘anti-bubble’ opportunities – those that are implausibly cheap – according to analysts at Research Affiliates.
Financial bubbles are a major concern to investors. The collapse of the last major bubble in US property in 2007 set the scene for the worst financial crisis in modern history.
Bubbles are a risk because their impact can only be definitively measured in hindsight after a market correction, an impact we are still experiencing today will continuously low interest rates.
As such, Research Affiliates founder Rob Arnott and head of research Shane Shepherd have highlighted three bubbles in markets now that are worth avoiding.
The first bubble identified by the pair is Tesla, the electric car manufacturer overseen by Elon Musk.
Arnott and Shepherd have previously argued that the company is an example of a single-asset micro-bubble because it “has little chance of delivering the heroic future cash flows needed to service its debt, let alone justify the valuation of its stock”.
The stock, which is a favourite of Scottish Mortgage’s James Anderson, has seen its share price soar in recent years with little justification, according to Arnott and Shepherd.
“Interestingly, although the company’s valuation is based on explosive growth and profitability that is ‘just around the corner,’ that has been the case for seven years reflecting an ongoing battle between expectations and reality,” they said.
Source: Research Affiliates
A series of announcements of new models and vehicles have kept share prices high but the company has failed to produce consistent profits.
“The Tesla experience illustrates the large challenges in predicting the evolution of bubbles,” Arnot and Shepherd said. “Expectations can keep prices at bubble levels for years until suddenly the bubble asset loses its magic and the market outlook switches dramatically.
“In true bubbles, we should expect them to soar—until they don’t.
Annott and Shepherd added: “While the stock has come off its highs, its valuation remains at a point well above that justified by even optimistic expectations of future cash flows. Thus, avoid.”
Another popular investment that the Arnott and Shepherd said is a major bubble risk is cryptocurrency, bitcoin.
Gaining popularity from its anonymous transaction element, it underwent an aggressive rally after selling off in 2018.
“Is this just volatility or a true bubble?” they asked. “Based on our definition, plenty of bubble indications remain.
“If bitcoin truly becomes an accepted currency, no valuation ‘model’ for it exists other than what the public chooses to believe it’s worth, much the same as for the dollar or any other fiat currency.”
The pair added: “Consistent with our definition of a bubble, cryptocurrencies hold little chance of offering a positive risk premium relative to bonds or cash based on a reasonable expectation of future cash flows, which are by definition zero.
“Predicting near-term price direction is a fool’s errand, but any expectation of a higher price going forward rests solely on the hope of selling to a future buyer at a higher price.”
Finally, the pair offered up technology stocks as another example of a bubble.
“Whereas the bubble is most evident in the large-cap technology stocks, market cap-weighted indices correspondingly rely on these pricey names to drive returns,” they noted. “The more concentrated these top names are within an index, the larger the bet being made on these holdings.”
“The concentration of market weight in these top technology names is at a level not seen since the build-up of the dotcom bubble.”
Indeed, the Russell 1000 now commits more than 14 per cent to Facebook, Amazon, Netflix, Microsoft, Apple and Google-parent Alphabet.
Performance of Russell 1000 over 10yrs
Source: FE Analytics
With the notable exception of Apple and Microsoft, other tech names do not justify current valuations and some even qualify as ‘zombie companies’ which need new capital just to pay the interest on debt.
Part of the reason for this is that all of these tech stocks are in serious danger if another financial crisis occurred.
“Even in a turbulent market, most of these tech stocks are trading at valuations nearly as rich as they have ever traded,” they said. “The volatility in the fourth quarter of 2018 should serve as a strong reminder of the risk inherent in any investment strategy: the assumptions a strategy is based on must be right in order to derive long-term profit.”
Arnott and Shepherd said identifying bubbles in real time can add considerable value for the patient investor. But being able to identify a bubble does not guarantee that a bubble will burst at all, or a timeline of when it will happen.
While there are several bubbles in markets, currently, there are also ‘anti-bubbles’ that are more common than the market realises.
Once such “anti-bubble” is “unloved and shunned” state-owned enterprises within emerging markets.
“Many investors choose not to own them at any price,” they said. “Yet many of these entities are earning substantial profits and are trading at levels that require implausible projections to not meet the future cash flows priced into their shares.”
While there is a real risk of the state expropriating profits if they want continued access to international capital markets they will need to return some to external shareholders.
“The state-owned enterprises and governments that most support growing shareholder rights and the rule of law will be best able to expand their access to global markets,” they noted.
Closer to home, the UK stock market, offers up an attractive ‘anti-bubble’, which Arnott and Shepherd said were made more desirable by Brexit, especially if the outcome of a hard Brexit becomes more likely.
“The MSCI UK index offers a dividend of 4.52 per cent— even higher than the dividend yield of our basket of emerging market state-owned enterprise stocks,” they said. “The market is pricing UK stocks at 13.8x earnings, a full 25 per cent discount to the MSCI World level.”
Price performance of FTSE All Share vs MSCI World since 1 January 2017
Source: FE Analytics
Since the UK share prices have been flat since 2016, Brexit would have to destroy a significant amount of value in order to nullify this “compelling risk premium”.
“An overhang of uncertainty is keeping the discount in place,” they said. “The capital markets hate uncertainty. A resolution in either direction will reduce the uncertainty and should encourage some capital flow back into the U