Proceed With Caution!

OK, it’s time to have a serious conversation. I’ve said before it’s really easy to cry bubble and be way early and look stupid for a long time. But also, these people are usually right in the end.

While I’m not ready to scream sell everything yet, I think it’s time to raise a big red flag. This is a very dangerous time to invest.

For the insurance readers, to put it in terms you are familiar with, this is like when everybody knows reserves are being set far too low, but nobody has yet admitted that their picks are light. It is easy for the casual observer to think all is well, but the wise observers know that turmoil is imminent. It is only a matter of when people confess, not if.

I’ve talked before about some of the excesses (NFTs, etc.) and will talk some more about them. But, new to the party are the bad actors like Greensill and Archegos. Bad actors always show up late in the cycle.

Then, you throw in policy mistakes and the elevated risk of geopolitical turmoil and you have quite the witch’s brew for volatility. This is about as textbook a late cycle playbook as it gets. It’s so predictable as to be boring.

So what I decided to do today is compile the checklist of end of cycle warning signals. We can add to them over time as they grow. I’m sure I’ve forgotten some as well and I’m happy to take your suggestions for additions.

But before we start the list, let me say it again…this is a very dangerous time to invest.

Sentiment Indicators

Let’s start out with some sentiment indicators. A big part of what creates these market dangers is “irrational exuberance” and one of the easiest tells of that is popular metrics, such as the old trope about the magazine cover indicators (which tended to work very well but also had a lot of false positives…and who reads magazines anymore anyway?).

Round Number Highs

Round numbers on the index are a great sentiment indicator. Dow 10K happened in 99 as we neared the top of the tech bubble. At around the same time, the S&P got to 1500. Guess where the S&P was in 2007 just before the mortgage bubble popped? Right back at 1500. It barely cleared the 2000 high and that was the top.

So the fact that we passed S&P 4000 last week should be at least a yellow flag of caution.

Celebrity Influencers

When celebrities think they can lend their name to something and create free money, that’s an awfully good sign there is too much froth and things are about to turn ugly. Whether it be Shaq with his SPAC or Gronk selling NFTs, when athletes and actors are the new “smart money”, it’s time to run for the hills.

SPACs and Oversupply

Speaking of SPACs, the whole SPAC craze is obviously out of control and will end poorly. It’s not just the celebrity SPACs or some of the really dodgy companies that are going public well before they are ready for it, but the supply of SPACs is very troubling. Eventually, the music stops and too many SPAC sponsors will be unable to find deals before the clock strikes midnight.

For those unfamiliar with the game here, I’ll try to do the super fast explanation. Hedge funds know that, in a bull market, most SPACs will go up from the offer price when they find a deal.

Thus, they line up to buy the IPOs (remember, the IPO is when the SPAC is formed as a shell, not when it buys something to go into the shell) because it is low risk (they can get their $ back if the SPAC doesn’t do a deal) and all upside. Basically, they are taking opportunity cost risk (tying $ up at no return) but little risk of loss.

However, while it may be low risk for the IPO buyers, it is not low risk for the secondary buyers who bid the SPACs up. Because then, if there is no deal, they will take a loss when the SPAC winds down at par. Of course, this creates an incentive for bad mergers to be done before the clock expires.

And yes, I know, these deals can be voted down, but was Nikola voted down? Was Lordstown voted down? There aren’t enough diligent investors in these deals to sniff out the bad deals before they are voted through (especially when the disclosure requirements are much less than a traditional IPO).

So, as we get late in a cycle, SPACs have moral hazard risk, where they have an incentive to try to sneak bad deals by naive shareholders. This risk is amplified when we have way too many SPACs and way too few deserving acquisition targets. As Chuck Prince would say, the music is playing, so the SPACs need to keep dancing!

In many ways, this is reminiscent of what finally toppled the tech bubble. There had been way too many IPOs and, as they came off of lockup, far too few buyers to sop up all the supply.

It is no secret SPACs are facing a similar upcoming supply/demand imbalance. We have already had more SPACS formed YTD than IPOs in a typical year!

This Time Is Different

Let’s add one other sentiment indicator before getting into more tangible things: the Novelty Factor.

Change is exciting. Change is necessary. It’s what allows us to raise living standards. But not every new idea is transformative. The railroad had a lot bigger impact than the penny farthing.

One human foible is every time something new and novel comes around, a group of people get way too excited about it and declare it world changing. Sometimes it is (the internet). Sometimes it’s not (cloning).

Will everyone eventually drive an electronic vehicle? Perhaps. That still can’t explain the combined market cap of all the EV stocks.

Will everyone transact in bitcoin? That seems unlikely. And even if they did, by definition, it wouldn’t have investment value at that point (in the same way cash in your pocket doesn’t have investment returns).

But this time is different! A whole class of new rock stars (e.g. Cathie Wood, WallStreetBets, etc.) get created to evangelize how this time is different and these new technologies aren’t a bubble and will keep going on forever. Never once, has one of these prognostications ultimately proven true. But the advocates of them inevitably make a lot of money for themselves in the process before the ride ends!

You know what would really be different? A cycle where the bulls didn’t proclaim “this time is different”! That would really be something unique!

Fundamentals

Our second category of warning signs fall loosely under the grouping of fundamental risks, whether they be the risk of a change to the macro outlook or simply that investors will gain a new appreciation for fundamental prospects relative to sentiment.

Valuation Doesn’t Matter

This is a corollary to “this time is different”, as in “valuation doesn’t matter because this time is different“. Valuations can “not matter” for awhile. They can’t not matter indefinitely.

The other way to say it is the only time valuation doesn’t matter is when everything is going right. As soon as something goes wrong, suddenly those same investors start looking for bottoms based on traditional valuation metrics. This is how bubbles pop.

If you want to figure out when the bubble ends, figure out what the negative shock is that will make people doubt the prospects for Tesla or Uber or Nvidia. Then, we will suddenly switch to caring about fundamentals.

The Left Field Shock

I’m not going to call it a Black Swan because if black swan events happened as often as people claim they have in the last 20 years, they no longer qualify as black swans.

However, there will always be events that happen that nobody had on their radar. Like Covid. Now, the market was ultimately resilient in the face of Covid, just as it was in the 90s after LTCM. However, the ability to take a blow like that depends on how healthy you were going into it.

For example, Bretton Woods didn’t end the Nifty Fifty market. If anything, it provided it fuel. It took OPEC to end it. We have a market with limited resources to tolerate another shock. Now, maybe one won’t happen, but there’s not a short list of possible candidates.

I won’t put together an exhaustive list, but just off the top of my head…a new, stronger Covid variant that the vaccine doesn’t work on, a cyber war, rampant semiconductor shortages, foreign policy mistakes (China & Russia are certainly looking to test a new President), and, of course, a spark to inflation.

Monetary Mishaps

There’s the old saw about how all bull markets are killed by the Fed. But that ignores that most of those bull markets were first created by the Fed! Inflationary policies of the 60s led to the 70s crash. The Y2K stimulus pumped up the internet bubble which the Fed had to later withdraw. The mortgage bubble was created and ended by the Fed.

This bubble will eventually be ended by the Fed. What may be different is that it may be killed by neglect rather than action as Powell has insisted he will not withdraw stimulus. However, the market may test his will by driving interest rates up higher than the Fed expects and causing a crisis derived by the Fed’s inaction (the higher rates will cause delevering and the house of financial cards collapses).

Moral Hazard

Our final category of risks are those that come from people who try to exploit the system for their advantage by breaking the rules. While these actions alone will not pop a bubble, they do suggest excess has reached extremes and are thus a special kind of sentiment indicator.

Fraud

As mentioned earlier, the end of every bull market is preceded by fraud. Why? Because easy money allows more leverage and free leverage encourages bad behavior. The longer a bubble continues, the more fraudsters come along, and the more that come along, the greater the odds one of them missteps and gets exposed.

Once the leverage gets pulled out of the system, then the rest fall as well. Remember when Madoff and Stanford got exposed? Mortgage bubble. When did Enron and Tyco happen? Internet bubble. This is not a coincidence.

The fact that Greensill and Archegos have already failed is the equivalent of a tornado siren. It’s time to take cover!

As a brief aside on Archegos, while not the outright fraud that a Madoff or Enron was, it was a brazen attempt to skirt the rules and hide leverage from its lenders to enable greater risk taking. If reports are to be believed, Archegos controlled 30% of Viacom at the peak.

What’s interesting about Viacom is it was a heavily shorted stock before Archegos got involved. While I don’t know Archegos’s thesis, it is not unreasonable to think they were trying to force a short squeeze similar to what happened with GameStop, AMC, and others.

This may serve as a lesson to everyone who was celebrating when the “little guy” stuck it to Melvin Capital who was short GameStop. Melvin had bad risk controls, but didn’t operate unethically.

This time the “evil hedge fund” used the same tactics the WallStreetBets crowd did in squeezing a short, but the end result was its own demise by getting too leveraged on the long side and hiding its concentration risk from its lenders.

Risk Seeking Behavior

Ironically, the same people who were outraged that Robinhood shut down aggressive trading to prevent outsized losses don’t seem too upset that the investment banks stepped in to cut their losses once they realized the extreme Viacom position their client had built.

But, at the end of the day, this was the same short squeeze trade. The only real difference is one bet was concentrated with one holder while the other was spread among lots of small investors. In both cases though, people made irresponsibly sized bets relative to their balance sheets.

And that’s really the issue here. Risk taking is being done for the purpose of thrill seeking rather than maximizing risk adjusted returns. There is no way to win at this game unless you stop playing once you’re ahead.

Think of it like Russian Roulette. There are only so many times you can play before you get a bullet in the head. There is no way to ultimately win if you take each “win” as a sign of skill and play again.

Pump N’ Raise

Pump and dump operations aren’t limited to bull markets though they’re arguably easier to operate when people think investing is easy. However, when you truly get to a bubble, you get what I call the Pump & Raise.

To many of you, this will remind you of the Hare strategy of generating buzz about your company to raise cheap capital. The Pump & Raise is a sort of cousin to the Hare. In this case, the company doesn’t create its own buzz. It happens to them out of sheer luck.

Think of GameStop, AMC, even Viacom. These are genuinely struggling companies with little hope of something positive. Then, some promoter comes along and decides to rip the stock up, whether it be WSB, Archegos or someone else. Certainly, it helps if the company has high short interest to make it a test of wills and create more buying power once the shorts cave.

If this were a typical pump and dump, the originator would exit at the top and celebrate. But in the Pump & Raise, something else happens. The company – which had no involvement in the scheme – realizes it can take advantage of the pump and raise capital to save its crummy balance sheet.

While this doesn’t solve the operating challenges of the business, it removes the bear case of bankruptcy and thus there is little remaining reason for the shorts to return. And the pump operator doesn’t risk SEC investigation when they dump. Nope, they can sell into the high priced offering.

So instead of the pumpees being the losers, it is the original shorts who take the permanent loss while the big winner is the affected company who got this gift from heaven where they could inexplicably raise cheap capital!

Recall in my GameStop piece, I suggested they should raise capital at $70. Instead, they took their sweet time and are now raising at $170!!! They still have an awful business, but they have completely fixed their balance sheet.

While this may be good for GameStop and AMC, it is bad for the market overall. It is a misallocation of capital and what we used to call creating zombie companies. These are the kinds of things that happen in bubbles. Capital is misallocated and eventually gets lost.

Epilogue: NCAA Bracket

I guess the equivalent of a bubble in the NCAA Tournament would have been if Oral Roberts kept winning and made the Final Four. That didn’t happen because all bubbles pop!

For those that paid close attention, you’ll recall I had two themes this year. One, expect lots of upsets because it was an unusual season where it was hard to rank teams accurately. Two, Baylor was undervalued and were either a good value to pick to win outright, or at least a good hedge against a Gonzaga win where you would need to beat the other Gonzaga winners in your pool by getting the runner-up right.

So, yes, this is the pat on the back for getting the winner right for the second straight tournament and, both times, at good value for a 1 seed.