Editor’s note: I’ve known Dan Ferris, as both a friend and as a colleague at Stansberry Research, for many years. I’ve learned a lot from him about how to value stocks. So today, I’m sharing an essay from Dan where he shares several traits of speculative manias… and explains why today’s “safest” investments are likely to become tomorrow’s toxic waste.
[activistinvesting]
Q2 hedge fund letters, conference, scoops etc
Even though some markets around the world have come down sharply recently, shares are still super-expensive right now in the U.S.
Yet everybody thinks it’s easy to get rich owning them.
That’s always a recipe for disaster.
At a price-to-sales (P/S) multiple of about 2.22 times, the benchmark S&P 500 Index is just the tiniest bit under its all-time high value of 2.36 in January of this year – the most expensive single moment in U.S. stock market history. Historically, stocks have performed poorly 90 percent of the time when they’ve been this expensive.
In short, in many markets we’re in the middle of a speculative mania. And understanding the components and behavior of a mania is key to surviving it…
Today, I’m going to share five traits of speculative manias that we’ve found in our research.
It’s not an exhaustive list. And not every trait is present during every mania. But you can expect to find most of the traits we’ve identified when investors start bidding asset prices to dangerous levels.
I hope you’ll use these insights to bolster a conservative, long-term, value-oriented investing viewpoint…
1. Something new
New technologies and new financial innovations are key ingredients of speculative manias.
For example, optimism about technological innovations helped fuel the dot-com boom in the late 1990s. The S&P 500 price-to-sales ratio hit 2.25 times sales before that mania topped in early 2000. Until this January, it was the most overvalued equity market in history.
Similarly, financial innovation in mortgage-backed securities led to an enormous debt-fueled housing bubble, which finally blew up in 2008. That implosion caused the worst financial crisis since the Great Depression.
When technology and financial innovation combine, mania-watchers pay attention.
We saw that just months ago with bitcoin…
Bitcoin is a digital currency, a technology-driven financial innovation. It exists only in electronic form. Regular currencies are created and controlled by a central authority like a central bank. Bitcoin is “mined” by anyone who knows how to use bitcoin mining hardware to solve a cryptographic puzzle to bring new bitcoins into existence.
The value of a single bitcoin unit rose as much as 2,000 percent last year, hitting nearly US$20,000 in late December. But bitcoin is incredibly volatile, and no one knows what it will do from day to day. In my experience, an asset that can rise that far and that fast can plummet 90 percent or more even faster… Asset prices tend to take the stairs up and the express elevator down.
2. A mergers and acquisitions (M&A) boom
Speculative manias are generally marked by an increase in the rate of mergers and acquisitions.
In the 1920s, publicly traded investment trusts consumed one another, until most went belly up in the crash.
The “Go-Go” 1960s saw the rise of conglomerates. Ling-Temco-Vought (LTV Corporation) had its fingers in aerospace, electronics, steel manufacturing, airlines, meat packing, sporting goods and even car rentals and pharmaceuticals. It grew revenues via acquisitions from US$36 million to US$3.8 billion in just five years – more than a 100-fold increase.
Mergers are perhaps the least salient feature of the current mania, but it’s worth noting that all-cash deals are hitting record highs these days. Pharmaceutical company Bayer’s US$66 billion all-cash buyout of agribusiness leader Monsanto is the largest cash deal in history.
In December, drugstore chain CVS Health offered US$69 billion in cash and stock for health insurer Aetna. Charley Grant at the Wall Street Journal reports that CVS will need to take on US$45 billion in debt for the purchase, raising its debt to US$70 billion.
By our calculations, CVS is paying about US$205 per share for Aetna, or 4.4 times book value. That’s more than double the intrinsic value of the best insurance companies in the world (like Berkshire Hathaway, W.R. Berkley, or Markel), which I’d peg in the ballpark of two times book value. These two deals have “sign of the top” written all over them, for sheer size and valuation. I expect you’ll see at least one or two more of these mega deals in 2018.
3. A credit boom
It’s impossible to miss the bubble in bonds. Many Swiss, German and Japanese government bonds are trading at negative yields. In other words, investors paying those prices are assured to lose money if they hold the bonds to full maturity.
Many large financial institutions continue to buy these bonds simply because they’re restricted from holding most other types of securities…
Some large financial institutions, whether for regulatory or business reasons, can’t buy junk bonds. They’re restricted to higher-quality bonds – like so-called “investment grade” corporate bonds.
The lowest major “rung” that still counts as investment-grade is BBB. With “junk” status just one ratings notch lower, you’d think there’d be no way a BBB-rated bond could trade at a negative yield (indicating a high price and untarnished optimism about the prospects of repayment).
The assumption would be as wise as it is wrong.
Late last year, Paris-based conglomerate Veolia issued 500 million euros’ worth of three-year bonds at a yield of -0.026 percent, rated BBB. The issue was oversubscribed by four times. That means it only sold 500 million euros’ worth, but investors offered to invest more than 2 billion euros in the bond issue.
In other words, so many investors wanted in to a bond issue assured to lose money if held to maturity that their 1.5 billion euros had to be turned away.
A crazy situation can always get crazier. How long will it be until a junk-bond issue (rated BB or lower) is brought to market at a negative yield? In November, the Financial Times reported that European junk-bond yields were around 2 percent. They’ve come up slightly since then, but are still low by historical standards.
Always avoid insanely priced assets. I’d much rather hold cash than most bonds today. I take it as a sign of the grave distortions in the financial markets that bond investors think slow suicide is the best choice.
This is why you almost always see a credit boom during an equity boom. Investors seek more risk in equities as bond yields get low… And higher equity valuations make bond investors believe it’s just as safe as it was before when both debt and equity valuations were lower (and objectively less risky).
Bonds worldwide are more expensive than they’ve ever been in 5,000 years of recorded history. It’s not unreasonable to conclude that stock prices will continue to rise as investors take more and more risk in search of less and less return. Eventually it must end, but nobody knows when.
Prediction is unnecessary. Preparation is mandatory.
4. A reasonable fundamental taken to unreasonable extremes
This trait could double as the definition of a speculative mania.
Most times, a reasonable financial or economic fundamental remains reasonable until too many investors discover it. Then purely by too many people acting on it, the fundamental deteriorates into its opposite…
At one time, it was conservative to invest in housing and mortgages. Then investors noticed that U.S. housing prices hadn’t fallen in living memory. They took that to mean housing prices would never fall. That helped create a massive bubble, ending with the S&P 500 down 58 percent from its October 2007 highs by March 2009.
The same thing is happening with passive investing today.
Index funds are often referred to as passive investment vehicles. Passive investing makes fundamentally good sense for most investors. You won’t always be able to beat the market, so just own the market. Index funds are how you do that. They’re one of the greatest ideas in finance.
However, experienced investors will automatically ask, “So what’s next?” They know that in financial markets, success tends to sow the seeds of its own destruction…
Wall Street research firm Bernstein Research predicted that 50 percent of all U.S. assets under management would be passively invested by early 2018. In a 2016 report, it called passive investing “worse than Marxism,” and said it “threatens to fundamentally undermine the entire system of capitalism and market mechanisms that facilitate an increase in the general welfare.”
This is not as ridiculous as it sounds. Steven Bregman, co-founder of investment adviser Horizon Kinetics, says passive investing has two big problems.
First, passive funds buy baskets of stocks as new money comes in, without any reference to the fundamentals of the businesses they’re buying. When money comes into the fund, they buy. When it goes out, they sell. No due diligence required.
The second problem is that many active managers are penalized for taking contrary positions against the passive buyers. This is because over time, they command fewer and fewer assets relative to the passive herd. So their influence on the marketplace shrinks as the mindless passive herd of buyers grows… and experiences less and less pushback from more rational actors in the marketplace.
Passive and active buyers and sellers ought to balance each other out over the long term. It’s how the market tends to gravitate toward fair value for most securities, even if it takes a long time and a lot of irrational pricing to get there.
Bregman complains that the destruction of this kind of “price discovery” and the herding effect created by exiting active managers spells real trouble for financial markets.
With passive investing approaching 50 percent of total U.S. assets under management, it’s starting to feel like the tipping point is growing near. When nobody is left to buy the indexes, they’ll top out and start falling.
The market can go up for years more, higher than any rational person would ever expect. But passive investing has the potential to go horribly wrong, precisely because it’s so widespread and assumed to be so safe and conservative, which leads us to Trait No. 5 of speculative manias…
5. A risky scheme sold as a safe investment
The only way an asset can turn to toxic waste and wreak widespread financial havoc is if enough people accept it as safe and start piling in.
The widespread acceptance of assets as safe and conservative makes it more likely they’ll see more investor interest and wind up in more investors’ portfolios. The act of everybody buying them because they’re safe makes them unsafe, amplifying their flaws and weakening their strengths.
That’s the key: Today’s safest investments are most likely to become tomorrow’s largest pool of toxic waste.
For example, in the 1920s, publicly traded investment trusts were supposed to be diversified equity portfolios like today’s index funds. They became highly leveraged speculative vehicles. At one point, a new trust was floated on the public market every day. Many disappeared completely in the 1929 crash.
That same drama played out – with disastrous results each time – in mutual funds in the 1960s “Go-Go” bubble and the 1990s dot-com bubble and in complex bundles of mortgage securities in the housing bubble of 2007-2008.
Let’s go back to our index fund example… One strength of indexing is that you can easily hold a diversified portfolio in a single fund. But how diversified are you if everybody else owns the same thing you own?
If Bernstein is right and 50 percent of all U.S. assets under management are in passive vehicles now, what will happen when the stock market starts heading the other way? Will index selling turn a 10 percent correction into a 50 percent bear market?
Indexing is a strategy solely based on buying. Selling is not part of the deal. When selling goes into overdrive, indexers will feel less like they’re making a safe, conservative bet and more like they’re juggling flaming chainsaws.
Of course, we can’t know exactly what will happen if indexers start selling. Maybe enough of them will hold on for the long term that we’ll have nothing to worry about.
What I do know is this: What the wise do in the beginning, fools do in the end.
Indexing was wise for decades – an easy, low-cost, efficient way to get decent long-term investment results and prepare for retirement. But now that it’s the most popular strategy in the world, with the biggest index fund provider (Vanguard) taking in US$2 billion a day, I bet there are more fools than wise folks getting in today.
Good investing,
Dan Ferris
Editor’s note: We’re nine years into this historic bull market, and cheap stocks are tough to find. But Dan has found one stock he calls his brand-new No. 1 recommendation. “If I had to pick one stock to put every penny of my life savings into… this would be it,” he writes. “I’d bet my cash… my retirement savings… all of it… all on this single company.” Learn more about this stock right here.
Article by Stansberry Churchouse
