“The bull walks up the stairs. The bear jumps out the window.”
– Wall Street adage
I’ve written a lot recently about financial bubbles… and how we may be in one.
Several readers have also contacted me in the past few days with the same question.
“Nicholas, if indeed we are in a financial bubble, how can I profit from it?”
That’s the question I will answer today…
Let’s start with the current state of the markets.
Tech stocks sold off sharply in the past two weeks, their worst pullback since the market bottomed in March.
On the one hand, tech stocks may overcome their jitters this week.
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Seasonality is in their favor. The period between November and May is historically the strongest time of the year for the U.S. stock market.
On the other hand, the sell-off in technology stocks may be the start of a sustained market move down.
Even if this pullback isn’t sustained, it does highlight your need for a strategy for when the market bubble does pop.
Luckily, today there are more ways than ever to profit from a market downturn.
Let me explain…
The Challenge of Making Money 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 or near the top.
If you sell short (bet on the price falling), you risk that the stock will keep going up.
You can be wrong on both sides of the trade.
And you wouldn’t be alone.
Many brilliant people in history have gotten burned by bubbles.
Sir Isaac Newton – the father of mechanical physics and calculus – lost a 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.”
How Sir John Templeton Made a Fortune on the Dot-Com Bust
You don’t need a Wharton MBA to make money from the popping of a financial bubble.
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Being a student of human psychology and financial history will serve you far better.
Take the example of Sir John Templeton, the pioneer in global investing.
Templeton is best known for investing in Japan in the 1950s. That was when “Made in Japan” was synonymous with cheap toys and shoddy merchandise.
At one point in the 1960s, more than 60% of the Templeton Growth Fund’s assets were in Japan.
Templeton also had the savvy and discipline to exit Japan when it became overvalued. He sold his positions in Japan well before the stock market collapsed in 1989.
Most importantly, Templeton had a grasp of financial history – and the ebbs and flows of financial markets.
In 1999, Templeton predicted that most internet companies would be bankrupt within five years.
He then put his money where his mouth was and very publicly shorted the U.S. tech sector in December of that year.
At first, his positions went against him.
But by March 2000, Templeton’s bet against the dot-com stocks turned profitable. He made $90 million in a matter of months.
And with the benefit of 20/20 hindsight, his timing was almost perfect.
It’s a terrific irony that Templeton – a global value investor – made his quickest fortune by shorting U.S. stocks at the ripe old age of 88.
How to Profit From a Looming Market Collapse
Like Templeton, I’ve also made money betting against stocks.
But I’ve had it easy.
I have opportunities that Templeton did not have.
[Learn More: See Why Billionaires are Flocking to this Tiny Niche of the Tech Sector]
Today, with the help of sophisticated software Templeton could not even dream of, I can track hundreds of ETFs (exchange-traded funds) trading on U.S. stock markets.
These ETFs track hundreds of different strategies for different types of markets.
That makes today a special time in financial history.
As recently as the global financial crisis of 2008, most investors were powerless in the face of a sharp market sell-off.
Betting against the market by selling stock short required special permission from your broker. Shorting was also expensive. Trading futures was even further out of reach.
That has all changed with the advent of specialized ETFs.
Today, inverse ETFs allow you to bet against the market as easily as buying or selling a stock.
Say you’re convinced tech shares are set to crash and you want to profit from that sharp downward move.
You can bet against the Nasdaq-100 by buying the ProShares Short QQQ ETF (NYSE: PSQ).
If the index drops 10% today, this ETF will rise by the same percentage.
There are even leveraged versions of this short bet.
Invest in the ProShares UltraShort QQQ ETF (NYSE: QID), and when the Nasdaq-100 drops 10%, the fund will jump around 20%.
Finally, the ProShares UltraPro Short QQQ ETF (Nasdaq: SQQQ) offers triple-short exposure. A 10% tumble in the Nasdaq-100 could generate up to 30% returns.
Invest in inverse ETFs at the right time, and you can make more money, more quickly, once that bear jumps out the window.
(That said, understand that the pricing of leveraged ETFs is reset daily. That means they are for short-term speculators only.)
The bottom line?
Once you identify a financial bubble, there is probably an ETF that will allow you to profit from it bursting.
But caveat investor!
You are wading into treacherous waters. Betting against a bubble takes nerves of steel and a cast-iron stomach.
Even Sir John Templeton had to endure three months of pain when his bets against dot-com stocks went against him. And when you’re in the middle of it, this can seem like an eternity.
As the great British economist (and failed speculator) John Maynard Keynes observed, “The market can remain irrational longer than you can stay solvent.”
Good investing,
Nicholas
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