The normal rules of the game go out the window
Bubbles represent a problem that is outside the bounds of normal stock market volatility. True stock market bubbles may occur only a handful of times in a century. When they occur the normal rules of the game go out the window.
It’s easy enough to say that in a bubble prices get dramatically out of touch with reality. But, what really is a bubble? ‘Irrational exuberance’ was the expression used by Alan Greenspan in late 1996 to describe the Dot Com stock market as it built to its 2000 peak. I think that expression is a bit too tame. Humans are not fully rational at the best of times. Much of the normal year by year volatility of the stock market is caused by ‘irrational exuberance’ and ‘irrational anxiety’. I think the term coined by Charles Mackay in 1841, ‘madness of crowds’ is more appropriate. Bubbles are true madness.
We are used to stormy stock market conditions and a certain amount of turbulence. We frequently have to batten down the hatches when the usual storms hit. Then we come to realize a different kind of phenomenon entirely is on us. It is a hurricane. I think the contrast between a summer storm and a hurricane is a really good metaphor for contrasting normal stock market volatility and true bubbles.
I have experienced two generalized stock market bubbles: the Nifty Fifty market of the late 1960s and the Dot Com bubble of the late 1990s. I also experienced the gold bubble of the 1970s and Japan’s bubble of the 1980s which was both a stock bubble and a real estate bubble. I tried shorting the Japanese stock bubble but it didn’t work out.
Pundits often declare we are in a bubble. Since I started investing hundreds of bubbles have been declared. Only a few are real bubbles.
A lot has been written about bubbles. They are a feature of life and the successful investor is well advised to try to understand them and accommodate them in their overall strategy. It is a fact of life that some the best brains of Wall Street will periodically drive off a cliff in bubbles.
One of the issues I have wrestled with over the years as an investor is the question of what to do about bubbles. A policy of buying with a margin of safety for the long haul and riding out the roller coaster ride the stock market regularly dishes up, generally serves well. But, bubble are sui generis.
Going to cash in a bubble
I am convinced that a different approach is needed for bubbles. I have come to the view that the best policy to deal with true bubbles is to go to cash once a bubble is fully developed and stay in cash until the excesses of the bubble have been wrung out of the market. This approach has served Warren Buffett in the past.
Beginning in the mid-1950s Warren Buffett managed money through several limited partnerships. The partnerships did very well. In the ten years to 1966 the cumulative return was 1,156% as compared to the Dow at 122.9%. (Lowenstein, 1995,2008) p.94. By 1968 the Go Go market bubble of the late 1960s was in full swing. IBM was trading at 39 times earnings, Xerox at 50 times and Avon Products at 56 times. It was a true bubble. The bubble was not in one corner of the market such as tech companies. Blue chip stock became the ‘one decision’ Nifty Fifty’ stocks. It didn’t matter what you paid. You could buy them and put them away for fabulous gains.
In 1968 the Buffett Partnership had a return of 59%. In early 1969 Warren Buffett pulled the plug. He liquidated the partnership. He wrote to the partners: “I am not attuned to this market environment, and I don’t want to spoil a decent record by trying to play a game I don’t understand just so I can go out a hero.” (Lowenstein, 1995,2008)p.114.
It requires extraordinary determination to exit a roaring bull market that has morphed into a bubble. Other market participant continue to make pots of money – on paper.
Of course, this begs the question of how one identifies a bubble and how one picks the best time to go to cash.
Identifying a bubble
It is remarkable to think that when a bubble is in full swing, many people actually realize it. With hindsight everyone agrees there was a bubble leading up to the year 2000.
In December, 1996, Alan Greenspan made his famous comment about irrational exuberance.
In 1997 Andrew Sarlos published a very persuasive book, Fear Greed and the End of the Rainbow, which correctly identified the fact that stock markets in North America were in a bubble. (Sarlos, 1997)
Shiller notes that: “A Barron’s Big Money Poll of professional money managers in April 1999, less than a year before the 2000 peak of the market, asked, ‘Is the stock market in a speculative bubble?’ Seventy-two percent of the respondents said yes, only 28% no.” (Shiller, 2005 Second Edition)p.72.
Human nature is quite perverse. We often say that if we could have predicted any particular stock market collapse we could have avoided it. That is not quite right. Stock market bubbles give lots of warning signs. It’s just that we tend to ignore them.
Some people who realize there is a bubble choose to simply run with the herd. Others have no choice but to go with it. For example, in 1999 professionals managing technology focused mutual funds and exchange traded funds had no choice but to invest in high tech companies in the months leading up to the bursting of the dot com bubble.
Signs of a bubble
There are many different signs that point to a true stock market bubble. Euphorically high prices are one. A bubble can exist in individual stocks without the whole market being in a bubble. For example, $TSLA might be in a bubble but this does not mean the whole stock market is in a bubble. But, madness in a few stocks can spread into a market sector or the whole market.
A mania or bubble in one asset class, including real estate, stocks and commodities, and one country, can morph and flow to other asset classes and other countries and regions.
There are various other warning signs. New era talk may be in vogue. Many will argue that this time is different, that the rules of the game have changed. Shoe shine boys (grocery store clerks) giving stock tips.
Euphorically high prices
A strong bull market may take markets to nosebleed territory without being in a true bubble. As well, the stock market might remain overpriced for years with the Price/Earnings ratio of the S&P 500 going much higher.
In a bubble, the stocks in one’s own portfolio will also become seriously overpriced. This may be some evidence that a bubble is forming. It is not a signal by itself to go to cash.
So what about stock prices today. We know from our understanding of volatility and the normal tendency of stock markets to swing above and below fair value, that stock markets have a regular habit of becoming overpriced. Let’s look at a tiny slice of evidence.
With $AAPL trading at 34 times the last twelve month’s earnings and $MSFT at 35.4 x TTM, it’s fair to ask if these stocks are evidence there is a bubble today. Because of the impact of company investment in intangibles of lasting value I also like to look at price to free cash flow. $AAPL is priced at a Price/Free Cash Flow multiple of 30.9 and $MSFT is trading at 34.8 p/fcf. See here for discussion of intangibles and p/fcf. As I write this Morningstar values $AAPL as significantly overpriced and $MSFT as underpriced. They use a Discounted Cash Flow methodology based on discount rates. Since the risk free rate, commonly pegged to the 10 year UST bond, is close to around 0.6%, fair values can reasonably produce high earnings multiples and high price to free cash flow multiples.
This is not very compelling evidence of a euphoric overpricing; $TSLA yes, $AAPL and $MSFT not so much.
Readers will have to make up their own minds as to whether there is a bubble at present. This is not an advice blog. I am 100% in common stocks and see no reason right now to change that allocation.
Going to cash
The main reason for treating bubbles differently from normal bull and bear markets is that when bubbles pop the ensuing panic not only can take the stock market down a long way, 50% or more, but prices may take years to recover.
A few years being entirely in relatively short term bonds will not hurt a lifetime performance. By lifetime, I mean sixty years or so. What will hurt a lifetime performance is being caught up in a market crash that vaporizes fifty percent of your savings and takes a decade or more to come back.
The freedom to go to cash in a bubble is an advantage the individual investor has over almost all professional money managers. The individual investor comes under no pressure from clients or peers. They simply have to keep their head and their investing principles intact when all about them are losing theirs.
The thorny question is when to move to cash. In spite of the fact that it is not that difficult to identify a bubble, an investor has absolutely no chance of picking the top. One shouldn’t even think about it.
The best policy is one that with hindsight you will say got you out too early. There is nothing wrong with being early. I was in two year government bonds from late 1997 to 2002. I believe that was a good decision. I kept my hand in with a few small stock positions on the side. I avoided a real stock market bubble and kept my powder dry to re-enter the stock market in late 2002.
We have looked at stock market bubbles, what causes them, how one identifies them and, most importantly, how one deals with them. This effort is well rewarded if an investor, just once in their lifetime, is able to take some advantage of a bubble and avoid the worst effects of the panic and crash that follows. That, as they say, would be worth the price of admission.
If you would like to read further about bubbles, they are dealt with in the Motherlode in Chapter 29. Bubbles, crises, panics and crashes
That Chapter continues with these Sections:
29.01 What to do about bubbles?
29.02 The subject of bubbles has been studied
29.03 Globalization and bubbles
29.04 Bubbles have always been with us
29.06 Warning signs of a bubble
29.10 CAPE as an indicator of bubbles
29.11 Use of charts as a warning of bubbles
29.12 New era talk – this time is different
29.13 Barbers giving stock market advice
29.14 Corporate predatory behavior
29.16 No bell goes off to warn the investor of an impending crash
29.17 Picking the time to go to cash
29.19 Selling by others during a panic
29.21 No return to the dark ages
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