This is as precarious an investment environment as any that I have experienced during my two decades of investing. Prices of many securities and asset classes are optimistic, in some cases bordering on irrational. When the pendulum of the market swings so far towards greed, we need to be even more careful than we usually are in our capital allocation. Just because most market participants are in a generous mood does not decrease the amount of uncertainty facing businesses. What it does is make it very easy to lose large amounts of money and hard to make good returns.
Q3 2019 hedge fund letters, conferences and more
It is almost impossible to be confident as to whether or not we are experiencing a bubble in real time. I recently listened to the recordings of the Berkshire Hathaway annual meetings from 1994 through 2019 in rapid succession. Of the insights that I gleaned, one stood out. Even the best investors in the world, Warren Buffett and Charlie Munger, did not fully realize the extent of the bubbles that they were in during either the late 1990s nor the run-up to the Great Financial Crisis.
To be sure, they were properly cautious, and in some cases had been warning about the latent dangers for years. However, they did not fully realize the extent to which prices had become irrational while in the midst of either of the two crises. I am not suggesting that they should have known better. Rather, what I am saying is that it is too much to ask to know with confidence if we are in a bubble today.
The best that can be done is to become increasingly more cautious as asset prices become more and more optimistic. One can also use a checklist approach using various aspects of capital market activity to see where we are on the spectrum of pessimism to optimism for each one.
Here is a list of such aspects for which I would argue we are at or near maximum optimism:
- Interest rates [Extremely low]
- Credit Spreads [Below average]
- Credit terms [Loose]
- Abundance of speculative IPOs [High]
- Corporate share buy-back activity [High]
- Venture capital activity [Exuberant]
- Equity valuations [High]
Surveying the landscape, it seems likely that if there is a bubble that it is not in equities but rather in credit. In an environment where low single-digit positive inflation is widely expected by market participants, how can it be rational for “investors” to buy long-term bonds with negative yields? Investing, after all, is about laying out capital today for a reasonable expectation of greater purchasing power in the future. There are plenty of other danger signs in the credit markets – loose covenants, below-average spreads, risky issuers able to raise long-duration low interest debt, and permissive leverage allowed by banks in private equity-led buyouts. If these do not describe the very peak of the credit cycle, then I don’t know what one would look like.
Hyman Minksy once put it well: Credit is like oxygen. You don’t notice it when it’s there, but you sure do miss it rather quickly when it’s gone.
The question then is: what, if anything, should you do about it in your portfolio?
The default option is to do nothing. My circle of competence is bottom-up, micro-economic analysis. I spend very little time thinking about macro trends or markets as a whole and focus my activity on valuing individual companies and making investments in them with what I believe to be a large margin of safety. It’s therefore tempting, and perhaps altogether proper given the above, to ignore the warning signs and proceed as usual.
The downside of that approach is that if the environment is as over-optimistic as I believe it is, a very possible future reaction is the market swinging its sentiment pendulum in the opposite direction. In such a scenario, capital would quickly dry up, credit terms would go from loose to draconian, even solid deals would not get financed, and the market value of most securities would drastically decline (albeit not necessarily permanently in the case of solid enterprises).
Such an environment would also present amazing buying opportunities. However, to take advantage of those opportunities you would need available capital. No matter how carefully you choose your investments, in a severe market dislocation many will still drastically decline in price. You would not be able to take advantage of the newly available amazing bargains easily.
One solution is to override your bottom-up investment considerations and just keep a meaningful amount of cash on the sidelines. There are two problems with that approach:
- Doing so would be outright market timing, something that neither I nor anyone that I know has a particular competence in.
- While the drastic market reversal scenario I outlined is a possibility whose likelihood is increased by how far towards optimism the pendulum has swung, I have no reason to believe that it is the most likely scenario nor that it would happen soon.
The cost of a decision to keep a meaningful portion of your portfolio in cash (or bonds) is foregoing the high expected return from the current investment portfolio, and it is not one that I am willing to bear given the investments that I am able to find.
If the concern is a high-severity event of unknown probability and timing, then investing the partnership’s portfolio as if such a scenario were the base case is inappropriate. This means that any solution that requires me to take a meaningful portion of capital and redeploy it towards securities that will only do well in the event of a severe market dislocation is out. The opportunity cost is simply too high and my confidence in being able to predict future market movements too low.
The ideal solution then must meet the following criteria:
- It should only use a small portion of your portfolio
- It should provide a very large pay-off in the event of a severe market dislocation
- It would be preferable for it to rely on skills within your circle of competence – bottom-up fundamental analysis for me
How should you implement this insurance policy? That’s too dependent on your circumstances and abilities for me to give a broad, generic answer. I have taken an approach that I believe to be right for the long-term value partnership that I manage for like-minded investors. However, should you choose to ignore the risk, do so knowing that you are taking a small but quite severe risk of losing a portion of your wealth should the pendulum swing to the other extreme from the current rosy optimism prevalent in financial markets.
Note: This article was adapted from Silver Ring Value Partners’ Q3 2019 letter to the limited partners, in which I describe the solution I found to be appropriate to best solve this dilemma for the partnership.
If you want to watch educational videos that can help you make better investing decisions using the principles of value investing and behavioral finance, check out my YouTube channel where I regularly post new content.
Disclaimer: The above is my personal opinion, and does not constitute investment advice.
An earlier version of this article was published by me on Forbes.com
Article by Gary Mishuris, Behavioural Value Investor
