Full Transcript: Andy Constan on Navigating a Bubble Regime

How Investors Can Adapt When Markets Go Parabolic

Justin: Welcome to episode two of First Principles with Andy Constan. Andy, nice to see you again. Last week we sat down to talk to you about the writing that you’re doing on your Substack and on Damp Spring to your clients, and your thoughts on bubbles and the stages of bubbles, and how investors should be thinking about that the way that you think about it, the experiences that you’ve been through in your investing career.

And so where we, I think, left off in the discussion was, you know, what — now if you’re, when you’re thinking about a bubble or a bubble regime, which we’ll talk about, you know, how do you react to that? And how do you think about it, and how does one, you know, how does that inform someone’s investment strategy, portfolio positioning, asset allocation?

So that’s really gonna be, I think, the heart of what we’re gonna discuss today. But I thought maybe where we could start is for those that didn’t listen to that episode, which we certainly encourage you to do, or go and read Andy’s research, could you talk about a recap of the phases of a bubble and how you think of where we are today?

Andy: Yeah. So I’ve written an extensive report for my clients, and I’ll give you a hint of what that looks like. In our last episode, we talked about a bubble regime as being a particular portion of a market phase. Let me just kick that off by repeating what we were talking about, which is most bubbles, pretty much all bubbles, start with some sort of meaningful change.

Often it’s a technological change, but it also can be a regulatory or monetary policy change, or the invention of a financial product that creates a new levering up. And so what typically happens when you have a change — and we saw that — I really like to think of this particular phase as starting in late 2022, where the central banks all recognized inflation.

The first cooler inflation print, and the US Fed in particular was very willing to say, “We’re done with hiking,” which set up for an easing while all equity markets were on their backs. The generals had been shot. And then in January — well, many of us had already started playing with ChatGPT, the sort of first broad release of ChatGPT.

And in January, Microsoft sort of blessed that whole thing by acquiring a piece of OpenAI. And that was the change, a combination of easing and a technological inflection point. You know, AI, for many of us who have been doing big data, statistical analysis, neural networks, machine learning — AI has been part of our lives for over a decade, as far as I’m concerned, in one form or the other.

But it really was an inflection point in which everyone now could play with it. And so that’s the change phase. And typically, what happens in the change phase is early adopters recognize it, and you have what I would call a normal bull market, and we had that. And then there’s an escalation, and an escalation happens for a variety of reasons.

Often, it’s because a central bank will ease into that bubble, and that’s happened in the past. 1998 was a great example where long-term capital had gone under, and the central bank massively overreacted. In this case, the SVB drama, the tariff taco could be seen as being escalatory, um, impact on markets.

And so we started to ramp up. And then I’d say, and this is the key thing — you’ve had the change, you’ve had the normal, you’ve had the escalation. Now you’re in the parabolic, and the parabolic is the heart of what I call the bubble regime. It involves extended — a variety of factors, but one of them is extended expectations, and another is parabolic pricing, market returns.

And so when you enter into that parabolic phase, when it ends is anybody’s guess. I’m not making a call. This is one of the important things when people talk about bubbles. People immediately assume what you’re talking about is calling the top, and that’s not what saying it’s a bubble regime suggests.

It just says it’s different. It’s different than any of the things that are more normal in markets. Normal business cycles, normal bear and bull markets. This is not normal, and that’s what differentiates it. And so I think we’re in that. Could be early, could be mid, could be late. My view is it’s toward the late end, but I’m not calling the top.

The last part of a bubble is the popping, and pretty much all bubbles that pop result in significant market price moves and also ongoing economic hardship. And so that’s basically the picture of my bubble framework, and this particular conversation is about how one, as an investor, should consider tweaking their various investment strategies.

I like to break them up between long only, like what we all do, and market timing or alpha, which is something that some of us do and is very, very hard, but gets a lot of attention from people. And so when you’re in this bubble regime, as I describe it, you need to tweak your investment strategies.

Justin: And if you were to try to hone in on — so yeah. So it’s being more nimble or maybe, you know, being open-minded toward this shifting of your investment strategy. So is it — and just let’s go, let’s sort of start to work through that. Like, what is the — is that the mindset shift? Is that, as an investor, you need to be open-minded to how your process or your investment strategy should be

Andy: changed?

Well, I’d like to think that you’re always that way. Right. But I’d also say that bubbles by their nature — and part of the literal reason why they happen is because of human nature that causes people to make the same mistakes time after time. Usually, it’s different people, frankly.

Like, the people who’ve been through a bubble or two typically don’t make the mistakes of the people that are new to bubbles. But in aggregate, the major thing is literal FOMO. You know, when you’re an investor and your neighbor says, “You know, you guys should be more in stocks than you are, I’m making twenty percent annual returns. You’re making fifteen.” You know, nobody really cares. That doesn’t create emotion in people. They just say, “Well, okay, fine.”

But when your neighbor and your neighbor’s neighbor and your neighbor’s neighbor — everybody but you — is making 100% returns, you can’t ignore that.

And what you do is make the same mistakes that everybody ever does, and that is you chase a bubble, you get involved in the FOMO, you get involved in the hype, and you are late to the party. And so I guess the big difference between my regular investment process and the investment process I wanna use during a bubble is to know myself better.

Know whether I’m vulnerable to FOMO. Know whether I’m vulnerable to — you know, a lot of people say, “Well, you can buy the absolute top of a bubble, and as long as you have a 20-year horizon, you’ll make money.” That’s very true, but if you’re the type that says, “Gosh, I’m such an idiot. I bought the top of the bubble. I need to puke,” you’re gonna make some major and potentially life-changing mistakes.

And so the big takeaway from this, and I’ll repeat it at the end, the big takeaway is bubbles bring out the worst in you, and you should know what you’re capable of.

Jack: One of the interesting things about what you just said is, like, how difficult that is to do, to know yourself. And you made this point in the last episode and, like, I look at someone like you who’s traded through basically every type of market environment that could exist, and you’re openly admitting this is really hard to do.

So I think all of us have to take a step back and say it’s not just like, “Oh, let’s know myself better.” It’s a really, really hard process, and it’s especially hard to the point you mentioned when everyone around you is making tons of money.

Andy: Yeah, I mean, we’re all gonna make mistakes in our lives. You just have to make sure that — all I’m getting at is this is a time in which you’re more likely to make mistakes than other times, and you should just know that going in. And so there’s — if you know that going in, you know a little bit more about how you could react. It’s always critical to know what is going to drive you and how sensitive you are to various things, but that’s a lifelong lesson, and it requires you to fail to actually learn anything, at least.

I mean, I think pain does create progress, as my ex-boss used to say. And sometimes you just have to live through it. But what I’m trying to do here is say, “Hey, you’re gonna do what you’re gonna do.” And you’re gonna make mistakes. And all I’m getting at is here’s a couple of ideas to help you make the same mistakes — ‘cause you’re gonna make them. But at least not really jeopardize your investment performance.

Jack: And we’re gonna get into more detail on this as we go, but I’m just curious, are there any practical things you do from that perspective? Like, I’m thinking maybe some people might rely more on quant type stuff during something like this. Or some people might write a lot of things down to try to challenge themselves. Is there anything specific you can do, or is this just something you’ve just gotta know yourself?

Andy: Ideally — and it’s gonna be dissatisfying to most people who hear it — but ideally, if you’re an investor, you stop looking at the markets. Like, just it’ll be fine. Ignore it. Do anything in your life that is not looking at screens. So any sort of habit that could have you do that, to me is a good one.

And if you’re in a cocktail party or, you know, at a barbecue next door and everybody’s talking about investments, change the subject. It’s — I, listen, it’s hard. Don’t get me wrong. But we’re all constantly bombarded with news. And many of us really pay attention to news, and the news is often wrong, always built to generate emotion in you, to grab you, to make you change your mind.

And it’s very effective in terms of doing that. And so we all deal with this all the time. And so the people that get sucked into one particular news narrative or market narrative, it’s very hard for them to realize that themselves, that they’re getting sucked in.

Jack: In terms of how bubbles resolve, I mean, most people assume — or many people at least assume — that you have to have maybe a crash or a huge bear market on the backside.

And based on your study of bubbles in history, I mean, is that the reality or are there other ways these things can resolve?

Andy: Yeah. I’ve been asking myself, can a bubble not pop? And the way that would happen is — so what is a bubble often? And let’s talk about equities. A bubble often is future earnings expectations are massively overestimated versus what actually will occur, and potentially valuation based on those already elevated expectations are high relative to history.

So those are two common criteria for bubbles. Well, time solves that and has solved that forever, in that the earnings grow. You know, there was a period of time during 2000 in which the market crashed and fiber was oversupplied and compute was oversupplied and companies had over-levered and all those sort of things happened.

And so but these companies ended up making a tremendous amount of money in aggregate. I mean, obviously, when you pick winners and losers, some fail. But in aggregate, earnings are massively higher than they were in 2000. The same thing applies to pretty much everything. So the question is — if you go parabolic, expectations go crazy, and then the market goes sideways for X number of years until everything grows into the valuations, that can happen.

I’m just not sure I’d call it a bubble. Like, it wasn’t a bubble if that was what happened. It was just a little bit of exuberance relative to expectations. I think a bubble needs to pop for it to be a bubble. But people disagree.

So once again, I said this in the last episode, I’ll say it again. Everyone knows what a bubble was in retrospect. That’s for sure. And I think everyone that agrees that a bubble existed, they know it because it popped. So I think today could evolve in a way in which the market never sells off in a meaningful way. And if so, no one will ever look back and say, “This was a bubble.”

Jack: Yeah. It’s almost like without the crash or without the big bear market, it wasn’t a bubble in the first place — right — sort of by definition.

Andy: Yeah. In retrospect, I don’t know how you could — I just don’t know how you could — I don’t think you’d be successful convincing anybody a bubble existed if it never popped.

Jack: You mentioned the different categories of investors, long only and maybe more active.

As we get into those, I wanna first define long only because I think many people who are watching will consider long only — you know, I’m a hundred percent long stocks, or I’m long stocks and bonds. And I know you think of long only in a little bit of a different way. So can you talk about that?

Andy: Yeah. I mean, so when I think about investing generally, I recognize that every asset on the planet — your home, an apartment building, a commercial property, a stock that owns either a private or a public company, a corporate bond, a mortgage, whatever it might be — are all assets. And what is true is that savers own all those assets.

So when you think about asset allocation, the market portfolio — by the way, that also includes gold and things like that — the market portfolio is far more diverse than stocks. And so somebody has to own them, right? All those things have to be owned by somebody. And if you decide to buy stocks, it takes away stocks from the market portfolio that everybody owns.

So you are overweight stocks relative to the market portfolio, and it forces somebody else to be underweight stocks, which forces them to be overweight something else. And that could be bonds, real — all those things. If your force — if by your action you’re forcing others to be overweight something that they would rather not own, they’re gonna charge you for that.

They’re gonna cause you to bid up stocks, and they’re gonna discount those things that they have to be overweight, and that’s expected return. So if you’re only investing in stocks, you’re paying up relative to the market portfolio for that choice, and you’re offering return for the things you didn’t buy.

And to me, what matters is the market portfolio. The market portfolio is the thing that is the free money — that if you own all of the market portfolio, you’re likely to have the best Sharpe ratio. So what is that for me? I own commodities. I own more bonds than most investors, more TIPS than most investors.

I own gold more than most investors, and I own less stocks. But what I own is trying to match the market portfolio. It doesn’t — listen, it doesn’t do it perfectly. There are assets I don’t wanna own that are too illiquid, that are hard to own in a diversified way. So everyone makes their choices about what portion of the market portfolio to own.

But those choices matter. And so for me, I’d prefer to choose from all the assets. They also have the benefit of being diversified. If you own stocks, growth has to beat expectations. Growth doesn’t have to go up — growth always goes up. I mean, the population grows, the monetary base grows, all manner of things grow that are bullish for stocks, but they have to grow more than expectations for you to outperform.

And I don’t know how you can guess that growth is gonna beat expectations, because that means you know something that the world doesn’t. And so to me, being pro-growth is a bias that you shouldn’t have. You can be pro-growth, like be optimistic — that’s a different thing than saying, “I think stocks are gonna — growth is gonna be higher than everybody else does.”

That’s a different thing. If you think growth is gonna be equally as high as everybody else does, you’re not gonna make money by choosing just stocks. And so I choose bonds because I wanna — I could be wrong, and growth could be lower than anybody expects. In that case, bonds diversify.

I choose commodities because they’re pro-growth. I already own stocks, but I don’t mind having something else that’s pro-growth in my portfolio. I own gold because I want to have a monetary debasement hedge, a falling confidence in central banks exposure, and largely an inflation hedge as well.

And so I just wanna own all those things, and that ends up with a lower risk portfolio. Now, if you own equities, equities are riskier, so they’re gonna have an absolute return that’s higher than owning bonds. Bonds are less risky. And so a lot of people chase returns and feel, “I have to own stocks because a five percent corporate bond is only gonna make me five percent, and I need to own stocks because I wanna make ten, twenty percent.”

That’s true, but they’re three times as risky. And so, if you have a return threshold, you have to lever up my portfolio that you don’t have to do with equities only. And people say, “Forget levering. That’s risky.” No. Betting all on growth is risky. Levering a diversified portfolio is less risky, and you can generate the same return.

So anyway, that’s a long story about how to invest that doesn’t require that you own equities. In fact, over the last couple of years, if you owned no equities and just had a reasonable allocation to bonds, gold, and commodities, not only did you outperform on an absolute basis unlevered, but you didn’t experience any drawdowns in April of ‘24 or ‘25 at all.

So there are lots of ways to diversify. Owning stocks is the least diversified way, and there are many better ways. And I just encourage investors to consider other alternatives than just owning stocks.

Jack: I wanna get back to how that changes how you might respond to a bubble. But first, I wanna ask you — you talked about this idea for people who are more of the long-only investors, they should think about lowering their maximum exposure threshold during a period like this.

So can you talk about what you mean by that?

Andy: Sure. So one of the things about — that I think is unique to a parabolic bubble regime is markets trend more than they mean revert, meaning we just go up and to the right until we go down and to the right. We go up and to the right and then down and to the right.

But it trends. And also in a very common way when you’re in a bubble regime, the volatility is also quite low. Realized volatility is quite low. And so what that means is that your personal portfolio experience is pretty casual. Like, you don’t have any drawdowns. You make money every day. It’s not very volatile. You just keep making money every single day.

So what do you do when you’re faced with that situation? Most people say, “Hey, this is just gonna keep going on. Let me lever up. Instead of owning a portfolio of semiconductor stocks, let me own the hottest semiconductor stock. Instead of owning the S&P 500, let me own the QQQs. Instead of owning the S&P 500, let me buy calls on the S&P 500. Let me buy on margin.” All of those things are the natural thing to do if your portfolio is trending with low volatility.

It’s just a natural thing to do. In fact, bubbles expand because people do that. They look at their portfolio and say, “I don’t have enough risk. I’m never losing money. Why wouldn’t I put more risk on?” And so that’s what people do.

Now, stepping back — that’s what you really should do. Like, if you had a proper measure of your own portfolio and said, “Hey, based on my multi-year outlook or even multi-month outlook, my portfolio is gonna be less volatile than I’m willing to suffer,” that’s when you should be taking on more risk. You should add risk in that case. And when your outlook for your portfolio is, “Geez, I think it’s gonna be a really volatile environment going forward,” you should probably de-lever somewhat.

And that’s an investment concept called risk targeting, vol targeting. And while there are funds that specifically do that — when their expectation of volatility is falling, they lever up; when their expectation of volatility is rising, they de-lever — they do that systematically. But we all do it. When we’re in the midst of a drawdown and we’re experiencing high volatility, we all cut our exposures, cut our losses. When we are experiencing low volatility and positive returns, we all lever up.

So we’re all risk targeters in some basic way, and it’s a just a very classic and sensible thing to do. Except what it tends to do is, when risk is perceived to be very, very low in your portfolio, you lever up a lot, and that’s the worst possible time to lever up. And so the way to confront that generally — not just during bubbles, generally — is you’re skeptical about your own ability to measure your future portfolio risk.

And because you’re skeptical, you cap how much you’re gonna lever up. Like, no chance I will ever have more than thirty percent more assets than I have cash. That’s a could-be rule. That happens to be my rule. I also, even in the most volatile times, I’m always long — only 50% of what I normally allow or allocate, but I’m always long, even in the most volatile times.

So the unique thing about a bubble regime, as I mentioned, it’s trending and it’s low vol, which makes investors believe that their portfolio is very, very low risk. And the mistake that they make is they lever up at the absolute time when they shouldn’t be, and that inflates the bubble.

That’s literally the mechanism that inflates the bubble — people levering up. And so what I do in a concrete way in my long-only portfolio is that 130% rule I used, I bring it down. I say, “You know what? This is a bubble regime. I will never take more than 110% exposure to the market. I’m normally willing to take 130%, but this is different. I’m gonna lower my max leverage and just operate that way.”

Jack: How do you think about this from the perspective of a stock and bond investor? Like, on one hand, you could argue — if you’ve got a pretty balanced portfolio, your response to this might be nothing. On the other hand, maybe you could argue in terms of this maximum exposure limitation, you could say someone could slowly take down their exposure in a bubble, which is, I guess, some form of market timing, but in reality, just slight risk reductions.

Like, how would you think about that type of thing?

Andy: So that’s the re-weighting thing. So in a bubble, what is likely to happen is — let’s say you’re sixty/forty. Let’s just say that’s a perfectly fine diversified portfolio. It’s not mine — I like some gold and commodities — but let’s just say you’re sixty/forty, and stocks go up fifty percent.

Well, all of a sudden, you have ninety dollars’ worth of stocks, and you still only have forty dollars’ worth of bonds. You are way higher than sixty/forty. So typically, what prudent investors would say is, “I really only wanna be sixty/forty all the time.” And so they sell into the rally. They rebalance.

And that’s how most investors operate. I encourage that type of thing. But it’s interesting. Every time you rebalance, you’re setting your risk target back to what it was because you were out of balance. You were more risky. Okay, fine. That has a cost. Every time you trade, you’re paying some sort of transaction cost.

I know they don’t charge commissions on retail platforms. Let me tell you — Jane Street and Susquehanna and Citadel, they aren’t making that money because you’re not paying any costs. Their profit is your cost. And so every time you trade, every time you rebalance, you’re paying a cost. And so I discourage rebalancing unless you’re really out of balance.

In a bubble regime, you actually can lower your costs by rebalancing even less than you normally would, because the markets trend so much. The best thing about a trending market is rebalances — avoiding a rebalance has a positive return, meaning not selling into the rally has a positive return. So again, it’s just a tweak. I’ve already told you I won’t take a lot more risk, but I am willing to let my winners run a little bit more in a bubble regime.

Jack: How do you think about cash? Because cash could be a lot of things in a bubble regime. It could reduce your risk. It could give you optionality to buy later.

Like, how do you think about cash in a bubble regime?

Andy: Yeah, I mean, let’s talk about what’s reality, right? I mean, here we are as investors, as humans who do our jobs and make money in some way. We may own a business. We may be an employee of a business. Whatever it might be, we earn money doing something that is not trading.

I’m talking about the main — I’m not talking about degenerates that are watching us, that are trying to earn their whole livelihood off of trading. I’m talking about real people who go about their lives, meaning all of us. So what happens? We earn some money. Hopefully, we earn enough money that we can meet all of our obligations and save.

And so each paycheck, we save a little bit. And typically, what we do is we invest that. In fact, it usually is pretty mechanical. Most of us have 401Ks in which we contribute regularly. We also have our savings plans in which we take our after-tax savings and just invest it every two weeks. Every time it comes in, we invest it.

And that’s a very passive investing style. Occasionally we have a windfall amount of cash that comes our way. I was dealing with somebody today, a client who had an IRA inheritance from a relative. And that relative had all bonds in that IRA. And now this client had only bonds — a windfall. Not a life-changing windfall, but a windfall. And his question was, “Should I change the investment?” And my answer was, “Of course, you should.”

Your portfolio that you had before you got this windfall, you liked. This portfolio is different than that. What if it was just cash? Well, you should be invested in what you own. And so that talks about lump sum investing. And the basic answer is it pays for you to be out of cash in assets. Time in market is the classic thing. If you are in cash, you are missing out on the ability to collect risk premium, and risk premium is free money.

A portfolio — most any construction looked over an extended period of time, whether it’s mine, which is more like a Bridgewater all-weather portfolio, or a sixty-forty, or all stocks, or even all long-term municipal bonds — you outperform cash over time. And so if you’re in cash, returns are passing you by. So conceptually, if you have savings, put it in the market. That’s my view.

Now, at the same time, some people don’t like the market. They wanna try to time the market. And this is — we’ll come back to knowing yourself. If you wanna time the market, you better be good at it. You’re probably not. So the best thing to do economically is to just invest cash as you have it and keep your risk target.

Now, let’s talk about risk target. If the only portfolio available to you is gonna give you a ten percent realized volatility and the possibility of a twenty percent drawdown each year — that may be unacceptable to you because of your personal situation. If those sort of risks are unacceptable to you, you can’t own that portfolio. You have to have some cash on the sidelines. And so you have to know your risk target.

But once you have a risk target, the amount of cash you hold — or margin you’re using — should be calculated versus your risk target, not based on, “Hey, I think the market’s gonna get cheap.” That’s alpha, and you probably don’t have it.

Now, let’s talk about psychology. If you’ve got a lump sum today — I mean, I think for the passive investor who contributes a little bit every month, the odds that they’re gonna say, “You know, I’m just gonna take a break and not contribute for a few months because I think the market looks pretty high.” But if you’re sitting on cash or you get a cash windfall for some reason and you say, “Should I invest all this cash immediately into the portfolio I like?”

This is where you have to know yourself, because you have to distinguish between the following thing. If you put all the money in as a lump sum today and the market falls 10%, are you gonna be pissed? Are you gonna act? Meaning, are you gonna say, “Gosh, I am such an idiot. I put it in at the top. I’m now gonna take it out and get back into cash because I was stupid and I should’ve taken time to invest it”? Are you one of those people? There are lots of people like that.

That’s for the people who invest a lump sum all at once. Other people say, “You know what? I’m gonna invest in a dollar cost averaging way, this big lump sum a little bit every month.” And so what happens to them when the market rallies 10%? They’re gonna say, “Ugh, God, I should’ve just invested the whole thing.” And so they may have had a plan to put one-tenth in for the next 10 months, and they put one-tenth in, the market ran away from them, and they say, “Screw it. I’m putting nine-tenths in right now because I have FOMO. I can’t miss this.”

Well, of course, the next thing that happens to them is — the plan that they had, which was sensible, 10 months of a little bit each month — now they’re 100% invested, up 10%. Now, it could work out for them, but more likely, they’re gonna say, when there’s a 5% drawdown or a 10% drawdown, “Ugh, why didn’t I do the thing I said I was gonna do?” And they’re gonna reset back to this plan of slowly investing.

So you have to know yourself to say — am I gonna chase when I’m sitting in cash? If you are that type of person, don’t use DCA, ‘cause you will definitely make a mistake.

On the other hand, if you really suffer from buyer’s regret and you’ve decided, “Hey, I’m gonna do a whole lump sum because that’s the economically smart thing to do,” and you don’t realize that you are the type of person that has very painful buyer’s regret, you’re gonna make mistakes.

So again, it’s all about knowing yourself. Are you more sensitive to FOMO pain, or are you more sensitive to buyer’s regret type pain? And plot your strategy that is consistent with who you are.

In terms of knowing yourself during a bubble — a bubble is going to be FOMO on steroids, and it’s gonna be buyer’s regret on steroids. So what I recommend is just invest in what your portfolio is at your desired risk target and live through it. But if you’re trying to market time with a bunch of cash — and you hold cash on the sidelines or you put it all in at once — your FOMO or buyer’s regret is gonna be on steroids, and you’re gonna make terrible mistakes.

So this is where it’s critical that you really say, “Am I a FOMO guy, or am I a buyer’s regret guy?” And really know, because if not, you’re gonna mess this up. So anyway — you wanted to ask about alpha strategy.

Jack: How about for more active investors? We’ve talked about long-only investors. I know you run an alpha portfolio at Dam Spring, and that’s for your subscribers, so we’re not gonna talk about what’s in it. But I am curious, do you change the rules in a period like this?

Do you have different rules? Do you run different strategies? Are there things you do differently in that portfolio because you think we’re in a bubble regime?

Andy: Right. I mean, this is a complicated question for sophisticated investors. I think the first thing one should think about when doing any alpha trade is — do you have alpha?

Like, if you don’t have alpha and you don’t know why — if you don’t know how you have alpha — you don’t have it. If you go into a casino and you win at blackjack and you don’t know how to count cards, you don’t have alpha. If you win at the poker table and have no idea about poker strategy and you just happen to win, you don’t have alpha.

So you should probably know what your strategies are that you think have alpha. If you don’t, a bubble regime is simply just the payouts of bets are gonna be bigger. The losses are gonna be bigger, the gains are gonna be bigger. And in that case, the simple answer is: in a bubble regime, for somebody who doesn’t have alpha but likes the casino, size down. That’s simple.

Now, there are so many alpha strategies out there. There’s stock picking, which requires a whole set of things to understand companies. There’s relative value trades. There’s momentum strategies. There are mean reverting strategies, all manner of strategies. There are macro strategies — that’s what I focus on — in which you try to tie together multiple asset classes, what they’re saying, what they’re priced relative to the macro regime, all of those things.

So what I’ve noticed in looking at bubble regimes is strategies that work most of the time don’t work as well in bubble regimes, except for one: momentum strategies. And boy, do mean reversion strategies not work in bubble regimes. So if you’re a swing trader, or if you have a mean reverting strategy, I’d be concerned.

A lot of relative value trades are mean reverting strategies. You buy one thing, you sell the other. When one thing’s rich and the other thing is cheap, you buy the one and sell the other, and then it mean reverts. Well, the problem is that the thing that’s getting rich is the thing that’s in a parabola. And so you’re gonna get burned. You’re gonna get taken out.

So this is what I’m saying — know what your alpha is, and then on top of that, know that your alpha is probably less than it has been, because your sample set that you’ve used to train your alpha, train your mind, use your strategy, doesn’t include very many bubble regimes, if any.

So degrade your expectations for returns, and probably upgrade your weighting on momentum factors, because the markets trend in bubbles. That’s the big takeaway in terms of those things.

But one of the things about this that’s interesting — I remember Alan Greenspan talking about irrational exuberance. He said that in December of 1996, four years before the bubble topped. He was early. He doesn’t know — he had no idea, and he’s the chairman of the Federal Reserve. And so part of the thing that happens in radical technology changes, subsequent bubbles, all that sort of thing, is policymakers don’t know what to do.

And if they don’t know what to do, and your alpha strategy is predicting what they’re gonna do, how can it be as good? They’re just normal people. They operate in things, and this is outside their sample set. And so they become unpredictable, which says to me: degrade your alpha strategy.

And then another topic which I find happens all the time is when a bubble is occurring, it’s typically in a particular asset class or a large portion of an asset class. It may affect the overall asset class, but it’s broad enough to really matter to everybody, but also somewhat narrow. And so that leaves a lot of asset classes sort of boring. And there are lots of silos in the world. And so if you’re a fixed income relative value trader in an equity bubble regime, your asset class may go to sleep.

You know, it just may sit there and not move around much because all the hot money is in the bubble.

And so that means there’s lower alpha for you because the thing you trade doesn’t move around as much. And so what happens — it also appears less risky. So instead of doing a trade where you might have five basis points of edge that you lever 20 to one to make a nice return, you see that there’s no five basis point opportunity anymore. There’s only three basis point opportunities. So you do them and you lever them 25 to one.

That’s how trades get crowded in non-bubble space. People compress their returns — what they need to return — and add leverage just so that they can continue to earn. And so in a bubble regime, when it breaks and your volatility explodes across all assets, that’s when those positions can unwind and create contagion.

So for non-bubble asset classes, I would just stick with your discipline, not squeeze every penny out of the trades that you know.

Justin: Well, I always had thought it was the size of Greenspan’s briefcase that was the indication of how big the bubble was gonna be. That was the indicator. But on contagions — let’s just, I mean, I think within all bubbles, there’s this contagion theme that can emerge and happen. And just, Andy, let’s talk about what that term means and then how investors should think about when the market reaches a contagion-like atmosphere.

Andy: Right. So there’s two phases. There’s the escalation phase, and there’s the other side.

So in the escalation phase, anybody who’s short equities — either explicitly or unbeknownst to them exposed to equities rallying — there are some classic examples of that — gets blown up. And so when it gets blown up, the positions get unwound. That drives the market up.

Now, it’s possible, but it’s pretty rare, that when they get blown up, they have other — the contagion is an investor blows up and happens to own something else that they have to sell. The thing that they blew up on, they close out. But their investors redeem from them, or they get margin called, and so they have to sell something else. And that something else, somebody else owns, and that starts cheapening, and so now they have to sell that and something else. And that’s how a contagion flows through the market.

In a bubble regime parabolic move, there’s so much liquidity going on that even when you’re having a short squeeze that’s causing real pain for real investors and potential contagion because they have other stuff — there’s so much liquidity that that stuff that they also have to sell gets easily absorbed by the system.

And so it’s very rare that you have a short seller killing the bubble because of contagion. On the other hand, after the bubble pops, every bubble has had contagions. Because now everybody needs to get out, and they need to get out of other stuff, and that stuff needs to get absorbed.

And in many bubbles, there’s so much leverage in the system that financial intermediaries are unwilling to provide credit. And sometimes — in 2008, not only are they unwilling to provide credit, they need credit themselves. And so they are forced to unwind, and there’s no buyers. And so that sort of contagion then influences the real economy because nobody’s able to borrow for securities prices, leverage.

They certainly aren’t willing to borrow for business investment or mortgages or whatever it might be, and that’s how it flows through to the real economy. And so when I think about a bubble regime — and I’m not trying to call the top — I’m just trying to say it will top, and when it does, there’ll be a contagion on the other side.

And I just wanna think about that. I just remind myself that I can’t pick the top, and there’ll be a contagion afterwards. And so if I have those two thoughts in mind at once, that should inform what I do today.

Justin: I remember in ‘08, in the middle of the financial crisis, it was like people were afraid to be long going into the weekend because they really didn’t know the next major institution that was going down or what was happening with stocks.

So that was a — I think when you hear stuff like that, that is a telltale sign that contagion has now kind of taken over the market.

Andy: Yeah. And by the way, there’s lots of alpha on the other side for the people that are not puking. And that’s part of what I’m getting at. If you are preparing for the other side — not shorting, trying to pick the top — but thinking where will the contagions be?

You can get ahead of it. Once the bubble pops, you can get ahead of the contagions. And so I think there’s real alpha in just game planning that. Not saying, “I’m gonna short ‘cause I think it’s the top,” or “I’m gonna do all these trades because there will be a contagion.” But saying, “There’s gonna be a contagion. I don’t know when it’ll happen, but I’m prepared when it does. I’ll have capital ready to deploy, and I’ll know where to deploy it.”

And so it’s just looking past the top of the mountain, not saying we’re at the top. And that’s just what I’m doing. Wherever I can think of trades that — if we are in a tech bubble and if it pops, where will the contagions be? But first the bubble has to pop for me to do the trade. That doesn’t mean I can’t prepare for it. And it’s just not something you need to do during normal regimes. Normal regimes don’t have contagions. They just don’t.

Justin: Great. Thank you, Andy. I’m glad we were able to circle around and do this follow-up to the last one. We really appreciate your time, and we will see you next month.

Andy: Sounds great.