How to Spot Stock Market Bubbles (Rebroadcast)

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Hi, it's Jack Howe. The Streetwise Podcast is on vacation this week, but don't worry, we have an encore episode for you. Meta, what timeless crowd pleaser have you selected?

We've selected How to Spot Bubbles, featuring an interview with investor Jeremy Grantham. We published that earlier this year.

When I was a kid, there were bubble gum wars, Meta. You had a couple of main brands, Bubblicious, Bubble Yum, and then you had this new arrival on the scene called Hubba Bubba, and they rolled out this commercial. It had these two Wild West gunfighters who faced off against each other.

It's gonna be a gunfight!

It's soft, juicy, and delicious. One of them pulled out a pack of Hubba Bubba, and they both blew bubbles, and the bubbles got bigger and bigger, and all the townspeople were watching. And then the bubbles popped, and the hero, I guess, of the commercial just peeled his right off his face and then turned to the camera and said, Big bubbles, no troubles. Big bubbles, no troubles. The idea was it doesn't stick to your face.

Well, you've kind of summed up the episode right there.

So the idea of this episode is, is it big bubbles or is it no troubles? Which is it going to be? I think I've explained that in a way that won't get us sued by whoever controls the Hubba Bubba IP at this point, right?

I think so. I think we're good.

On to Jeremy, and we'll be back with a regular episode next week. Thanks for listening.

So that's my worry, that we're demonstrating extreme levels of euphoria, and from now on, any little bump in the road will cause a retraction. And once you start to retract, confidence is eroded more money is pulled back, and it becomes a self-reinforcing move. And there is no real value to support it as far as the eye can see. And that is why following these bubbles, the declines are very severe, typically 50% or worse.

Welcome to the Barron Streetwise Podcast. I'm Jack Howe. The voice you just heard is renowned investor Jeremy Grantham. He's co-founder of a Boston-based money manager called GMO. He's also a market historian known for his occasional letters to investors warning about speculative excess bubbles. He sent one of those just this month warning that we appear to be in the late stage of a bubble and that it looks like, in his words, a real humdinger. Listening in is our audio producer Meta. Hi Meta.

Hey Jack.

Meta, do you know what they say about the shoeshine boy and the stock market?

I do not.

There's a story about Joe Kennedy, the father of America's 35th president, and supposedly he made a killing in the stock market during the Roaring '20s. And one day in 1929, while he was sitting for a shoeshine, the boy who was shining his shoes gave him some stock tips. And as the story goes, Joe said to himself, When even the shoeshine boys are giving stock tips, it's time to get out. And he got out, and he avoided a big stock crash that year. Now, that story might be an urban legend, but it was a popular saying on Wall Street for decades. When even the shoeshine boys are giving stock tips, get out. But I think it might be time for a new one. I mean, for one thing, the long trend toward athleisure makes shoeshine sound Archaic. Tycoons today all wear sneakers. Also, Meta, when I use the phrase shoeshine boy, is it just me, or do I run the risk of sounding classist, ageist, and sexist all at the same time?

Yep, all at the same time.

I knew it.

I also wonder whether kids today still work, although maybe that's just my ageism talking. I was never a shoeshine boy, but I washed dishes at a nearby restaurant a couple nights a week in school, and I mowed lawns on weekends. My kids haven't, shall we say, unlocked the entrepreneurial spirit just yet, unless you count wanting to be YouTube and TikTok video game stars. But even putting all these things aside, the pandemic has surely cut down on in-person shoe shines for now. So we need a new indicator, and I might have heard one the other day. Hey, all you cool cats and kittens, A colleague brought a penny stock to my attention. Now, this stock had multiplied in value in a matter of days, and the rally seems to have started just after the company received a key endorsement in an online video.

I'm definitely invested in finding out more about this product, TruForma, from Zemedica.

It wasn't Warren Buffett who made the video, it was Carol Baskin. Oh, it's going to be a good one.

I just feel it in my cat bones. Check it out.

Yes, she's best known for her feud with Joe Exotic in the Netflix documentary Tiger King. They have a heart and a soul and a mind. I've learned from them. But Carole Baskin keeps saying, I can't handle these tigers.

If he ever had an enemy in his life, it was Carole Baskin.

Hey, all you cool cats and kittens, it's Carole at Big Cat Rescue.

Now, if you're wondering what Carole Baskin thinks of Bitcoin, I'm afraid I haven't had the chance to ask her, but Lindsay Lohan, the former child actress turned entrepreneur, said in a video recently that Bitcoin is going to $100,000.

Hi, Crypto Buzz. I'm just here to say that Ethereum is going to $10,000 and Bitcoin is going to $100,000.

Both Carole Baskin and Lindsay Lohan issued their investment forecasts over a service called Cameo. That's where famous and sort of famous people charge money to make videos saying whatever the customer asks them to say. And when Cameo celebrities are being paid to tout speculative investments, is that a sign we're in a bubble? Are they the modern version of Joe Kennedy's shoeshine boy? I don't know for sure. If I see Mr. T telling me to buy Tesla, I'm gonna be concerned. Let me be clear, I don't have any special ability to predict the short-term direction of the stock market, and I don't know of anyone who does. For the most part, when guessing about stocks, I try to always guess up because that's what stocks tend to do over the long term. When valuations seem high like now, my best guess is that stock returns will be below average over the following decade. I don't see that as a reason to sell though, and we've heard on this podcast from plenty of smart forecasters who are bullish. Just this past week, Keith Parker, the chief stock strategist at UBS, wrote in a note to investors that he expects the S&P 500 to push another 5% higher during just the first half of this year. He cites as bullish signs vaccinations and government stimulus spending and potential for upside surprises in company earnings reports. Companies cut costs during the downturn, and so as revenues rebound, Keith says that should translate to higher profit margins. But I also saw a recent note arguing just the opposite, that we're in a bubble, a big one, and that it might pop by summer. Yes, price-to-earnings ratios look high, but the author of this note said it's not just about valuation metrics.

Far and away, the better indicators are psychological.

That's Jeremy Grantham, who co-founded asset manager GMO in 1977. As of a couple of years ago, it managed more than $60 billion for institutions and wealthy families. GMO takes a value approach to investing, and for more than a decade, growth investing has absolutely trounced the value approach. That's another way of saying that investors are enamored of fast-growing companies and not especially concerned about how expensive those companies appear relative to profits or revenues or free cash flow. In the past, when growth has outperformed value for long time periods, it has led to a reversal with better outperformance for value. Investors have been watching for that to happen. There were signs of a rotation to value last year Some investors think the shift will continue. Others say it's just another in a long series of false starts for value stocks. Jeremy has a record of calling the tops of market bubbles. He did so with high accuracy during the dot-com stock bubble just over 2 decades ago. There was a massive bubble in Japan in 1989 that he called, albeit 3 years early. He warned about the housing bubble that peaked around 2006, 2007, and this past summer he started warning about a new stock market bubble. So far, the market has ignored those warnings. Critics of Grantham say he warns about bubbles too often and too soon, and he misses out on some of the market upside. But in fairness, there seems to have been a lot of bubbly activity over the past few decades fueled by ultra-low bond yields. Grantham says he's not trying to call market peaks. He's trying to call moments when if an investor sells, he or she will reach a future moment when they'll be glad they sold because prices will be much lower. When I spoke with Jeremy this past week, I asked him to tell me more about how to spot bubbles.

A bubble peaks when you reach almost unbearable levels of ecstasy, enthusiasm beyond enthusiasms. Anyone who can beg, borrow, and steal has put their money in the market. Any extra debt that you could avail yourself of has been thrown into the battle. At that point, it doesn't need much to cause someone on the margin to start to pull back.

Unbearable ecstasy makes me want to write a Wall Street romance novel or maybe come out with a new fragrance. Is that fiscal stimulus you're wearing? No, it's unbearable ecstasy. Thank you, Meta. But as an investor, how will I know unbearable ecstasy when I smell it? Jeremy points to a scattering of signs in his latest letter. Tesla was recently valued at $1.25 million per car sold. That compares with $9,000 per car for General Motors. Companies like to sell new shares to the public when prices are high, and last year there were more initial public offerings than in 2000, the year the dot-com stock bubble popped. Even more remarkable, about half of them were SPACs.

SPACs have burst into the mainstream this year in a speed and veracity that few pockets of finance have seen before.

It's why we're taking— SPACs are special purpose acquisition companies, and lately we've been getting a lot of listener questions on them. We talked about them in an episode back in August. SPACs raise money and go public for the purpose of shopping for and buying other, often private, companies. A SPAC is like a bookmark that says this will be an exciting company at some future point, but we don't know what company or when. If investors are buying shares of so many companies before they know exactly what they're getting, maybe that's another sign of fraudtiness. Jeremy also points to an unusually high number of companies with small market values whose share prices have suddenly tripled inside of a year. That's sometimes a sign that relatively new and speculative investors are getting in on the action. The number of small options trades has exploded, multiplying 8-fold last year. We'll talk more about options in a bit, but just know that they can be used in conservative strategies to protect capital or in aggressive strategies to try to turn a small investment into a killing at the risk of losing it all. I'm guessing the huge spike in small options trades is not coming from conservative strategies. Jeremy says signs like these can point to bubbles, even if it's difficult to predict when when those bubbles will pop.

And that's why it's so impossibly difficult to know when that breaking point has arrived. Somewhat like a chain letter, it's drawing its power from the faith that it will keep going, and who knows which letter starts to break the chain. And we can never know that, but what you can look for is crazier and crazier manifestations of pure faith. When stocks start to rise vertically as Tesla is today, when one minute it's at 50 and the next minute it's at 250 and the next minute it's 880.

I asked Jeremy, what about these low interest rates and bond yields? The 10-year Treasury yield recently pushed back above 1%, but still its half-century average is well over 5%. People say there's no alternative to stocks, and the Fed says it'll keep short-term interest rates low for years because there's not much inflation. Jeremy says bubbles always come with wonderful stories. That's how investors reach those unbearable levels of ecstasy. In 1929, the U.S. was growing like China grows today. In 2000, the internet was reinventing commerce. In 2007, new financial instruments were making home ownership possible for people who hadn't been able to buy homes before. And now, ultra-low rates and a friendly Federal Reserve are said to bode well for stocks for years. So what will go wrong? Jeremy says nothing has to go wrong for bubbles to burst.

The market doesn't end with some terrible burst of bad news. It ends when things are pretty darn good, but not quite as good as yesterday, when somebody somewhere begins to say, yeah, yeah, it's pretty good, but at 80 times sales, perhaps I should take something off the table. And that is the end of the game.

Jeremy also says that the current bubble he sees is different from past ones because the economy isn't that good.

And let me point out that this is unique in that the real fundamentals underneath money have sucked this time. That is unique. There are no other bubbles for which that is the case. All of the other situations were wonderful economies that you could extrapolate forever in your mind, and of course, they would be worth a fortune. This one, if you extrapolated it forever, is a basket case.

As Jeremy writes in his note, investors assuming now that low rates will last forever is a lot like them assuming in the past that peak economic conditions would last forever. Neither can be true. He writes somewhat critically of big Wall Street firms that they always have bullish forecasts because it's good for business. He writes that all bubbles are different, but that historically speaking, we could be anywhere from July 1999 and February 2000 now. That was the last hurrah before the dot-com bubble peaked. Jeremy mentions that bubble a lot. He calls it the biggest stock market speculation in history. And he says when it ended, stocks like Pets.com flopped quickly, but it took longer for the damage to spread.

They took out the pet.coms and shot them, and the rest of the market continued to carry on as if it hadn't noticed. And then they shot the flaky growth stocks and the market continued to go up. And then they shot the medium growth stocks and the market went up. And then finally they got around to the Cisco's and still, believe it or not, the market hung in. And then finally, as if it took a while to work up the tail of— I like to think of it as the giant dinosaur— it finally reached its brain and the entire balance of the market, the whole 70%, began to keel over like some great iceberg turning over and went down for 2.5 years.

Jeremy's guess is that the longest the current bubble can survive is to late spring or summer. By then, he expects the most pressing issue facing the world, the pandemic, to have been largely solved by vaccines and for investors to breathe a sigh of relief and then look around and realize that the economy is still in poor shape. It's a pessimistic view, no doubt. What's most troubling about it to me is that I like to think that even if I'm invested in stocks during a big downturn, the market will eventually come back and hit new highs. If I hold for long enough, I'll be okay. Historically, that's generally been the case, but there are some exceptions. For example, if you held shares of blue-chip networking giant Cisco during the dot-com stock bubble, more than 20 years later, you're not yet back to even. The NASDAQ fell more than 75% during the dot-com stock bubble, it took 15 years to reach a new high. The S&P 500 lost more than half its value after the dot-com bubble and then fell by more than half again after the housing bubble. The most worrisome case of my lifetime is probably Japan. Its Nikkei 225 index is still way below where it peaked in 1989. Think of that for a minute. I was in high school back then, and people talked about Japan the way they talk about China today. Japan was beating the US in education, technology, and manufacturing, everyone said. There was a movie called Gung Ho that came out in 1986. It starred Michael Keaton. It's about a Japanese company that takes over a Pennsylvania car plant. Keaton plays Hunt Stevenson, whose job it is to get the complacent American workers to go along with new efforts by the Japanese management team to raise productivity. There are, for example, morning calisthenics, and the Americans don't respond well.

We will begin with our morning exercises.

Don't worry, there's a happy ending. A compromise is reached. The workers become more cooperative, they get pay raises, and they even do morning calisthenics, but with American rock and roll playing. The point is, Japan was the envy of the world at the time. Imagine buying into its blue chip stock index in 1989, just 3 years after Gung Ho hit theaters, and still being way down on your investment now. Okay, so what can investors do to protect themselves? Should they buy bonds? Jeremy says he's not an expert in bonds, that he always found them a bit boring, as he puts it, but that bonds now appear to be in a bigger bubble than stocks. In his recent letter, he recommends two groups of stocks: emerging markets and value stocks. There are many mutual funds for both, including index funds and actively managed funds overseen by stock pickers. Jeremy says investors can also buy an all-world ex-US fund. In other words, a fund that invests everywhere but the US if they have too much US exposure. Of course, investors can also hold cash while they're waiting for— what was the phrase, Meta? Rambunctious intimacy or exquisite urgency? What was it again?

I think it was unbearable ecstasy. Though I do prefer fiscal stimulus.

Ah, smells passionate. I mentioned options a few minutes ago. Some investors like to use them to buy downside protection for stock portfolios. I spoke recently with a money manager who just launched an unusual options-based fund designed to cater to investors who are worried about a stock market bubble. Hi, James.

Morning.

Hi, it's Jack Howitt, Barron's. How are you?

Good, how are you?

That's James McDonald, and he's the CEO of Hercules Investments, which opened shop just late last year. It has about $200 million under management and a brand new mutual fund. The ticker symbol is NFLHX, and that'll make more sense in a moment. What's a little unusual about the fund is that it uses stock index options to try to grow investor money and protect against downturns. Right now, the fund is bearishly positioned. Here's James.

We compare today's market metrics with those throughout history, and at no time in American history have markets been valued this high relative to earnings, relative to GDP, or relative to the risks within the economy. And so we believe that markets not only are overpriced, but because of the expanding risk and uncertainty surrounding COVID, they're ripe for a major pullback. And so most of our investing right now is positioned to take advantage of that.

There's something else that's even more unusual about James's new fund.

Our mutual fund is the only 2-and-20 fee mutual fund in the United States.

Let me explain. When James says a 2-and-20 fee, he means the fund charges 2% a year no matter what happens, plus 20% of any upside. That type of fee is exceptionally high for a mutual fund, but it's common among hedge funds. James has gotten permission to use that fee structure by agreeing to follow the same rule hedge funds follow: to accept investment money only from qualified investors with high net worths and plenty of experience. I asked James to explain who might buy his fund and how they might use it.

It can be used as an overlay to an existing portfolio. And when I say an overlay, meaning if someone's got existing exposure to equities in the U.S. and/or internationally, our fund is a good tool with a 5 or 10% allocation to offset risk of the market.

One way James tries to make money in a falling stock market is by buying put options on stock indexes. Anyone want a 20-second explanation of how options work? Anyone at all, just speak right up.

Yeah, yeah, yes, I, I'd love it. I thought you'd never ask.

Okay, you've got it, Meta. Options are limited-time bets on stocks or stock indexes. Now, a call option is a bet a stock will go up, and a put option is a bet it'll go down. That sounds simple, but it gets complicated quickly because you can buy or sell both puts and calls. If you're selling a bearish bet to someone else, you're not bearish, you're bullish. You're betting that the bet you're selling won't pay off and that you'll pocket the price of the bet. One of James's strategies involves buying index puts, which means he's betting against broad groups of stocks. If the underlying stocks fall, he can make a lot of money. If the underlying stocks rise or stay the same, he can lose the cost of the bet. But with options, since you put up only a little money to control a large bet, you can limit your losses when your bets don't pay off. That's enough for now. One last thing I'll say is that options can be used for cautious strategies like squeezing extra income out of your stocks by giving up some potential upside if prices rise, but they can also be used for profoundly risky strategies. Is some of them risk not just all the money you pay for the options bet, but all the money you have. If you're someone who isn't sure if, let's say, stocks are for you, I tell you, read up on them, give them a try. But if you're not sure options are for you, I tell you, they're probably not. I guess I've never been a big fan of options. James's fund is too new and the fees are maybe too high for me to recommend it for now, but I'll be watching it with great interest, especially when the next big downturn hits. For folks who aren't high net worth investors and who don't trade options and who want to know what to buy if they're worried about the market, I asked James what he would recommend. He mentioned a new exchange-traded fund from another company. It has kind of a long name: Simplify US Equity Plus Downside— hold on, I gotta take a drink of water. Where was I? Ah, Downside Convexity ETF, ticker SPD. It says it seeks to boost performance during downturns with a systematic options overlay. Again, it's too new for my taste, but I'll keep an eye on it. One more thing, I asked James how he got started in investing. Now, I've heard a lot of origin stories over the years. His was pretty specific and a first for me.

And so I'm a football player. I've been playing football for 12 years, and I've been in the investment industry for 25. And my dream and goal is to buy an NFL team. And they're expensive. You know, you have to write a $2.2 billion check. And there are only so many ways that you can generate that type of cash. And in the hedge fund space, if you're great at what you do and if you deliver returns, you can earn that type of money. And so I got into this business to generate $12 billion in profits for clients so that I can write a check for a football team.

I guess that's where his fund ticker comes from, NFLHX. I asked James if he has a preference on the team. He says The best team for me is the cheapest one, and that he's heard that the Denver Broncos might become available in a couple of years, but also that he grew up near Washington, D.C., so it might be fun to own the football team there. James, thanks for telling me about your new fund and your options approach, and best of luck with the football team. I'm not in the market for a team myself. I did coach T-ball the year before last. Does that count for anything? Probably not, right? Thank you for listening. Meta Lutzoff is our producer. Meta, should we give a shout out to the rest of the team this week or just keep all the glory for ourselves? I mean, I think you know where I stand.

I think we should give a big shout out to Katie Ferguson, Brian Price, and Melissa Haggerty.

Okay, you went a different direction with it. Subscribe to the podcast on Apple Podcasts, Spotify, or wherever you listen to podcasts. And if you listen on Apple, please write us a review. If you want to find out about new stories and new podcast episodes, you can follow me on Twitter. That's @jackhoug. See you next week.

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