No profit in comfort.
There is always a reason to be concerned. Markets could be lower in two years; they could be higher. The question, then, becomes: what is your tolerance for discomfort? What are you going to do if the market goes down ten per cent? What are you going to do if the market goes down twenty per cent? Will you sell. If the answer is yes, you should be reducing it today.
There's a great Wall Street urban legend involving Joseph Kennedy Sr. and a shoeshine boy. This Kennedy - father of the 35th U.S. President - began building his family fortune in the stock market and through commodities trading. He also did well to secure the distribution rights for Scotch whisky ahead of prohibition — Kennedy Sr., a man of foresight.
As the legend goes, one day in 1929, Joe Kennedy is getting his shoes shined. The shoeshine boy began to give stock tips as he polished Kennedy's oxfords. At that moment, it struck Joe that he needed to leave the market. He reasoned, famously, if shoeshine boys have an opinion on stocks, the market is clearly, dangerously popular. Supposedly, he pulled out not long before the stock market crash, which led to what we know today as the Great Depression.
Last week, the WSJ reported that several South African investors had become concerned when their investment manager was not returning their phone calls. That manager was the Cajee brothers - and at the ages of 21 and 17, they are some of the youngest. They have 3.6 billion dollars of their client's money invested in crypto assets, and neither the brothers nor the money is anywhere to be found.
Financial siren songs come in many differing forms. Sometimes shoe-shiners. Sometimes a taxi driver's stock tip. And, sometimes, it is the fact that people are selling their homes to give their money to teenagers to buy and manage cryptocurrency for them.
Our long bull market may have finally matured into a fully-fledged bubble. An epic bubble. Overvaluation, continual price increases, frenzied issuance, and speculative investor behaviour that is bordering on hysteria. It could be one of the great bubbles of financial history, right up there with the South Sea bubble, 1929 and 2000.
***Most of the time, likely five-eighths of the time, major asset classes are well priced relative to one another. Prices ebb and flow and investors place their bets based on their sense of weight and measurement. They look for relative cheapness. And with reasonable skill at assessing value, they survive with some slight outperformance as prices oscillate around the long-run mean. Life's certainties: death, taxes, and reversion to the long-run mean.
A manager can add value in the implementation during this phase: from the practical selection of geographies, industries, sectors, and individual companies as well as major asset classes. But asset allocation in this phase is not the test.
The real test is when asset prices move far away from fair value. Long, slow-burning bull markets can spend many years above fair value. These events can outlast the patience of most investors. Market irrationality may far eclipse the solvency of the prudent value-orientated manager. Watching one's neighbour become rich is an insidious force that calls people to reckless action. And when price rises are very rapid - as is customary toward the end of a bull market - impatience compounds into anxiety, then envy, then careless action.
The U.S. market is most probably in a significant bubble event. It will very likely end badly, although nothing is certain. Predicting when a bubble breaks is hardly about valuation - all prior bubble markets have been highly overvalued, as is this one. Overvaluation is a necessary - but not sufficient - condition for their bursting. Forecasting the bubble burst is all but impossible to pinpoint to a week, month or quarter. The most significant indicator of the late stages of the great bubbles of history has been crazy investor behaviour, especially by individuals. We lacked such wild speculation for the first ten years of this bull market, which is the longest in history. But now we have it and in record amounts.
The litmus test for a financial bubble:- Prices are high relative to traditional reasonable measures.
- Prices are discounting unsustainable conditions indefinitely.
- Atypical buyers have begun to enter the market.
- Broad bullish sentiment abounds.
- Purchases are being financed with high leverage.
- The number of extended forward purchases have significantly increased.
- Tesla valued over $650 billion, amounts to around $1.25 million per car sold each year versus $9,000 per car for General Motors.
- The "Buffett indicator," total stock market capitalisation to GDP, broke through its all-time-high 2000 record.
- The 150 companies with a market capitalisation of over $250 million that have more than tripled in the year - which is over 3 times as many as any year in the previous decade.
- The volume of small retail-like purchases of call options for less than ten contracts on U.S. equities has increased 8-fold compared to 2019, and 2019 was already well above the long-run average.
- Robert Shiller's CAPE asset-pricing indicator shows stocks are nearly as overpriced as at the 2000 bubble peak.
- Bonds are even more spectacularly expensive by historical comparison than stocks.
- U.S. indices have advanced from +69% for the S&P 500 to +100% for the Russell 2000 in 9 months (South Sea bubble to the Tech bubble of 1999, has been an acceleration of the final leg, which in recent cases has been over 60% in the last 21 months to the peak).
A nearly vertical and accelerating stage of unknowable length is what you should expect to see from a late-stage bubble such as this. Ironically, this stage at the end of a bubble is shockingly painful and full of career risk for bears.
Bubbles are unique to one another. Typically they coalesce with the sentiment of perfect economic conditions, which are wrongly perceived as perpetual. Bubbles are nearly always strong economies, with solid profits extrapolated forever. Today's wounded economy, which is facing a very high degree of uncertainty, is enjoying that same sentiment. The market is much higher today than it was twelve months ago when the economy looked fine and unemployment was at a historic low. Today the P/E ratio of the market is in the top few per cent of the historical range, and the economy is in the worst few per cent. It is completely without precedent. Investors are relying on zero real rates extrapolated indefinitely. Valuations assume peak economic performance forever. This is justifying much lower yields on all assets and thus correspondingly higher asset prices.
If the conditions for calling a bubble are too high in your investing life - and such that you must call the top precisely - you will never try. This condemns investors to ride over the cliff every cycle, along with the great majority of investors and managers.
Fortunes are made and lost in a bubble such as this, and investment advisors have a rare chance to earn their case of beer. As always, there is no free lunch. And these opportunities come stocked with career risk.
What to do about it.These great market dislocations are where fortunes are made and lost – and where investors genuinely prove their mettle. Positioning a portfolio to avoid the worst pain of a significant bubble breaking is likely the most challenging part. Every career incentive and every fault of individual human psychology will work toward sucking investors into the abyss.
I have ten well-considered ideas of how to best position for an impending bubble burst. Here's one:
Today's market features very high disparities in value by sector and asset class. Those at the very cheap end include traditional value stocks worldwide, relative to growth stocks. Value stocks have had their worst-ever relative decade ending December 2019, followed by the worst-ever year in 2020. Spreads between value and growth performance averaging between 20 and 30 percentage points for the single year. Emerging market equities are at relative lows against the U.S. At the nexus of these two ideas - value and emerging markets - is where your relative bets should go. We are also generating excellent righ-adjusted returns using structured credit where there are tangible assets available. Combine these ideas with the strongest possible avoidance of SPACs, Bitcoin and U.S. growth stocks that your career and business risk will allow.
