A Little Bubble Talk Among Friends

As the glow of another Thanksgiving recedes, one of the things I’m thankful for is a close-knit group of longtime friends.  We’ve kept in touch ever since college, and one of the ways we do so is via a wide-ranging, usually irreverent group text.  Last night, one of them posted an article from The Economist entitled “How To Spot a Bubble Bursting” and asked for my opinion.  Here’s my response.

Before I chime in, I’ll do my best to quickly summarize the article’s salient points for those who can’t access the link. 

1. While valuations become elevated in a bubble, measures like P/E and Price/Sales are highly unreliable timing indicators.  They point out premature bubble warnings from the late ‘90s from famed investors like Ray Dalio, George Soros, Peter Lynch, Warren Buffett and others.  Those proved to be right – eventually – but only after costing them millions for fighting the tape.
2. There is a solid inverse correlation between investment returns and cyclically adjusted price/earnings ratios (aka “CAPE” or the “Shiller P/E”), but this is over a 10-year period.  On a 1-year basis, there is almost none.
3. There appears to be a relationship between spikes Google searches for an investment theme and subsequent falls.  When searches for terms like “ARKK”, “GME”, and “SPAC” spiked, those often coincided with peaks in those investments.

Given that backdrop, I offered one of my longer texts.  Here is what I said last night:

There’s a lot to unpack but I agree with the general premise.

Bubbles are obvious with 20/20 hindsight and usually give plenty of signals while they’re occurring.  But it’s important to remember that markets can remain irrational longer than you can remain solvent. 

Things are clearly quite frothy, though little by little the froth is coming out of some sectors (quantum computing, highly speculative pump and dumps).  Eventually we run out of frothy sectors and there’s nothing left but the big winners and then they come for them too.

Is that now, weeks, months, years?  Hard to say.  But since markets have a nasty way of making the maximum number of people miserable at the worst possible time, we’re nearly at a point where I don’t think there are many new people or much more money left to suck in.

As I re-typed that last sentence, I’ve come to think it’s a bit harsh.  For starters, I read a news report this morning that money market balances crossed $8 trillion for the first time.  While I believe that the concept of “cash on the sidelines” is yet another imperfect measure, there is indeed a surfeit of investable liquid assets.

More importantly, there is nothing wrong with democratizing investment – heck, I’ve spent decades working towards that goal – but I do get concerned when I hear that speculating is distracting people from their primary source of income – their jobs.  Let me be very clear – I have no issue if our hard-working service members are also successful investors.  I applaud the Sergeant who has built a six-figure nest egg mainly from index funds.  But I am concerned that the experience of the truck driver with a $38,000 salary who has made and lost five figures multiple times in recent years is becoming increasingly typical.  Anyone is capable of investment success, but when trading and speculation become excessive that can become a worrisome sign.  The problem of course is defining “excessive.”  The apocryphal story of Bernard Baruch and/or Joe Kennedy avoiding the Crash of 1929 after getting stock tips from their shoeshine guy has always stuck in my head. 

This morning a friend followed up.  He has been phenomenally successful in his chosen career and has the multiple houses and museum-worthy collectibles to demonstrate it.  He wrote:

I’m at the point in my life where I have achieved everything I want… and I just don’t want it taken away from me.  I’ve become an incredibly cautious investor… I see no reason to take any risks in any market.  Am I wrong? …  I can do a lot of good as long as I don’t lose money

My response:

Absolutely not!… that’s a worthy goal.  Capital preservation along with some income generation is how to achieve it.

Knowing this friend’s success and charitable goals, various other friends (all well versed in finance, real estate, and the like) offered similar sentiments.  One recommended all fixed income, a mix of corporates and Treasuries.  Another suggested that equity needs to be part of the mix as an inflation hedge.  I echoed that low-beta, high-dividend stocks are appropriate for conservative investors nearing retirement, as my friend is (with the caveat that the companies’ cash flows comfortably finance the dividend payouts). 

Bottom line, we may or may not be in a bubble, and while I agree there are elements of the latter that may be present, timing its demise is essentially impossible. Thus, it all comes back to your risk tolerance and life situation.  If you’ve achieved your retirement goals, then consider what you are willing to risk and what you need to preserve.  If you’re older and don’t feel that you’ve reached that point, consider carefully how much risk you are willing to take to achieve your goals and what the damage might be if you assume too much risk.  And if you’re a younger investor with the potential for a long career ahead, you have more leash to take risk and to recover from bad experiences, but be sure you don’t lose sight of the career that could provide you with long-term success.