In my time as an investment manager, which now exceeds thirty years, I’ve witnessed two prior bubbles. In the late 1990’s the bubble was in internet and growth stocks, some which were priced at infinity times (negative) earnings. Prior to the financial crisis, real estate prices crescendoed to unrealistic levels. Each time, markets advanced into a “shared speculative hallucinationi” that was followed by declines approximating 50% in broad market indices.
Among the most extreme examples of market bubbles was Holland’s 17th century “Tulip-Mania,” during which some investors paid small fortunes for one, rare, tulip bulb.
It used to be that excesses were followed by depressions, which allowed for inefficiencies to be worked out of the system. However, through efforts of the government and the Federal Reserve, the natural cycle of boom and bust seems to have been replaced by a boom boom cycle, interrupted with sporadic and spectacular temporary market crises.
A confluence of events that includes easy money and government stimulus has created a situation where we no longer have to look back almost four hundred years to tulip-mania to wonder, “How could such lunacy prevail?” We now are living with real time examples of modern, digital, tulip level bubbles. Despite these excesses, with economies re-opening and fiscal stimulus still flowing, we may still be in the early stages of what may later be viewed as the bubble to eclipse all prior bubbles. I’ll look at five different areas of excess. I’ll then discuss what has always been our specialty, which is planning for the contingencies of market crashes, an eventual certainty in our opinion.
Five Examples of Extreme Markets
During the internet bubble, dramatic increase in internet usage created a frenzy. Investors wondered if new technology might render traditional ways of valuing stocks obsolete. Companies grew to billions in valuations even before they had meaningful revenue or earnings. If companies didn’t have to build buildings, or make substantial capital investments, they might be able to grow in ways that transcended traditional norms.
Today we have a parallel ascendance of stocks in the form of digital or innovator companies, with valuations in many cases as extreme as what we saw during the internet bubble. As an example, the holdings of one of the most popular “innovator” ETF based on inflows over the past year provides a window into the similarities. Of this ETF’s top 20 holdings only 8 have positive earnings (the rest lose money). Those stocks that do have earnings are priced with a p/e ratio of 140ii. That ETF increased in value by 185% over the past yeariii.
Moving further out into the bubble takes us to SPACS, or Special Purpose Acquisition Vehicles. These investments offer shares to the public to allow the SPAC to purchase “blank check” companies. Once funded, SPACS then purchase private companies that might have normally gone public themselves. To purchase shares means having a high conviction of confidence in the company that issues the SPAC that they’ll both be able to find and then fund desirable companies.
According to Bloomberg, SPACS raised over 100 billion dollars in the last quarter, more than during all of 2020. Not knowing anything (thus the terminology “blank check”) about the future acquired companies when investing is a new level of detachment from fundamentals, earnings or assets. Companies acquired by SPACS as a whole may have no earnings or large losses.
During the past quarter, one of the biggest market events was the speculative frenzy in GameStop, a company that has traditionally produced the bulk of its revenue from physical stores that sell video games and movies (think Blockbuster Video). Perceived by much of the investment community to be on a path to bankruptcy, hedge funds took short positions in the stock, betting that it would continue a multi-year long stock market descent. In a bid to squeeze these hedge fund short sellers and make a quick profit, investors large and small began purchasing the stock, bidding the price up from a recent low of 4 to 486, an over 12,000% increase! This bubble level pricing continues, with GME still priced at
172 per shareiv. An important distinction between the GameStop bubble and both innovator stocks and SPACS is that, at least with those other vehicles, investors were likely basing their bets on the long-term success of companies that they held. With GameStop, earnings and the company itself became irrelevant. Instead, GME became a gamble, and nothing else. Get in early while the rally is occurring, then sell before it collapses. This complete departure from concern about earnings or assets is an important distinction, because we think it is a crucial departure from rational pricing that should guide investing decisions. It also leads us further out into the bubble to crypto/currencies and NFT’s.
One likely annoyance for advocates of very highly priced stocks (Innovator ETF’s, SPACS) is the insistence of some investors on comparing valuations to their earnings and revenue as I have done here, forcing the conclusion that pricing may be irrational. For investors wishing to participate in speculative bubbles free of such burdensome comparisons, one option would be to consider cryptocurrencies like Bitcoin. These increasingly popular “investments” have no earnings, yields, or assets. Instead, think of bitcoin as a currency that has limited supply that you can use to purchase few things except a Tesla, that, like GameStop, has prices driven entirely by speculation.
Like other effervescent assets over the past year, Bitcoin has soared, increasing from 7,234 to over 56,000, an increase of 674% in just over a yearv. Total outstanding Bitcoin is now over 1 Trillion dollars (not billion, not million). So now the question: Is bitcoin overvalued? Who knows, it has no data to support any valuation. As a comparison: If the dollar, supported by the strongest economy in the world has remained steady or declined somewhat in the past year, what possible justification could there be for a 674% increase in Bitcoin?
A final few words on Bitcoin: First, you could surely lose 100%, especially if governments decide (conclude) that cryptocurrencies create opportunities for money laundering and challenges their own currencies. Second, we think Bitcoin has been ineffective as a diversifier. During the stock market pandemic led decline, Bitcoin lost over 50% of its value. So while being a purely speculative investment, it hasn’t acted as a diversifier in recent history.
Among the most extreme examples of a bubble investing environment is the recent explosion of valuations of NFT’s. NFT’s are essentially digital ownership of images such as digital art, video clips, or even tweets from Twitter CEO Jack Dorsey. In the first quarter, a record was set of a 69 million dollar purchase of the digital artwork, Beeple. What is fascinating and hard to comprehend for many is that the same digital art that may demand millions of dollars can be downloaded and stored by millions of others. So effectively the purchaser of an NFT is the official owner of a JPEG file, while everyone else just has the file on their computer.
There may be some legitimacy to the idea of NFT’s when it comes to licensing rights. However, paying thousands of dollars for a cat meme is likely just a further extension of excesses created by an excess of money supply.
Conclusion: Digital Tulip Bulbs Abound
In each of the prior bubbles discussed (internet, housing), the mania in limited asset classes spread into the broader stock market and helped fuel economic growth and optimism. When the bubble crashed, it caused losses broadly across financial assets, ultimately leading to recessions. We believe that the bigger a bubble becomes, the larger the subsequent crash and economic consequences may be.
Looking back at history, it’s easy to see aberrant markets and identify mistakes. Our behavioral challenge is that, even with this knowledge, it can be difficult to comprehend similar phenomena even when it’s happening right in front of us. And it may be happening right in front of us. It would be hard to argue that paying $56,000 for one bitcoin, or $69 million for a JPEG file is any less irrational than trading two horses and a carriage for one rare tulip bulb.
Investing During Market Bubbles
may do, and what you can do about it. The second can be even more difficult than the first. Unfortunately, there’s not a sign on I-95 that announces bear markets ahead. If investors participate in the first 10-20% decline, they may feel that they have to stay invested to avoid selling low, making them susceptible to further declines. I recall a number of similar conversations that I had with advisors during the market rout in 2008. With equities down over 40%, most decided to hold rather than attempt to de-risk, leaving them vulnerable to further losses at times when visibility is nil.
In our opinion, investors should strive to de-risk portfolios when volatility is low and markets remain elevated. This perspective is amplified when considering the velocity with which the last two declining markets have occurred.
We believe that the key is to attempt to both be able to remain invested, but plan for the worst:
- Attempt to remain invested in some approximation of a conventional portfolio that holds both stocks and bonds. This potentially allows investors to participate if markets stretch higher as the economy opens.
- Hold at least fifty percent of your stocks in hedged equity of high conviction tactical strategies that attempt to exit or uncorrelate from markets if they turn south.
- With yields near historic lows, adopt unconstrained fixed income strategies that address the possibility of rising interest rates or inflation, two emergent concerns being realized as the economy continues to strengthen this year.
For our investors, our strategies were conceived with the objective of attempting to help navigate extreme and unexpected markets. If markets do crescendo and then turn lower, remember, that we have strategies that were designed explicitly to attempt to address significant long-term declines.
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(ii) Source of data: Morningstar as of 03/31/2021
(iii) Source of data: Morningstar as of 4/7/2021
(iv) Source: Bloomberg Finance L.P.
(v) https://coinmarketcap.com/currencies/bitcoin/ date accessed 04/07/2021