Two Strategies to Manage the Market’s “Irrational Exuberance”

by Nicholas Vardy
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"Irrational exuberance is the psychological basis of a speculative bubble. I define a speculative bubble as a situation in which news of price increases spurs investor enthusiasm... bringing in a larger and larger class of investors, who, despite doubts about the real value of an investment, are drawn to it partly through envy of others' successes and partly through a gambler's excitement."

- Robert J. Shiller, Irrational Exuberance

Yale University professor and Nobel laureate Robert Shiller is worried...

Last week, in an interview at the annual World Economic Forum in Davos, Switzerland, Shiller highlighted the unsettling parallels between today's stock market and where it stood in 1928 - the year before the Wall Street Crash of 1929.

Like then-President Calvin Coolidge, Donald Trump is a business-friendly president.

(Recall it was Coolidge who said, "The business of America is business.")

Like Coolidge, Trump is anti-regulation.

And like Coolidge, Trump is overseeing a rapidly expanding U.S. economy.

The result?

There is an "irrational exuberance" among investors that has made the U.S. stock market overpriced by all conventional measures.

According to Shiller's own favorite measure - the cyclically adjusted price-to-earnings (CAPE) ratio - the U.S. stock market is trading at a level of 30.5.

That's higher than any time since the dot-com bubble burst in 2000. And it's been that high only one other time in history... 1929.

Save Your Wealth and Profit From the Bear

No one can accuse me of being a doom-and-gloomer.

After all, only two weeks ago, I wrote how the Dow could hit 2 million in the next century.

At the same time, I also recognize that financial markets move in cycles.

Sure, the U.S. stock market could rise another 50%.

After all, the S&P 500 hit a CAPE ratio of 44 at the peak of the dot-com boom.

Still, in my mind, a bear market is not a question of "if" but "when"...

That's why it's crucial you have a plan for when the bear market finally does arrive.

Here are two strategies I recommend...

1. Set Trailing Stops on Your Long-Term Positions

The U.S. stock market has gone almost straight up since March 2009.

Yet financial history tells us that Wall Street rarely gives investors such a smooth ride.

Even the world's best investor - Warren Buffett - has suffered massive drawdowns in the past.

Buffett's Berkshire Hathaway Class A shares suffered 37% losses in both 1987 and 1989, endured a 49% loss between 1998 and 2000, and lost 51% from 2007 to 2009.

As Buffett has warned... "Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market."

In a bear market, "buy and hold" becomes "grin and bear it."

Here's why I think what Buffett says does not apply to you...

Buffett couldn't sell in a bear market even if he wanted to - Berkshire Hathaway has simply become too big.

As well as you may have done in the market, it's unlikely this restriction applies to you.

In fact, your ability to sell during any major market downturn is your biggest edge over the "smart money" on Wall Street.

You don't have to endure the 50%-plus drawdowns that Buffett says are inevitable.

The Oxford Club recommends you set trailing stops of 25% on all of your long-term positions.

I urge you to ensure you have those stops in place today.

2. Prepare to Bet Against the Market When It Turns

Value investing legend Sir John Templeton made his first fortune investing in the economic recovery of Germany and Japan after World War II.

It is less well-known that Templeton made his quickest fortune shorting 84 Nasdaq stocks in January 2000 at the height of the dot-com boom.

Templeton's timing was almost perfect.

For two months, his short positions went against him.

But by March 2000 - as the boom started busting - Templeton's bet against the dot-com stocks looked ingenious.

Templeton made tens of millions of dollars in a matter of months.

As Templeton put it, "It was insane, and I took advantage of the temporary insanity."

Today, you can replicate Templeton's strategy at the click of a mouse.

Unlike in 2000, you can buy inverse exchange-traded funds (ETFs) that bet against - or "short" - the U.S. and other financial markets.

In fact, you can even leverage your short positions.

While I'm not ready to bet that global stock markets are about to fall off a cliff...

I will tell you the right ETFs to buy when they do.

Why You Should Ignore Both Shiller and Buffett

Robert Shiller warns us about the dangers of irrational exuberance and an inevitable, painful and costly stock market collapse.

Warren Buffett advises us that, when a bear market arrives, we need to just suck it up and wait for the market to recover.

But neither Shiller's nor Buffett's advice will offer much comfort as you watch your life savings evaporate before your eyes.

So use the two strategies I outlined above to both help preserve your hard-earned wealth...

And generate John Templeton-like gains as the stock market tumbles.

Your financial prosperity depends on it.

Good investing,

Nicholas

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