Dealing with market bubbles

Poon How Ee
12/8/2013

A CONTRARIAN approach to deal with bubbles and exploit market inefficiencies is through the deceptively simple strategy of value investing.

Perhaps the most delighted of investors when markets crash are value investors like Warren Buffett. They see crashes as opportune moments to pick up stocks cheaply, way below their "intrinsic value".

Booms, or periods of irrational exuberance, are extremely frustrating for risk-averse value investors, who find it hard to identify undervalued stocks in the face of soaring stock prices.

Many opt to hold cash or invest in fixed income assets, reduce their exposure to stocks, and just wait for that "Minsky moment" before striking like bargain hunters in a discount store.

Timing the market during boom-bust cycles is not easy. Nevertheless, empirical evidence shows that even without market timing, value investing outperforms the market if investors are willing to take a long-term perspective.

Sticking to the principle of buying cheap stocks and avoiding popular growth stocks usually protects conservative value investors from the worst crashes and puts them in a good position to recover from the positive correction afterwards.

Three critical factors are then necessary for value investors to avoid these bubbles:

The first is to avoid leverage. As mentioned above, having a long-term perspective is integral in value investing and that requires strong holding power. There can be nothing worse than being forced to liquidate your positions when they are least favourable and during times that you should be buying.

The second is to have a margin of safety. Following Benjamin Graham's instructions, buying a stock only when it is way below its intrinsic value is the best way to manage risk and protect investors from mistakes in valuations.

In times of bubbles, it will also steer investors clear of overvalued stocks.

The third tip is patience. Indeed, the investor's worse enemy is often himself. Not following the market when everyone is exuberantly buying and making heaps requires great fortitude and patience, knowing that the market will eventually correct itself.

And buying when the market is continuously falling to levels below its intrinsic value requires confidence that it will eventually rise and patience to wait it out.

Sir John Templeton, founder of the Templeton funds, summed up this investment philosophy well when he said: "To buy when others are despondently selling and to sell when others are greedily buying requires the greatest fortitude and pays the greatest rewards."

At this stage, proponents of the Efficient Market Hypothesis (EMH) can no longer deny the existence of bubbles and its implications for certain assumptions of the EMH.

Their arguments that market participants are rational and that they make decisions independent of each other are seriously flawed, especially during times of exuberance and panic.

However, some still hold on to the EMH, insisting that the disproof of the capital asset pricing model (CAPM) and Fama French multi-factor models do not prove that EMH fails, but merely that these models are still insufficient in capturing all possible risk factors.

Some have moved on to try to propose new models that try to account for systematic deviations from rationality, which is an approach that looks promising.