BUBBLES AND DIVERSIFYING ASSETS
As a large bubble inflates and creates the unbearable FOMO vacuum that sucks almost everyone in, the bubble causes people to sour on otherwise sensible, reasonably high expected-return diversifying investments. One of the signs of the bubble is the expected long-term real returns actually increasing on assets that aren't participating in the bubble.
For example, during the 1999 TMT bubble, U.S. REITs, EM equities, EM debt, U.S. TIPS, Barclays developed gov't debt, and international small-cap equities were all shunned and had their expected returns grow to reasonable levels. You could lend money to Bill and George W. at 4% real because the market loved equities and there was no love left over for anything else! The price of these diversifying investments didn't go up or down much during the 1999 TMT bubble, even though fundamental values did steadily grow, which over time increased the long-term expected returns on these diversifying investments.
Investing in those kinds of bubble non-participants doesn't really protect your mark-to-market relative PโnโL during the bubble. Only being long the bubble can protect your relative PโnโL from the bubble!
However, investing in those diversifying investments does position you well for the bubble burst and deflation, as those investments work well during the deflation stage. Such diversifying investments during the bubble may make sense if you aren't confident about being better at timing the bubble than the next guy.
Of course, those who believe they have the divine touch of market timing will plan to be long the bubble until they can see the eyeballs of the enemy and then rotate to these diversifying investments at the last moment. Godspeed to those of you, whom I know are numerous!
Relating this to my framework about the stages of bubbles:
Steps 5-8:
- Diversifying investments become less correlated with the bubble.
- Diversifying investments start producing disappointing returns.
- Diversifying investments begin to have muted price reactions to legitimately good fundamental news.
Step 9 and after:
- Diversifying investments continue to produce acceptable absolute returns and start producing very good alpha.
- Diversifying investmentsโ past fundamental news will be reinterpreted more positively as new fundamental news arrives.
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Late to convo but the regs and requirements for US etf operators to easily move into the European market are intense. But that is by design. Vested interest do not want robust US financial services competition in their markets or they would get destroyed. Not saying our products/services are perfect, btw