When the bubble bursts, how to "smartly" short?

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Author: Campbell, Macro Analyst

Translation: Yuliya, PANews

Editor’s Note: Recently, the U.S. stock storage chip sector has become the main theme of the tech rally, with companies like Micron Technology, SK Hynix, and SanDisk continuing to see their stock prices soar. At the same time, debates over whether AI has entered a bubble phase have heated up again. The market is divided: well-known chip analyst Dan Niles from the internet bubble era believes that current AI development is more akin to the mid-stage sprint of internet infrastructure construction in 1997, rather than the bubble’s end in 1999. He points out that the rise of AI agents is driving a surge in computing power demand, and while chip stocks are currently overvalued in the short term, they still have long-term potential. Hedge fund legend Paul Tudor Jones also predicts that the AI bull market has already completed about 50% to 60% of its run and may continue for another one or two years. In contrast, Michael Burry, the real-life inspiration for the movie “The Big Short,” warns that the current market closely resembles the pre-2000 internet bubble burst.

In a time when frenzy and concern intertwine, and industry giants hold conflicting views, if a bubble truly exists, how should we respond? The author shares a hardcore practical guide on “how to short a bubble,” based on personal experience. Below is the original article:

Honestly, I don’t know whether we are currently in a bubble, and I’m not even sure if that’s a knowable question. My understanding of the situation is similar to yours: the AI revolution is real.

Although I have given up my professional investment career to go long, and have been writing about related topics over the past three years, I still feel I haven’t gone long enough. Like you, I look around and see many people becoming extremely wealthy just by connecting tokens to develop AI applications (or fully allocating their capital into infrastructure projects that generate tokens for garlic grain production), which makes my spine crawl and stirs jealousy. This then creates a feedback loop, making it hard to tell whether my views are influenced by jealousy or if jealousy is telling me a fact I already know: “Keep going long.”

To some extent, I do feel that “the future is here, and we need massive computing power,” so you might indeed want to buy these assets.

I don’t think software stocks are performing particularly well, and the market is selling off these stocks, so there’s no real profit to be made there.

Like you, I’ve also noticed the extremely low valuations of Korean stocks and am very interested in their market openness, which is obviously related to the recent stock market rally.

I am also surprised by the quiet easing of the supplementary leverage ratio (eSLR) by regulators, allowing banks and funds to hold less regulatory capital to buy U.S. Treasuries—this is classic “wolf in sheep’s clothing” liquidity expansion.

I can imagine a day when interest rates rise enough to end this “liquidity feast,” but that day hasn’t come yet.

I can also imagine that war might end this feast, with intense volatility shaking me out of the rally, so who knows what the future holds.

I also imagine that Canadian bank stocks with a price-to-book ratio of up to 3 and very low volatility are excellent shorting opportunities, but due to lack of trading channels and sufficiently long-term options, I can’t write a good article to provide some practical insights.

Honestly, there are many things I can’t say openly here. While this won’t change my fundamental view of the trend, it does greatly limit the people and matters I can discuss here. If you understand Andreesen’s “stop internal friction” theory, you’ll know that my cautious personality is doomed to never become a billionaire.

But there is one thing I do know how to do. And that’s the alpha I can offer you. Today, we’re not discussing whether we’re in a bubble, but rather how you could short a bubble if you want to.

Why is shorting a bubble so difficult?

What is a bubble? If something looks like a bubble, sounds like a bubble, shoots straight up like a parabola, and requires ever-higher expectations and leverage to sustain the price increase, then it is a bubble.

Why is shorting a bubble so hard?

The problem is, the easiest thing to short is something where the deteriorating fundamentals are gradually recognized by the public, leading to a slow decline and eventual collapse. During this process, you might encounter short squeezes (where short sellers are forced to buy back to cover, causing a big rally), but that actually provides a good opportunity to add to your short position because that thing will eventually go to zero.

But shorting a bubble is a completely different story. When an asset’s price skyrockets in an unsustainable manner, your short risk exposure grows exponentially as the price rises.

Don’t believe me? Ask those who shorted Porsche and Volkswagen in 2008.

Ask those who shorted GameStop.

Or ask the unknown shoe company that a few weeks ago turned into an AI company and crushed all shorts.

Longs, if they sell, at worst just go to cash and wait. But shorts, if they sell, mean they have to buy back the next day to close their position. If you can make their bill five times larger, they’ll be twice as motivated to close, sometimes at any cost.

Another reason why bubbles are hard to short is that the very features that make bubbles look exciting—“surging volatility! Amazing!”—make their options ridiculously expensive.

If it rises 10% daily, the annualized volatility is 160%. For options with 160% volatility, just buying a call option today can cost about half the stock price. The hedge value brought by actual volatility is so high that these options are essentially unusable for directional bets.

So, we are left with the following options.

The only ways to short a bubble are:

a) Find a “wedge”—something that can puncture the bubble from outside.

b) Short the “victims”—those deeply connected to the bubble and likely to fall hard.

c) Wait for “confirmation”—wait until the trend and chart truly break.

The rest of this article will provide examples of each method.

A) Finding the Wedge

The first method to short a bubble is not to short the bubble itself directly.

You need to find that thing which can burst the bubble. Then buy it to protect your account from the shock of the bubble bursting.

Let’s start doing this today, right before CPI (Consumer Price Index) data confirms what we’ve known all along: inflation is rising.

Interest rates are likely to go up too. As Bob Prince used to say, stocks also contain bond-like attributes.

That’s the “wedge.” You don’t short the bubble; you go long the trend that can kill the bubble. If AI is a bubble, then interest rates are the wedge that can burst it.

All assets with sky-high valuations are essentially disguised long-term assets. When the discount rate (interest rate) rises, the present value of those rosy expectations drops sharply, and stocks driven by fantasies of cash flows in 2030 will revert to reality.

The core principle is: in every bubble, there are some things that must rely on the bubble to survive. As soon as the bubble pauses slightly, the weakest links will break. You’re not betting on the market frenzy ending; you’re betting that the weakest links can’t withstand the market’s pause.

The beauty of the “wedge” strategy is that you don’t need perfect timing. The bubble doesn’t even need to burst; it only needs to stop accelerating for a quarter, and those highly leveraged junk assets will start collapsing.

Where is the current “wedge”? I’ll tell you what I’m watching. Those Canadian banks with a P/B ratio of up to 3, holding “negative amortization” mortgages (where borrowers owe more than the value of their property, and the difference is rolled into the principal, like PIK loans with capitalized interest), face a real estate market that makes the U.S. housing bubble of 2007 look restrained.

I can’t buy options on these banks, but I keep watching them. And on the broader credit market, as we wrote in “Credit Watch,” the current private credit market feels like a “cockroach nest,” reflecting increasingly lax lending standards. Money goes in but doesn’t come out. When the bubble pauses, these assets’ book values won’t change because no one forces revaluation. Until they have to face reality.

B) Short the Victims

The second method is to find the collateral damage assets that will fall alongside the bubble’s collapse—that is, assets right next to the bubble.

Evergrande is a good example. You don’t need to short Chinese bank stocks, which would just make you lose money for ten years. You need to find that highly leveraged developer relying on pre-sales of properties—any slowdown in China’s housing market can blow it up. The bubble can keep inflating, but Evergrande can’t hold on.

Look for “downward convexity” (meaning the speed and magnitude of decline accelerate). You can’t directly short those skyrocketing assets, as that would be fighting the double momentum of their rise.

But look at their neighbors—perhaps their options volatility isn’t as exaggerated as 70.

Recall the airlines before the pandemic. They weren’t in a bubble, but due to extreme asymmetric risk, their declines would be brutal. Puts were expensive but not absurd. You could buy options on both ends. That’s what we did back then. It seemed obvious in hindsight, but at the time, the “bubble” was just blind optimism about “everything being normal.”

Similarly, think back to the financial stocks of 2007/2008. You didn’t need to short real estate directly (which is technically very difficult and high barrier—unless you can find CDS default swaps on mortgages, which would be impressive). Just short U.S. banks.

The core principle is: bubbles create a correlation that only reveals itself during a crash. Options markets usually only price this correlation when disaster strikes. Your task is to find those “victims” with cheap options that are doomed to be dragged down by the expensive options of the bubble assets.

Who are the “victims” today? Honestly, I haven’t identified them yet.

C) Waiting for Confirmation

The third method tests discipline, and that’s why most people mess up.

It’s: wait.

I know, waiting is the hardest. Sometimes you see something soaring straight up, and you just can’t control your hand. But again, you absolutely don’t want to be run over by a speeding train.

So you wait for confirmation signals. What do those look like?

Usually a combination of:

• Fundamentals starting to weaken;

• Buying momentum drying up, market sentiment exhausted;

• Trendline breaking down completely.

Note, not a minor pullback, but a true breakdown. The kind where a previously strong rally suddenly falls below a key support line, and everyone starts screenshotting and sharing on Twitter. We saw this in silver’s move earlier this year (but don’t look now; it’s back up, and we’ll discuss it in future articles).

Depending on your timeframe, chart signals can vary greatly.

The most important truth now is: regarding AI, the only worsening factor is that too much cash flow is still tied to distant future expectations.

The problem is, you have to discount the future pie with today’s interest rates. If inflation picks up, policymakers will be forced to tighten monetary policy (imagine oil prices soaring to $150–$200 a barrel—they’d definitely do that), and the net present value (NPV) of these assets will shrink dramatically. This is the same logic we discussed during the 2021 bond bubble.

Another key point is correlation. When previously reliable patterns suddenly stop working, and they become sensitive to factors that were once easily ignored, beware. We might be witnessing this right now.

Practical Summary

What did I do today? (Early morning, Beijing time, May 13) Before the market plunged, I had already hedged some positions, but not enough. I shorted 5% of the S&P 500 (SPX) and 10% of high-yield bonds (HYG), then bought some short-term put spread options. Then I stepped away for a bit. When I came back, things looked terrible.

What exactly did I do? I didn’t short semiconductors because their core fundamental demand is still there, and the uptrend hasn’t broken. But I did short more bonds—this time, directly buying put spreads on U.S. Treasuries. If the trendline holds and the market rebounds, I’ll consider it a small expense for my “wedge” strategy—no harm done. If the trendline breaks, I still have cash and some protection, and only then will I go all-in on specific short targets. Oh, and I sold 5% of Canadian bank stocks.

Hedge, find the wedge, wait for confirmation, then go big.

Listen, I don’t know if we’re in a bubble right now. This rally might only be in its fourth game (probably not, the price action has been too fierce), or it might already be in the ninth (I doubt it; that would require a breakdown of demand for tokens, the underlying computing power, but I haven’t seen signs of that yet). The only thing I know is that the unstoppable feeling AI gives me is very similar to how I felt in 1999 when I first pieced together my internet stock portfolio in high school. Yes, those stocks eventually rebounded, and giants like Amazon emerged. If you held on until today, your internal rate of return (IRR) could be over ten percent.

But I also haven’t forgotten the brutal crash back then.

So, if you’ve read this rambling essay to the end, you might feel tense. If you do, the answer is definitely not to short that vertical surge. The answer is: find the wedge, buy puts on the victims, wait for confirmation signals, then go all-in.

In the meantime, don’t fight the market trend. Don’t short assets that are skyrocketing in parabola.