Wall Street Fears a Market Bubble. How to Trade One.

A trader makes a bubble with a chewing gum on the floor of the New York Stock Exchange. (Johannes Eislele / AFP / Getty Images)

Key Points

• The S&P 500 has increased 100% in five years, trading at 26 times aggregate earnings, raising concerns about a potential market bubble.
• A strategy for navigating a potential bubble involves staying invested in equities and allocating to distressed companies like those in the Russell 2000.
• Another component of the strategy is shorting long-term government bonds, betting on rising yields, as 12 of 14 past bubbles saw this trend.

Worries grow that stocks are in a bubble. There’s a way to trade one.

Oddly enough, that means staying invested in equities for the moment, while also betting against bonds.

Several strategists have written in research notes this week the chances the market is in a bubble have risen. The S&P 500 is up 100% in the past five years, and has touched new records this year. While much of the jump is well founded, reflecting continued earnings growth on the back of artificial intelligence, strong growth across sectors, and a Federal Reserve interest rate cut, many wonder if the rally is excessive.

The rally reminds many of the late 1990s, just before the technology bubble burst, when the S&P roughly doubled and investors anticipated that the internet would change the world. Today, there’s a similar setup, with the market counting on AI’s emergence.

The S&P 500 is trading at about 26 times aggregate earnings for the last 12 months, which is in the top decile since 1960, according to Evercore strategist Julian Emanuel. Investors expect earnings to grow enough to justify the valuation, but if recently slowing economic growth causes analysts to reduce profit expectations, stocks will falter.

“Odds that a bubble has begun are increasing,” writes Emanuel.

A bursting requires a catalyst.

That could be too-hot inflation. Friday’s data showed the Fed’s preferred gauge of inflation, the personal consumption expenditures index, rose 2.7% year over year in August. The Fed’s goal is 2%, but tariffs have done their part to keep inflation elevated. If the PCE rises just a tick—to 3% or above—rates would rise and stocks would fall.

With all of that said, there are some big differences between today’s market and the late 1990s.

First off, the 90s tech bubble featured soaring stocks for many earlier-stage companies that weren’t profitable, whereas the soaring stocks today are massive companies with high profitability.

Secondly, the S&P 500’s earnings multiple, while high, is well below the over 30 times it touched in the late 90s.

The point is that, while a bubble most likely hasn’t formed today, it could be in the process of forming. For traders or investors that want to position their investments accordingly, there’s a strategy.

First, keep some money invested in the stock market. Bubbles usually take years to burst, and when people just begin to warn of one, there’s more to the market’s rally. The average equity bubble that Bank of America strategists studied saw prices rise 244%, so the market likely needs to rally more before it becomes overly inflated.

So keeping money in S&P 500 companies sense. Some investors may choose to sell a bit, while others may choose to hold on to every share. But the point is that investors should maintain a healthy allocation to stocks, which have tons of upside potential left.

Meanwhile, allocate some money to stock in distressed companies, BofA says. The idea: Rising financial asset prices—mostly stocks in this case—makes it easier for companies to raise money in the form of equity or debt financing. Distressed companies can raise money, remain in business, and see their stocks jump.

Plenty of distressed companies are in the Russell 2000 index. That tracks smaller companies, many of which are losing money. Some of the worst performers could use fresh capital, whether that’s part of a bankruptcy solution or to protect a company from filing for Chapter 11.

An example is Bumble, the online dating app that has seen declining sales in the past few years and lost almost $500 million last year. Another is BlackBerry, which has lost almost all market share to smartphones and lost almost $90 million last year. Buying a basket of these types of names like those in the Russell 2000 makes more sense than betting on just one.

Lastly, short long-term government bonds. That’s a bet that bond prices will fall, as yields rise. The increase in borrowing, often accompanied by central banks cutting short-term rates, creates inflation, sending longer-term bond yields higher. BofA notes 12 out of 14 asset bubbles it studied came alongside rising long-term bond yields. With the 10-year Treasury yield down for the year, there’s room for it to rise.

Shorting it means borrowing a bond from someone who owns it, immediately selling it, thereby raising cash, and then buying it back later to return it to the owner. The idea is to buy it back at a lower price and pocket the difference. It sounds complicated, but it can easily be done at most widely used trading platforms. Or you can buy at ETF like ProShares Short 20+ Yr Treasury, which shorts longer-duration Treasuries.

For those so inclined, this is a clear trading strategy.

Write to Jacob Sonenshine at jacob.sonenshine@barrons.com