Bubbles!!!

I think we are near the end of a business cycle and primed for a crash. This cycle has been driven by the greatest injection of new money into world economies in human history. Adding liquidity like this is bound to cause asset bubbles – in stocks, housing, and existential stuff like fine art and cars purchased by rich people with too much cash. To illustrate why I think this is almost the end, please consider the following.

Asset bubbles go through five phases…

1. The Change – there is a beginning based on things like a new technology; new money flowing into the economy from previously unknown investors; the development of new management techniques that drive efficiencies etc. The Smart Money sees these changes, and invests.  

2. The Build Up – the value of companies that are part of The Change rise through the normal course of investment with investments tied to actual profit growth and other rational barometers like the expansion of market share. As these companies rise, confidence grows and the entire market follows suit. Astute average investors and professionally managed money is invested here.

3. The Euphoria – the value of companies and the price of their shares become divorced from anything rationale as share prices rise seemingly without limit. For example, in the 1990’s people started talking about The New Economy based on the Internet, forgetting that companies in this new world still had to make money. The main way to gauge the value of a company ion the stock exchange is the P/E ratio – price of the shares over the earnings per share.  A healthy company with normal valuations – like a bank – should have a P/E of about 15. A quickly growing company with loads of upside should have a P/E of about 30.  At the height of the High Tech Bubble, Nortel had a P/E as high as 124. This was an insane level, that screamed that the stock would eventually crash – and it did, falling from $124 a share to $0.67 a share (…yes, you read that right – the price fell to sixty-seven cents a share from $124 a share).  Neflix’s P/E today is…..124. In the Euphoria, unknowledgeable people who believe the BS about “New Economies” etc., pile in so that they don’t miss out!  They are more commonly known as “Suckers”.

4. The Crisis – once it becomes clear to some that the share prices are divorced from financial reality, especially for companies that lead The Change, the Smart Money starts to cash out. This causes the prices of these companies to fall.  The Suckers keep buying with every drop in share prices seen as a “new buying opportunity” or “new entry point” utterly divorced from any actual analysis. The result of these sales and purchases are massive swings in the prices of these stocks, which is matched by wild swings in the value of the overall stock market. The S&P 500 has moved up and down by an average of about 8% six times in a year and a half. This is not normal.   

5. The Collapse – when it becomes clear to everyone that stock prices are divorced from financial reality, the market falls dramatically. This can be anywhere from 20 – 60% in a short period of time. Some of the companies that started The Change will go under at this time – they were only ever a fantasy. With the Smart Money long gone, only the Suckers get killed as they try to sell in a collapsing market.  Professional managers keep money in at this point telling their investors to “hold for the long run.”

This process of bubble and collapse is usually hastened by corruption and malfeasance that seems to underpin every bubble. You never really know what corruption that helped drive a bubble was until the bubble has collapsed, as it is the collapse itself that starts the real enquiries and audits. Think Savings and Loans in the late 1980s, and Enron, Madoff, and subprime mortgages in the mid-2000’s. Next time, I think we will discover malfeasance in stock buybacks and manipulation of options (…companies buying their own stock in the stock market to pump the price – they bought back $1.1 TRILLION in their own stocks in the USA last year, and $50 Billion in Canada – then managers blow out their options at the higher stock prices…), and corporate bonds which I think are mostly based on nothing but predictions of forward earnings that will never happen. We shall see.

Why does this matter for you?

If we are at the end of a cycle, it is time to think about asset preservation not about making more money. Given the wild movements in the S & P 500 over the last 18 months, I think we are in The Crisis phase of a stock market expansion. No one knows when The Collapse will come, but it will come.

Note – commentators are saying that Trump’s trade war with China is responsible for the latest market woes. These same people conveniently ignore the massive injection of cash into the markets courtesy of corporate buy backs, without with the markets would all be in the red. Reality is that real confidence is not shaken by trade wars, nor does it need a back stop of hundreds of billions of dollars’ worth of buy backs.

Suggestion - you may want to meet your advisor and lighten the amount of your cash that is exposed to the stock market, and move it to something like “Money Market Funds” which basically buy super safe bonds. You won’t make any money doing this, but you won’t lose any either. I don’t give advice that I would not follow – I have had my professionally managed cash in these super safe funds for almost three years.

If you want to short, please see HFD on the TSX which is a 2 x inverse play on Canadian banks whose debt has been downgraded twice in the last three years owing to concerns about Canada’s housing bubble. 

Do your own do diligence!