The Bubble Addicts Are Here To Stay: A Bubble Investment Strategy

A quick bubble history.

Since getting involved with the stock market in the mid-’80s, I’ve experienced four major bubbles.

The mid-’80s – A commercial real estate bubble. To stimulate an economy in serious recession in the early ’80s, the federal government encouraged real estate construction by (A) instituting huge tax breaks and (B) giving savings banks a new ability to invest in commercial real estate loans with minimal capital requirements. It worked for a while – commercial construction and investment soared. But then so did the amount of empty office buildings, etc. The bursting of the commercial real estate bubble in the late ’80s caused a recession and a massive savings bank bailout.

The late ’90s – The internet bubble. The development of internet commerce created the biggest stock market valuation bubble ever, as measured by P/E ratios. Two fun examples:

1. Cisco. This supplier to the internet highway briefly had the market’s largest market cap. The stock hit $82 in early 2000, from less than one before 1993. And then $9 two years later. After 22 years of solid earnings, the stock is $48 today.
2. Netbank. This start-up boasted a website. That’s it – a website. That was enough to drive its stock price to 10 times book value. Compare that to Goldman Sachs, which is trading a bit over 1 times book today. If memory serves, that website alone was valued at about $1 billion. In 2007, Netbank declared bankruptcy.

The mid-00s – The housing bubble. Hopefully you’ve seen The Big Short or read some of my Seeking Alpha articles. Dazzlingly stupid mortgage lending, combined with an accommodating Federal Reserve, led to soaring home prices and huge overbuilding. You know the rest – a housing collapse and another big banking bailout.

2020/21 – The COVID bubble. The trifecta of a “disruptive business model” stock bubble, SPACs and crypto. You know how this story is ending.

Why do we keep bubbling?

Homo Sapiens are the pinnacle of evolution, the highest life form (although we are learning that viruses are pretty special too). So why do we keep making the same very costly mistake of chasing investment bubbles? Because I’ve come to believe that certain groups of investors are simply addicted to them. I see three groups of “bubble addicts”:

The greedy. Some of us just think we deserve more. I think of an acquaintance who said he was approached to invest with Bernie Madoff, who famously promised steady 10% returns. My friend turned down the offer because he required 15% returns.

Pension funds. This $30 trillion pool of investment dollars targets about a 7% return in order to meet future pension obligations. If pension fund managers can’t consistently earn at least 7%, they have to go to their sponsor – a state government, a corporate CEO, etc. – and ask for more money, or for pension benefits to be cut. And probably lose their job in the process.

Back in the day, bonds were the mainstay pension fund investment. But over the past 20 years, bond yields haven’t gotten the pensions anywhere close to 7%. So increasingly they have invested in stocks and alternative investments like private equity, as this chart shows:

Source: Pew Institute

And venture capital fundraising, in large part from pension funds, has soared since the pandemic:

Source: Pitchbook

How many great new ideas are out there for venture capitalists to invest in? So their investments are by necessity getting riskier. But if the pension funds back away from the growing risk, they have to admit they can’t earn that 7%. Then bad things happen, to retirees and to pension plan sponsors and then to pension fund managers. So pension fund managers are pretty much addicted to chasing bubbles.

The relatively poor. The “absolutely poor” have income below defined poverty levels. The “relatively poor” feel that they should be doing better, because their friends are, or their parents did, or because the Kardashians are, or whatever. Their current income and prospects just aren’t getting them to the lifestyle they aspire to.

I got an eye-opening look into this issue in the comments to a Seeking Alpha article I wrote about AMC in mid-2021, at the height of its meme bubble. Take a look at them. Big, big dreams that of course have been sadly crushed. And crushed again by crypto and SPACs.

But can the relatively poor just walk away from chasing bubbles? Not without giving up dreams of better lifestyles.

The bubble feeders.

Bubbles don’t just spontaneously occur; they require skilled hands to shape them. And those skilled hands profit handsomely from their creations. Who are these feeders?

Private equity and venture fund managers. They typically earn a 2% management fee plus 20% of profits earned. That adds up fast. A $10 billion venture fund could easily generate $400 million a year in income, spread among a pretty small group of people. VC News lists 14 venture capitalists who are billionaires.

SPAC sponsors. Put these two quotes together:

“Per SPAC Insider, SPACs raised more than $83 billion in 2020 and more than $97 billion in the first three months of 2021.” (Yahoo Finance)

“If the SPAC is successful in acquiring a target company, the founders will profit from their stake in the new company, usually 20% of the common stock.” (Corporate Finance Institute, my underlining)

That’s $36 billion in free stock to SPAC sponsors. Meanwhile, a CNBC SPAC stock index fell by more than 80% from its early 2021 high to today.

Wall Street earns fees from (A) raising funds for private equity, venture capital and SPACs, (B) buying and selling companies, (C) trading bubble stocks, crypto, etc., and (D) other stuff I’m not thinking of right now.

The Federal Reserve. Part of the Federal Reserve’s mandate is to reduce unemployment. Lowering interest rates increases stock values, which creates wealth, which drives the “wealth effect”. The wealth effect is the estimate that households increase their spending by about 3% as their wealth increases. More spending increases GDP, which reduces unemployment, which makes the Fed happy, and politicians happy with the Fed.

In my view, the wealth effect is why the supposed economic geniuses at the Fed never figure out that bubbles are occurring, so they never take steps to minimize them.

Social media and CNBC certainly benefit from more viewers while bubbles are blowing up.

How to play the bubble addictions – the short term.

Unfortunately, markets are still unwinding from the disruptor company/crypto/SPAC bubbles. The next year or two should therefore be a traders’ market, with brief rallies followed by lower lows. To me, neither aggressive longs nor shorts will pay off sufficient to their risk. Value stocks are probably the best near-term bet, even if they can’t offer the adrenaline jolt offered by bubble stocks.

In my area of expertise (consumer and housing stocks), my favorite value stock is Farmer Mac (AGM). It is an 8% EPS grower protected by a government-granted moat, selling at a 9 P/E. It’s my biggest holding. If you’re intrigued, check out my initial Seeking Alpha report on AGM, or my latest update.

How to play the bubble addictions – the long term.

I can’t predict when the next financial bubble will arise or what it will be. But I am certain that the bubble addicts need another one. So when the next one shows up, what should we do?

To come up with a strategy, let’s take a look at the recent bubble. This chart shows a 5-year history for bitcoin and for Redfin (RDFN), a “disruptor” bubble stock I wrote about beginning in June 2020.

Source: Yahoo Finance

When to buy. Clearly, buying Bitcoin and Redfin in 2018 or 2019 would have made you a lot of money, but you would have had to forecast the bubble. A more realistic strategy is to wait for the parabolic rise, which took place during 2020. Once the parabola is firmly in place, it looks like you still have a good 6-12 months of further bubbling ahead, with a 50-100% gain opportunity. I sadly admit that I’ve never done this before, because buying into a bubble seems crazy. But I will next time.

When to short. Again, the chart shows that the bursting of the bubble takes a while to play out. Trying to get in early is risky, as I’ve learned. For example, my initial June 12, 2020 sell call was at $33. Yes, the stock is $4 today, but not before the stock nearly hit $100. Better to wait for a substantial drop of maybe 20-30% to confirm that the bubble is clearly bursting. Catching Redfin at $70, or bitcoin at $40,000, on the way down left a lot of room to go.