5 Important Things To Do Before the Market Bubble Bursts
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Yes, you are living through a bubble in the financial markets. No, this is not an article about how to time the market. No, you don’t know when the bubble will burst (and neither do I). Yes, there are still things that you can do that will set you up for investing success.
The common argument for the existence of a bubble in the market is based on valuation. You already know that, and don’t need me to re-hash the data. The even scarier evidence of a bubble is behavioral.
I could share a dozen data-points about worthless digital tokens sky-rocketing to insane prices, speculators, both retail and “institutional,” rampantly gambling on short-term price movements, or the wave of highly suspect profitless IPOs. However, you probably already know all of that too.
Perhaps you have even become somewhat numb to each additional piece of news about market insanity. Or perhaps there is a little voice inside your head that is starting to ask: “maybe it is different this time?”
Instead, I will share a story from my Value Investing Seminar where I teach college and business school students about value investing. We had already finished studying Benjamin Graham’s Security Analysis and Philip Fisher’s Common Stocks and Uncommon Profits. On a day when Tesla’s stock approached $1,200 per share I mentioned to the students that I had a lot of respect for Elon Musk, and that I had read and thoroughly enjoyed his biography. Nonetheless, I told the class that it was my belief that with a market cap in excess of $1 trillion, the likelihood of attractive returns in Tesla’s shares from this starting point was extremely low.
That afternoon, one of the students sent me an email. The message was written in a very respectful tone, one that younger people might use to show the elderly that they have lost their way without hurting their feelings too much. He wrote that since I had already realized how amazing Elon Musk is, that I was half way there. Half way to where, you might ask? Half way to fully appreciating how amazing of an investment Tesla is. He then proceeded to very earnestly explain to me what I was missing about the stock and why it will be a great investment.
The point isn’t whether he is right or not. The point is that this is a young man at the very beginning of his investing journey. He has much to learn about investing, and he knows that, as evidenced by him enrolling in my completely optional value investing seminar. And yet, he has a very strongly held belief that despite doing very little real analysis he has profitable insights about a very popular stock, which up until that point has been going straight up for over a year.
This isn’t quite the same as getting stock tips from cab drivers in the late 1990s, but it is in the same genre. The point is that a bubble is formed when the following ingredients are mixed together:
Belief replaces analysis among many market participants
A group of speculators achieve visible success in the markets, driving upward price momentum and attracting other speculators
There is a plausible pretext for thinking that “it’s different this time” – a story
A combination of financial leverage and trading frequency allows the bubble speculators to displace more fundamentally-driven market participants in setting prices
Taken together, these forces create a disconnect between prices for the favored financial assets and any fundamental reality. All that matters is that there is a story + belief + price momentum + speculators. And so the bubble continues, growing ever larger and sucking in ever more converts until… it bursts.
The bubble is rarely all or nothing. Sometimes almost all financial assets are very dangerously priced. More frequently, there is an area of assets where the bubble rages which co-exists with other assets being priced within the bounds of reason. This tiering of the market into assets swept up in the bubble and those left out is a common bubble phenomenon. So don’t think that just because you can come up with some investments that are not at bubble prices that this represents evidence that we are not experiencing a financial bubble.
You might be thinking: but isn’t it actually different this time? And as this thought occurs to you, your brain might serve up 3-4 genuinely new and important developments that have occurred this time around but not during prior bubbles. Well of course! It would be way too pessimistic a view of human nature to expect us to keep bidding up tulips to insane prices every few decades.
Are there new, valuable business models that have emerged this time around? Ones that actually produce copious amounts of cash flow? Absolutely. Is that different from the profitless internet companies of 1999? Yes it is. Is there intellectual property value and useful applications to block chain technology? Yes. Are crypto-tokens scarce and supply constrained by design in a world where central banks have lost prudence and restraint? Yes.
None of these arguments refute the existence of a bubble. The bubble is created due to a combination of insane or near-insane prices for assets, as well as a behavioral dynamic among participants that significantly over-extrapolates the kernel of truth in the story into a financial phenomenon far out of proportion with reality.
We do learn. For a new bubble to start, it can’t be easily refuted by pointing out that this exact set of assets had already seen a bubble come and burst, leaving plenty of financial pain in its wake. No, there needs to be a story about something new, preferably mysterious and exciting. Because while we do learn, our brains just don’t evolve rapidly enough over a few centuries to get rid of all of the behavioral biases that, combined with the right circumstances, have led to prior bubbles.
Tulips had never been in a bubble until the tulip-mania. Besides, there had never been such new, rare and beautiful varieties. Surely these were worth almost any price? Especially since many other people would gladly pay you even more for them… until they no longer were willing to do that.
Radio companies were among the bubble darlings of the late 1920s. Such amazing new technology with such great growth potential had never been seen before, the thought went. In September 1929, Yale economist Irving Fisher said that “Stock prices have reached what looks like a permanently high plateau.” He was right. For another couple of months. Oops.
If you haven’t studied the go-go market of the late 1960s, I highly recommend the informative and very entertaining Money Game by “Adam Smith.” Remember the Nifty-Fifty and the one-decision stocks? The companies in most cases turned out to be quite good for many years. However, many of those investments proved to be one bad decision…
Then of course there was the Internet and Telecom bubble of the late 1990s. Remember “new era economics”? Price-to-eyeballs ratios? Of course it should be different this time – look at the massive innovation that the internet was producing.
Finally, the housing bubble of 2005-2007 deserves an honorable mention in the “also ran” category. Chuck Prince, then CEO of Citigroup, said it well in 2007: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance.” Those of you who started investing in the last decade or so probably haven’t heard of Chuck Prince. That’s probably because things got complicated for him and his company while he was still dancing.
Chuck, at the helm of one of the largest financial conglomerates of the time, didn’t get the advance warning that the bubble was about to burst. Chances are, neither will you. When I joined Fidelity in 2001 at the tail-end of the internet bubble, they just finished firing a few grizzled value investing veterans and replacing them with growth-and-momentum favoring analysts. Those old value fuddy-duddies had been predicting doom and gloom for too long.
Alan Greenspan used his famous term, irrational exuberance, in 1996. The bubble raged for another 3+ years. Perhaps it is this concerning example of leaving the dance floor while the party was just getting started that caused Chuck Prince to err in the opposite direction. We will never know.
So far, I hope I have convinced you that 1) there is a bubble and 2) neither you nor anyone else will know when or how it will burst. If you are not convinced, please feel free to stop reading and get back out on the dance floor.
Bubbles are frequently accompanied by a tiering of the markets. There is usually a group of securities (e.g. radio companies, internet/media/telecom companies, conglomerates, housing-related derivatives) that are trading at astronomical prices. Alongside, there is frequently another tier of securities which are out of favor or at least not caught up in the bubble to the same degree.
For example, during the internet stock bubble of the late 1990s, you could easily find good, predictable industrial companies trading at very cheap valuations. They were called “old economy” companies, in contrast to the new-economy bubble names that were the market darlings of the day. It was a broad group of undervalued securities, allowing the careful investor to construct an attractive portfolio while the rest of the market was too busy bidding up the bubble names.
Which brings me to today. The market is comprised of three tiers. The first is the bubble tier composed of securities whose prices are completely disconnected from their fundamentals. The second, broad, tier is of high quality businesses that are valued at very high, but still rational prices. The problem is that these prices are only rational if you believe that long-term interest rates manipulated for a number of reasons by the central banks will remain at these depressed levels for decades to come. And then there is the narrow tier of cheap securities.
The problem is that, unlike in the late 1990s, this tier of cheap stocks is comprised of many companies that are experiencing real secular issues. Some might go bankrupt or see their profits greatly and permanently reduced, making them not at all undervalued in hindsight. And among these problematic securities there are a few hidden gems here and there where the prices are indeed unreasonably low and offering a high prospective return to the discerning investor. Unfortunately, these are few and hard to find.
So what should an investor do in such an environment?
1. Have A Written Plan And Stick To It! While at your most calm and rational, write out what you think your plan should be and how you will go about executing it. Are you someone who is just dollar-cost averaging into low-cost index funds? Terrific! Write down how much you will buy each period, which index funds you will use and when you will rebalance. Then do exactly that, regardless of what you hear on the news, what the stock market is doing, or how excited or scared you might feel.
Better yet, commit to this plan by sharing it with your significant other or someone else who has a stake in your financial success. Hold yourself accountable by explaining your future actions in the context of that written plan.
Why write it down? When I put together Silver Ring Value Partners’ Owner’s Manual, I described in it to my partners exactly how I will be implementing my investment process. Every time that I write to my partners, I explain my action in terms of how they fit into the investment process that I have committed to follow. This serves to both provide transparency and to hold me accountable. Not to how my portfolio wiggles arbitrarily in the market quarter-to-quarter, but to the quality of my decisions within the context of my investment process.
2. Avoid Margin or Portfolio Leverage. This one is easy. There is no shortage of examples, from the Archegos implosion earlier in 2021 to many a person who lost all their money gambling with money that wasn’t their own. Just don’t do it. You can’t be careful enough when your fortunes are at the whim of short-term market gyrations.
You never want to be a forced seller. As a value investor, I particularly enjoy buying undervalued securities from forced sellers – those who are selling irrespective of price, simply because they must. Don’t reach for that extra dollar of return and risk losing it all. Compounding your capital slower, but safer, is the better way.
3. Raise Your Standards. It’s easy to let your standards slip in a tough market environment where there are few obvious bargains. Being a wallflower is no fun, when Chuck Prince and those following his lead are having all the fun on the dance floor. So guard your mind against the impulse to convince yourself that an investment you are considering is good enough, either in terms of quality or in terms of price. If you have to think about it long and hard – just pass. Good investments might require a lot of research, but once all the facts are assessed it should be obvious to you that it’s a no brainer. Otherwise wait.
4. Don’t Be Afraid To Do Nothing. The math of waiting is very forgiving. You can earn zero for a number of years, and as long as you invest your capital down the road at an attractive rate of return, your overall result will still be good. It won’t be so good if you force yourself to act and lose a bunch of your capital.
5. Factor In The Likely Future Opportunities. Many make the mistake of convincing themselves that they must choose among the current opportunity set. Most mutual funds fall into this category. This leads to sometimes picking the least unattractive investments among a bad set. Don’t do this. Hundreds of years of market history suggest really good investment opportunities intermittently appear. There is no reason to think that this has changed. So set an absolute return threshold, and don’t put in even a penny unless you are highly confident it will be exceeded. Leave the short-term relative performance chasing to others.
This morning, I was about to start the chess lesson with my youngest son, Jacob. As we were sitting down on the couch, I shook my head and sighed: “This market is crazy.” Jacob looked at me and said: “No Papa, you are crazy. Just stop thinking about it.” Sometimes 5 year-olds have just the perspective that we need. Stop thinking about the market – focus on your process and judge yourself based on how well you are executing it. I wish you and your family a healthy, happy and prosperous New Year!
If you are interested in learning more about the investment process at Silver Ring Value Partners, you can request an Owner’s Manual here.
If you want to watch educational videos that can help you make better investing decisions using the principles of value investing and behavioral finance, check out my YouTube channel where I regularly post new content.
