<January 22, 2020>
Asset bubbles can be devastating to economies and investors. Fortunately, over the past few hundred years, asset bubbles have been rare. Some of the more famous bubbles include the Tulip Mania (1637), the South Sea Bubble (1720), the Roaring 20s (1920’s), and Japan’s stock market and real estate bubble (1980's). More recently we’ve had the technology bubble, the housing bubble, and currently, what some have labeled, the “Everything Bubble.”
When I began my career in the asset management business in 1993, never in my wildest dreams did I expect to live and manage money through three asset bubbles. Yet, here we are—my third bubble in a little over 20 years. Lucky me!
Many investors, including professional investors, have not been so lucky. For portfolio managers and analysts with less than 11 years of experience, this is their first asset bubble. What should younger investors expect? To withhold the suspense, I can tell you with a high degree of confidence that asset bubbles do not end well. Bubbles are also very unpredictable and typically surprise participants on the upside and downside. To help investors with limited full-cycle experience, I've put together a list of some things that helped me survive past bubbles.
Before the Bubble Pops
1. Pick teams. Once an asset bubble forms, it’s important to pick sides—either you play along or you don’t. It’s not an easy decision, especially for professional investors. Play along and you’ll likely participate in the market’s rise, keep your job, and spend less time defending your position. Of course, navigating through an asset bubble is never as easy as it seems. With valuations currently near or exceeding past bubble peaks, playing along may eventually be a very difficult position to defend. Assuming the bubble pops on your watch, large losses to client capital could damage your reputation as an asset allocator and fiduciary.
For professional investors refusing to play along, missed opportunities and poor relative returns can lead to restless clients, lower assets under management, and in some cases, unemployment. Essentially, professional investors who do not fully participate in asset bubbles can place their careers and livelihoods at risk. The rewards from abstaining, however, can be equally material. It’s difficult to put a price on the peace of mind and self-satisfaction that comes with doing what you believe is right, but it’s meaningful. Furthermore, assuming the bubble pops and your positioning is vindicated, your full-cycle track record and career will likely benefit. And last, but certainly not least, the opportunities after a bubble’s demise can be extraordinary and well worth the wait!
Picking teams, in my opinion, is one of the most important decisions professional investors need to make when deciding how to navigate through an asset bubble. Depending on which team you select, there will likely be significant near and long-term consequences.
2. Clear and consistent messaging. After picking teams, clearly communicate your investment rationale and positioning. If you decide to participate in the asset bubble, avoid phrases like “cautiously optimistic,” “constructively positioned,” and “pragmatically bullish” when communicating with investors. If the portfolio you’re managing is fully-invested and aggressively positioned, clients should understand that their capital is at risk. Take a stand—if you’re in, you’re in. And if you’re not in and are defensively positioned, clearly communicate the risks, including incurring meaningful opportunity cost and relative underperformance.
When the technology and housing bubbles popped, there was a furious storm of finger-pointing. This cycle, in my opinion, will be no different. Be clear and consistent in your messaging to limit misunderstandings and end-of-the-cycle surprises.
3. Back words with actions. Your messaging and portfolio positioning should be consistent. For example, if you’re warning investors about overvaluation and risk, the portfolio you’re managing should not be filled with overvaluation and risk. I’m reminded of an early Seinfeld episode when Jerry is arguing with a rental car agent about his reservation. Jerry says, “See you know how to take the reservation. You just don’t know how to hold the reservation. And that’s really the most important part of the reservation—the holding. Anybody can just take ‘em!” Such is the case with investing. Anyone can claim assets are overvalued and risks are elevated. The most important part; however, is positioning accordingly and following through with your messaging and commitments to investors.
4. Prepare personally and professionally. Unfortunately, when it comes to asset bubbles, there are no free lunches for professional investors. In fact, the bill can be quite substantial for everyone involved. Whether paying the bill now or later, few investors will escape having to pay a price for inflated asset prices and the madness of crowds.
For investors electing to participate in the bubble, the bill may come later, but don’t kid yourself—the bill is still in the mail! While deferring payment and pain may seem like the more desirable option in the near-term, it can carry a much higher price. When asset bubbles pop, large unrealized gains can evaporate almost instantly and are replaced with substantial losses. For professional investors benefiting from the bubble, I’d avoid extrapolating current incomes far into the future and consider passing on that second vacation house!
For those sitting out the bubble, the bill is typically paid upfront. Your income and possibly career may be placed under tremendous strain. Keep expenses low and prepare to hunker down financially for an extended period. Sound like fun? Of course not, and it’s why so few pay their “bubble invoice” early! On the bright side, I’ve found by paying early, you can avoid paying an even steeper bill (with penalties) down the road.
5. Have your shopping list ready. For those patiently waiting for the bubble to end, it’s important to be prepared. When the bids disappear and panic ensues, the sharp decline in asset prices can make it very difficult to concentrate. Having a plan and a potential buy list beforehand can pay tremendous dividends once opportunities reappear. Preparedness improves confidence and the ability to act decisively once the asset bubble pops.
After the Bubble Pops
1. Avoid the big freeze. During past asset bubbles, one of the things we frequently heard from investors interested in our absolute return strategy was, “Call me when you’re finding value and we’ll send you an allocation.” Although such a plan makes sense in theory, it’s much harder in practice. In fact, we’ve found during post-bubble panics, many investors have a tendency to freeze. Committees are particularly vulnerable to “waiting for things to settle down.” Based on our experience, by the time the worst is over, and investors are more comfortable allocating capital, many of the best values have already disappeared. To avoid the big freeze, know your opportunity set well and have a list of assets you’d like to own at predetermined prices. Furthermore, be willing to switch teams when the time is right. There should be a point in every market cycle when investors are getting adequately paid to take risk—don’t miss it!
2. Normalize. Similar to bull markets and profit cycle booms, we assume bear markets and recessions will not continue indefinitely. In effect, when an asset bubble bursts and we enter a recession, we assume the world is not going to end and trough results are not permanent. By normalizing operating results during profit recessions, we believe we can generate more accurate valuations and possibly find value where others are not. The opportunities after a bubble’s end can be tremendous. Normalizing can help you take advantage of them.
3. Consider taking operating or financial risk—avoid combining both. In the aftermath of the technology and housing bubbles, some of the best values could be found in companies with operating or financial risk. Examples of companies with operating risk, or above average volatility in cash flows, include those in the technology, industrial, and energy sectors. Companies with above average levels of debt, or financial risk, also tend to experience significant selling pressure during market panics. While investment opportunities in companies with operating or financial risk can be very attractive after asset bubbles pop, we are careful to avoid combining both forms of risk. As we like to remind ourselves, it doesn’t matter if you discover a 50-cent dollar if the underlying company doesn’t have the necessary cash flow or balance sheet to survive a prolonged downturn.
4. Remove yourself from the crowd. In my opinion, one of the most difficult things to prepare yourself for once an asset bubble pops is how distracting the collapse in prices can be to decision making. The flashing red prices luminating from your computer screen can be hypnotizing, making it difficult to concentrate and take action. Meanwhile, on financial television you can expect a constant stream of special reports on “the crash” with multiple guests providing a wide range of conflicting opinions. I’ve found the best cure from these distractions is to turn off the screens and begin researching a potential buy idea. Secluding yourself from the market and reading a 10-K is a good place to start!
5. Adopt a dog. Some of my best decisions after the technology and housing bubbles ended were made during long walks. While walking, I’d plan my day and form a list of small cap companies I wanted to consider for purchase. During the financial crisis of 2008-2009, my dogs Pete and “Big Jim” were particularly helpful (below). Dogs are great listeners and have a way of keeping those around them cool, calm, and collected. I highly recommend visiting your local animal shelter and adopting a dog before or after the bubble pops. If married, your spouse will thank you, as they’ll likely get tired of you constantly talking about the markets!
With a variety of valuation metrics flashing red, we are committed to successfully navigating through what we believe is yet another asset bubble. Our positioning, plan, and messaging are simple. Instead of playing along and keeping up with the crowd, we have taken a decidedly defensive position. This includes a very large and unabashed position in cash (92.4% as of 12/31/19). In effect, at this stage of the cycle, we want to avoid making large mistakes and position the portfolio for future opportunity. While our plan and positioning may seem overly cautious to some, we have seen firsthand how destructive a collapse in asset prices can be to wealth, profits, and economies. While the end of asset bubbles can be devastating for many, with the help of a thoughtful plan and sufficient preparation, they can be extremely rewarding for bubble survivors. Good luck!!!
For more information on our positioning, we’ve provided a link to our most recent quarterly letter (Q4 2019). Thank you for your interest in Palm Valley and our absolute return process!
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