- It’s possible to remain profitable even when the market collapses – if you use the right investment strategies.
- Today, Nicholas Vardy explains how to identify and profit from financial bubbles.
I love a good old-fashioned financial bubble.
Some market pundits prefer to parse company balance sheets and income statements in the hopes of unearthing value.
Contrast this with the art of profiting from a financial bubble…
There, you focus on identifying a situation where investors have piled into overpriced assets with the hope they’ll keep rising.
Get your timing right in shorting, or betting against, a bubble and you can make a lot of money very quickly.
As a bonus, you also get to feel smart while railing against the irrationality of the herd.
How to Spot a Bubble
A new paper from Research Affiliates titled “Bubble, Bubble, Toil and Trouble” provides a useful framework for identifying a financial bubble.
A bubble has two major characteristics.
First, the paper explains “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.”
That’s a fancy way of saying an asset is overvalued – and there is no justification for investing in it.
Second, most investors know this. But they don’t care. They buy the stock or asset no matter how ridiculous the valuation is.
Why? They expect to sell to a greater fool in the future.
These assets can be anything. They can be Dutch tulips in the 1630s, Florida real estate in the 1920s or dot-com stocks in the late 1990s.
What is today’s financial bubble?
According to Research Affiliates, it’s U.S. tech stocks. Think of market darlings FAANG stocks – Facebook (Nasdaq: FB), Amazon (Nasdaq: AMZN), Apple (Nasdaq: AAPL), Netflix (Nasdaq: NFLX) and Google parent company Alphabet (Nasdaq: GOOGL) – and Tesla (Nasdaq: TSLA). And you can throw in bitcoin and other cryptocurrencies for good measure too.
How to Profit From a Bubble
It’s one thing to identify a bubble. It’s another thing to profit from it.
If you buy into a bubble, you risk buying at the top. If you sell short (bet on the price falling), you risk that the stock will keep going up.
Things can go wrong on both sides of the trade. Examples of brilliant people in history who have gotten burned by bubbles abound.
Sir Isaac Newton lost the bulk of his fortune by betting on the South Sea bubble. As Newton put it, “I could calculate the motions of the heavenly bodies, but not the madness of the people.”
And as economist (and failed speculator) John Maynard Keynes observed, “The market can remain irrational longer than you can stay solvent.”
How to Profit From a Market Collapse
Despite Newton’s and Keynes’ experience, I’ve made money betting against bubbles.
That’s due in part to skill… and in part to opportunities Newton and Keynes did not have. Today, exchange-traded funds (ETFs) allow me to bet against the market as easily as buying or selling a stock.
Every day, I track several dozen inverse ETFs. These are ETFs that go up when the rest of the market goes down.
Say you buy the ProShares Short S&P500 (NYSE: SH). If the market drops by 2% that day, this position will rise by 2%.
Buy the Direxion Daily S&P 500 Bear 3X Shares (NYSE: SPXS) – a triple-leveraged bet against the S&P 500 – and it will rise by 6% that day.
And if you want to profit from the bursting tech bubble by, say, shorting the FAANG stocks, you can buy a triple-leveraged bet against them with the MicroSectors FANG+ Index -3X Inverse Leveraged ETN (NYSE: FNGD).
Invest in inverse ETFs at the right time… and not only do you never have to worry about the market going down but you can profit from the drop as easily as when the market goes up.
You need to follow the market closely – and know which ETFs to buy.
Interested in hearing more from Nicholas? Follow @NickVardy on Twitter.