market bubbles

Where Are You on the Ride?
photo shows people going down a hill on a roller coaster, yelling and arms either in the air of clutching a bar

With summer fading in such a strange year, we find ourselves revisiting old memories. This will date me, but I’m thinking about the summer thrills we used to enjoy at places like Omaha’s Peony Park or Lake Okoboji’s Arnolds Park.

Part of the fun of a thrill ride is the anticipation. There’s a story and a rhythm to each ride. On a coaster, you make the climb—with a thunk-thunk-thunk on a lot of those “classic” rides!—and you can see the drop coming. Although you won’t know what they feel like until you get there, you can see the curves ahead.

And it’s all fleeting. The climb may feel like it takes forever, the terror of the drop may flash your life before your eyes… but you don’t go up and up forever, and you don’t fall down and down forever.

Sound familiar? Clients, you’ve heard us say this exact thing as a reminder about the markets.

Part of this lesson could use more attention, though: the ride can just be a ride when we know where we are on it.

When investors enjoy the climb of a hot stock, some mistakenly rush to throw everything they have at it, not recognizing that they are already near the peak: that thing will not go up and up forever. Nothing does. (Incidentally, this exuberant behavior can contribute to bubbles.)

Likewise, some get the itch to sell out when a stock cools off—but things may just be down for now and not down forever.

We don’t have a crystal ball, and we don’t have a map, but we know there are rhythms and cycles. What pain could we save ourselves by using a little perspective?

Where are we on the ride?

Clients, we’re here to help make sense of your plans and planning. Call or email when you’re ready for us.

Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.

Two Economists

© Can Stock Photo / skaron

The story goes like this. Two economists are walking down the street. One says, “Look! A $20 bill, just lying there!” and reaches to pick it up. The other says, “You fool! If that was really a $20 bill, somebody would have picked it up already.”

The underpinnings of this joke might be what is called the Efficient Markets Hypothesis, or EMH. It holds that all available information is already in the price of every security, so it is not possible to ‘beat the market.’ Related notions include the idea that investment selection does not matter, only the asset class or investment allocation.

Of course, our experience tells us that at times, certain investments do get mispriced. Condos in Las Vegas in 2007, tech stocks during the dot-com era, oil at $140 per barrel in 2008: all of these things seem to be examples of when the market was not efficient at all.

At these times, consensus expectations drifted far from the unfolding reality. “You can’t lose money in real estate” and “We’re in a new era, tech stock valuations don’t matter” and “Oil will never trade below $100 again” were the refrains of those faulty expectations. You may remember them.

Of course, we believe that the crowd can be wrong. That space between consensus expectations and the unfolding reality is where profit potential lives. One of our jobs is to try to find those exploitable anomalies and invest in them. Another is to go against the crowd when we believe it is wrong.

The simple rule, ‘never join a stampede in the markets,’ is one way we express this.

As a consequence, looking at the world with our own eyes, doing our own research, finding our own conclusions, this is what we do at 228 Main. It takes some courage to go against the crowd, to take unpopular actions, to stick with our strategies even when they require more patience than we had planned on. You and we are in this together: without your persistence, we could not do what we do over the long haul.

Hopefully from time to time we will find those $20 bills that others do not believe in.

Clients, if you would like to talk about this or anything else, please email us or call.

Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.

All investing involves risk including loss of principal. No strategy assures success or protects against loss.

The Antiques Roadshow

© Can Stock Photo / felker

Everyone knows what junk is: discarded items of little use or value. Yet from time to time some fabulous treasure gets pulled from a trash bin or purchased at a second-hand store for a few bucks. We see these items on the long running television series, the Antiques Roadshow.

This reminds us of our work with a different kind of junk. The polite euphemism for bonds issued by relatively weak companies is ‘high yield.’ Just between us, let’s call them by a more accurate term: junk bonds. From time to time, at rare intervals over the past seventeen years, we have found something we believed to be investable hiding in the junk pile.

A perfect storm may be brewing in the junk bond world. Federal Reserve Bank statistics indicate that the size of the junk bond market has doubled in the past decade, to nearly $2 trillion outstanding. Adding in another category, junk-rated floating rate bonds, puts another $1 trillion on the pile.

1. When financial conditions tighten and corporate results weaken (as they will sooner or later), higher quality bonds may also be marked down to the junk category.

2. The capacity of dealers and other market makers to deal with waves of selling has been dramatically reduced by financial regulations1. Large banks were once players, but trading for their own accounts has been curtailed. Formerly, they stepped in at market extremes to support prices. In the next crunch, they are not likely to be there.

3. We believe some fraction of junk may be held by people who may not realize they own it—hidden in other financial products sold to investors.

4. We have characterized the movement into the apparent safety of bonds over the past decade as a stampede, based on the size of cash flows and the ridiculously low interest rates. (That’s just our opinion.) If that money stampedes out…prices may plunge to lower levels.

Clients, we strive to deal with reality as we see it. The next downturn in the economy is out there somewhere. Our holdings will continue to fluctuate in value, and we will have a down year at some point. But we are excited about the opportunities that may arise in the years ahead.

Junk bonds may not be appropriate investments for all clients. If you would like to talk about this or have something else on your agenda, please email us or call.

Notes and References

1Regulatory Changes Impacting High Yield Liquidity, Pensions & Investments. http://www.pionline.com/article/20151228/PRINT/151229939/regulatory-changes-impacting-high-yield-liquidity. Accessed June 11, 2018.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.

The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Floating rate bank loans are loans issues by below investment grade companies for short term funding purposes with higher yield than short term debt and involve risk.

High yield/junk bonds (grade BB or below) are not investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors.

What’s Your Story?

© gajdamak / www.canstockphoto.com

Thinker Morgan Housel wrote recently about the power of narrative in “The Greatest Story Ever Told.” The essay focused on the narratives that affect the whole economy, the big-picture themes. The future of the country didn’t change much from 2007 to 2009, but employment, wealth, and the markets all got slammed. What caused it? The central narrative, how we understood our economy, changed dramatically from the peak of the boom to the bottom of the bust.

Investment manias have a story at their core. They may come true or not, but while the story holds sway, real values are driven by the story. Housel summarized it this way: “this is not a story about something happening; something is happening because there’s a story.”

Stories are how we organize and understand the world and our place in it. “Stories create their own kind of truth,” as Housel wrote. We believe the same idea shapes the lives of individuals just as certainly as it shapes economic and societal trends.

At 228 Main, we have stories. About people who save diligently and achieve financial independence. About folks who invest with increasing confidence and less worry over the years. About investors who learn to live with volatility, and hold on through the downturns. (These are stories, not promises or guarantees—you long-time clients know your own realities.)

I would not be able to work with you as effectively without those stories—and more importantly, the narratives of my own life.

I have a story about a vibrant business in the face of steep personal challenges. I have a story about working to age 92. I have a story about new ways of doing business in the 21st century.

These stories have enabled me to thrive while dealing with major issues, live healthier than I have for decades, communicate more effectively with you than ever before, and make plans for the decades ahead while some of my contemporaries coast toward retirement.

It feels to me as if the stories I have crafted in turn have shaped my life. I am not done creating stories; life goes on and things change. We do not know the future. But if we take control of our stories, we may be able to influence our futures. No guarantees.

How about you? What’s your story? Are there aspects of your narrative that we could help you with? Clients, please email us or call if you would like a longer discussion.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.

The Coming Boom?

© Can Stock Photo / devon

We wrote more than a year ago about the steady if slow growth of the economy. Just as a slow-burning fire might last longer than a raging conflagration, we expected that the economic expansion would persist longer than some commentators believed.

Another way to say it is, a bust is less likely without a boom first. The excesses that build in boom times usually contribute to the bust that follows.

For the first time in a decade, conditions may be ripe for a boom. The improvement in small business sentiment and increased money flowing into the equity markets had us on the lookout for signs of a boom. Then the tax law passed.

The tax law has pro-cyclical features that may strongly encourage economic growth now, but plants the seeds for a later slowdown. There may be political aspects that contribute to this syndrome, too.

Businesses investing in long-lived capital investments will be able to deduct the full cost up front, instead of taking smaller depreciation deductions over many years. This increases the financial attractiveness of projects; capital spending is likely to rise. A dramatically lower tax rate on corporate income, combined with a feature to bring overseas money back to the US, are further inducements for more business activity.

For two administrations in a row, the signature achievement of each has been done on a partisan, party line vote. When the minority party becomes the majority party, that achievement gets attacked and the unwinding begins. We’ve seen it with the Affordable Care Act; some Democrats are pledging to undo the tax law as soon as they are able.

So the favorable treatment of capital spending begins to phase out in a few years, and corporations may ‘get while the getting is good’ before the law gets weakened or unwound. These conditions might begin to affect things precisely when excesses from the boom have created more potential for a slowdown.

Boom, then bust. We know how this works. Clients, we will continue to monitor all of this, and work to take advantage of our thinking. No guarantees.

If you would like to discuss any of this in more detail, or have something else on your agenda, please email us or call.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.

The opinions expressed in this material do not necessarily reflect the views of LPL Financial.

All investing, including stocks, involves risk including loss of principal.

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

 

The Benefit of Being Picky

© Can Stock Photo Inc. / Farina5000

Suppose you had the opportunity to attend a fancy catered gala. When you get to the dessert table, a dizzying array of delicious looking pies are spread out for you to sample, too many to choose from. Not knowing which ones might be the best, a fellow next to you tells you he’s going to sample a little bit of everything and offers to help load up your plate the same way.

If you happen to be deathly allergic to peanuts, you would ask your helpful friend to skip the peanut butter pie and just get you some of the rest.
“Nonsense,” he tells you. “You never know, the peanut butter pie might be the best of the lot.”

“But if I eat it I’ll go into shock and might die. I can’t even let it touch the rest of the dessert on my plate.”

“You don’t know the future. Just because you’ve had an allergic reaction before doesn’t mean that you’ll have one now,” he says, handing you a plate with a slice of peanut butter pie smack in the middle. Instead of getting to enjoy your dessert you’re left unhappily trying to pick around the edges of the uncontaminated slices of pie.

This situation sounds absurd, and it is. And yet it resembles a commonplace practice within the investment industry. There is a portfolio strategy known as asset allocation that says that since we can’t know for sure which assets are going to go up or down, investors should aim to own a slice of everything. Because different asset classes move in response to different economic pressures, when one goes down it will hopefully be balanced out by a different asset going up. The goal is to try to reduce volatility through diversification.

However, just like our unhappy party-goer in the example above, there are probably some slices you don’t want any of—period. Tech stocks during the dot-com bubble in 2000 and mortgage based securities during the real estate bubble of 2007 were two slices of the investment universe that were very dangerous to your financial health.

Proponents of asset allocation dismiss this notion as market timing, saying that you can’t predict when the bubble will burst and that you miss out on potential gains by staying out of the bubble. But if we’re allergic to the pie, we don’t care how delicious the pie might be—we don’t want a slice.

Our approach may or may not be the right one. Nevertheless, we believe that being picky about the slices we take may bring us better results than blindly grabbing a bit of everything. If you want to talk about how this may apply to your portfolio, please call or email us.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk. Asset allocation does not ensure a profit or protect against a loss.

The Philosophy Lurking in Your Portfolio

© Can Stock Photo Inc. / Paul_Cowan

Modernism is a philosophical movement that arose from the far-reaching transformations Western society underwent in the late 19th century. This gave way to the skepticism of the late 20th century which led to the movement we call Post-Modernism.

This sets the stage for our discussion of Modern Portfolio Theory (MPT), and our response to it.

If you have ever seen the customary asset allocation pie chart or heard talk of getting exposure to all the major ‘asset classes’ then you have been exposed to MPT. It presumes that historical data about the behavior of all the various kinds of investments enables computers to calculate the best mix of holdings to get the returns we desire with the lowest level of risk. One investment zigs when another one zags, leaving the total portfolio steadier than it otherwise would be.

Great theory. Here are the problems that arise in practice:

1. At times of greatest stress in the markets, when you most need MPT to work, the historical correlations go away and the most overpriced assets get slammed regardless of what the computer thought.
2. Common sense and fundamental investment analysis often reveal that one slice of the asset pie is likely to leave a very bitter taste. Large growth stocks in 2000, real estate in 2007, commodities in 2011…everybody knows now that the best allocation to these overpriced bubbles was ZERO.
3. Although the discipline of MPT reduces the damage from counterproductive crowd behavior, it neither eliminates the damage nor allows one to profit from the madness of crowds.

Our investment management approach, forged in the skepticism born of deep knowledge of MPT, is based on three fundamental principles. We believe these principles are timeless, suitable for any market. We have written about them before, we will write about them again, and we have talked incessantly about them for twenty years. For now let us simply note that, as a reaction to Modern Portfolio Theory, they might collectively best be known as “Postmodern Portfolio Theory.”

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

Anatomy of a Bubble

graph

The above chart was formulated by Dr. Jean-Paul Rodrigue in 2006, in the middle of the developing housing bubble. It illustrates the general pattern that most market bubbles tend to follow.

Early on, a small number of money managers and other sophisticated investors begin speculating that a given asset may be undervalued and establish small investments in the hopes of future gains. As these initial investments start to pay off, other managers begin to notice their success and follow suit, slowly ramping up prices. There may be one or more temporary sell-offs as early investors decide that their speculation has paid off and pull out of assets that they now perceive as overvalued.

Sometimes, this is as far as a price fluctuation will go. When a rising price starts to attract media attention, however, it creates the potential for a true bubble. At this point the price may already be significantly over asset value and the original “smart money” investors’ reasons for buying no longer apply. But as the general public becomes more aware of the success stories that the rising prices have created, more and more people buy in. This drives the price up even further, reinforcing the public perception that an easy money-making proposition has been discovered.

As the bubble nears its peak, wise investors quietly pull out as it becomes clear that the price is unjustified and unsustainable. Latecomers with little understanding of their holdings invent new explanations to rationalize the extreme overvaluations the bubble has created. They believe the old rules no longer apply and the inflated price is the new “normal.”

At some point, reality sets in and triggers a cascade in price. The bubble begins to deflate, although bullish investors may try to deny that this is happening. They see the initial decline as a buying opportunity, creating short-lived recoveries before the bubble goes into its final plunge. Often, the aftermath of the bubble leaves the asset so despised it becomes badly undervalued, creating buying opportunities for savvy investors—which may eventually generate the start of the next bubble, many years down the line.

We already know the lesson here: avoid the stampede. When we hear everyone else is buying something, it’s tempting to join in. But even when it seems like the price just keeps going up and up, we know what’s eventually around the corner.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

Investing involves risk including loss of principal. No strategy assures success or protects against loss.