The Dividend Cafe - A Primer on Bubbles

Episode Date: March 26, 2021

Who would have guessed that at the one-year mark of the worst market drop since the Great Financial Crisis, one of the hottest topics in financial markets is whether or not we are in a “bubble.” Am I the only one that sees a tiny bit of irony here? A year ago, the conversation was entirely focused on whether or not millions of American people were going to die, how long the entire American economy would be shut down for (hint: it lasted longer than 15 days to bend the curve), and whether 18,000 in the Dow would prove to be low enough. Painful times, painful memories. Today I want to look into the very idea of bubbles, evaluate as intelligently and objectively as I am able what is going on in markets right now and what is not going on, and see if we can’t offer a little clarity into a subject that I think gets quite polluted by poor punditry. Of course, if it weren’t for poor punditry, wealth advisors like us would have a lot less cleaning up to do. Join us in the Dividend Cafe … Links mentioned in this episode: DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, weekly market commentary focused on dividends in your portfolio and dividends in your understanding of economic life. Hello and welcome to this week's Dividend Cafe. I am recording here at my house in Newport Beach. beach, kind of bunch of things going on this weekend, but I'm really actually excited about this week's Dividend Cafe. The message from it, the content from it is something that I think a lot of people are asking about. I'm looking forward to talking to you about that here now on the podcast and the video. And then as always, I would love for you to go to dividendcafe.com where there's a little bit more elaborate written commentary. But the subject is this whole concept of a bubble and excess and the risk of things being in this really frothy period of time. And I want to first start with an observation that I think is fascinating. I'm sitting here recording going into the last weekend of March of 2021.

And one year ago, in the last weekend of March 2020, all of the questions, all of the punditry, all of the commentary, all of the conversation was totally understandably around how low are we going to go? How bad is it going to get? How many millions of people are going to die? Hospitals overrun? of people are going to die, hospitals overrun, the length and severity of a lockdown, questions about what the economic contraction would look like. Are people ever going to fly again? Are businesses ever going to open again? There was this peak level of where we were a year ago of uncertainty. And as markets in this week that we just got done memorializing hit their bottom through that period, there was an exorbitant amount of discussion as to retesting the lows, breaking through to new lows, lower than even that 18,300-ish figure that we had hit on March 23rd. And so all of those things at the time, contextually, there were a lot of people that

were wrong, those that predicted we were going to go all the way to 15,000, 10,000 or whatever didn't happen. And there's a whole lot of reasons. And I don't have any problem with that. That's the way the world works, that when the facts facts change people's opinions change i i say it to highlight the contrast of right now all of the discussion and and the sort of um context is in language about a bubble about uh mania uh how high are we going to go? How blown out is this going to get? Is such and such electric car company going to 4,000? Is such and such a cryptocurrency going to 100,000? Is the NASDAQ doing this? Is FANG doing that? So everything is just a polar opposite. It isn't just, and this is profound and interesting enough, it isn't just that a year ago we were all looking at this and then now we're in a different season.

It's that we're in this polar opposite. The hyper fear has now been replaced by a hyper emotion in a completely opposite direction and category. And some of that, I suppose, is prima facie reasonable. Most of it, I actually think from the punditry class, is just a weather person changing the sensationalism of their view, calling for extreme cold and then calling for extreme hot, you know, the point, the keyword is not cold and it's not hot, it's extreme, right? And that's, I think, where the way a lot of people sort of get their clicks and get their, drive their kind of business model. But my view here is a lot of things happened. A lot of them are really positive. A lot of them maybe are short-term positive, long-term negative. But when you look at where we were and how we've come out of it, I talked a bit about that last week, some of the fundamentals.

The cysts that the Fed gave into corporate credit alone and its bleed through benefits into equity markets, that alone was a very significant market impacting event. The fact that hospitals never got near overrun, the fact that the disease proved actually to be even more infectious than people thought, but far, far, far less fatal than people thought. There's just a whole lot of things that we didn't know a year ago, we know now. Some of them medical, some of them political, some of them economic, some of them monetary, but those things now are able to be better priced in. So then when the conversation turns to are we in a bubble, I think that we use language ambiguously, and I don't want to do it. I want clarity. I want specificity in the way I'm talking to my clients.

And I'm very much on the record about certain segments of the investment universe that I think are overpriced. But I want to provide a couple categories for you to help think differently about what might be overpriced, what might be stretched in valuation, what might be expensive, what might be ill-advised to be invested in versus a bubble. Because I don't think it's mere semantics. I think it's paradigmatic. And I want to drive this contrast for you. As a general rule, and this is not necessarily universal, but I think this is useful. I think that overpriced investments or expensive investments or ill-advised investments are paid for. You have cash and you pay a hundred bucks for something and it goes to fifty dollars

you have equity and that equity value has dropped when you start talking about bubbles you almost inevitably have talked about debt something has been funded we've borrowed money and and when you say well no look everyone loves this kind of overpriced stuff at 100, now it's dropping to 50, and the masses have come in. And so there's still a bubble, and there's still a lot of losses. And yet that was equity funded, not debt funded. The thing you miss is that along the way, you said the masses come in. The masses do not come in with their own money. The masses always come in with borrowed money. That could be hedge funds.

It could be institutional. It could be banks levering up their balance sheets in some cases. When you talk about the dot-com or retail crazes and the flipping of Las Vegas condos and whatnot, it's always debt field. I guess the point I'm making is that a characteristic, a hallmark of a bubble is the way in which it's financed. And the reason for that is that there's a very, very, very low limit to loss when things are equity funded. It can be brutal. Someone could lose 100%, but it is not systemic.

It's isolated to the holder of the investment. It drops in value. They've lost that money. Where debt-fueled investment now leads to losses both for the investor and for the lender. There's leverage on it, so losses are multiplied. They're more than one-to-one. And the nature of debt-fueled investment means that there's very likely

a whole lot more people that came in. So the loss is exponential. And then systemic, it bleeds into other things, because what starts as a loss in one area when it's filled with debt means another asset has to be sold to clear that debit to liquidateate that debt, and therefore it puts selling pressure on other aspects. So there's a systemic nature to debt field bubbles, which is just categorically different than the isolated losses of someone who may make a bad investment, who may have overpaid for something. And also a bad investment that might really be an early investment. They overpaid and maybe it works out later through time. But when it's debt field, you're never going to know that because the debt takes you out of the investment before the payoff that might come later. The other category that I want people to think about is a bubble in a productive asset versus

a non-productive asset. A railroad or broadband can be a bubble if all of a sudden all the hallmarks of overvaluation and excess and euphoria are there, but the underlying asset provides a utility to the economy. It provides some sort of productive benefit and it has a role in the supply chain, if you will, of the economy. Where a bubble in a non-productive asset has no such thing.

And I don't know if crypto fits into this category or not. And back in the old days, there were plenty of.coms that clearly fit into it. The point being that that distinction between a productive and non productive asset is almost a categorical distinction in the way that a bubble might impact capital markets in the economy. And so I think that right now we are dealing with a whole lot of questions about a bubble because we have some things and risk assets that feel and seem, and in some cases, most certainly are overpriced. You have awful lot of liquidity sloshing around the economy,

you have a very low cost of capital, you have incentives to lever up, to borrow, to invest, because of low cost of capital, because of a low available return on capital through treasury bonds, municipal bonds, safe assets, things like that. So there is a kind of paradigm in which there is a propensity for excessive valuation. Do I think some of the microcap tech stuff has gotten expensive? Of course. Do I think FANG got expensive? I do. I think that all those things I've talked about are true. But this is a distinction I want to make between the bubble that was technology and dot com in 1999, that burst in 2000, the bubble that was the housing crisis, which was the mother of all bubbles. I didn't live through it or invest through it. But the bubble of Japan in the late 80s, which I've studied immensely, this was a period of rank non-discrimination across risk reward decision

making. It was a period of silliness that was defined by apathy about risk, about fundamentals, about math, about logic, about economics, about truth. And so you got to this point, you have celebrities doing commercials for the E-Trade stuff at the Super Bowls and things in the late 90s. And it was a craze. It was a mania. It was debt field. It was irrational. It also felt so good when it was going on. Well, I think that there's pockets of overvaluation right now, but I really think that there's as much fear of a bubble or more fear of a bubble right now than there are signs of a bubble. And that's a hallmark definition of not being in a bubble. of a bubble and that's a hallmark definition of not being in a bubble the point of a bubble is when all of a sudden everyone is just positive that you can buy five condos in florida with no money down and nothing can ever go wrong well that's a bubble there was a complacency that

was systemic cultural in the housing crisis and the technology boom. I don't think we're experiencing that right now. I think we're experiencing pockets of overvaluation to the extent that all asset classes are somewhat frothy in valuation. That is at very different degrees. No one can look at the consumer staple sector and say that they're equally overvalued relative to historical valuation. overvalued relative to historical valuation. But I think that to the extent that there is a kind of macro high level evaluation, it is part and parcel of the monetary environment we're in, where there is a 0% reference rate in the risk-free,

that all assets are priced against something that is so low that it's boosted valuations across the board. So once you kind of deal with the rising tide nature of everything, then within that, you have to be discerning and you have to look at certain sectors from the SPACs to the crypto, to the micro cap, to the technology, to whatever else, look at those things, individual sectors, individual companies make those decisions. But I don't think it's useful to look at this binary as everything's in a bubble or nothing's in a bubble.

I think that we have a valuation conversation that's always and forever important for investors, but that cultural marker of a bubble, which I personally have lived through and invested through twice, and that we have experienced as a society countless times going back historically, I think that that's a different marker than what we're experiencing now. And I hope that distinction is helpful. All that can change. There could end up being a real debt field craze. There could be a lot of non-productive assets

that get bid up and there could come a point. And there's indications of some leaning in these directions. But by and large, I'm trying to make these distinctions for clients to help make discernments across asset classes and securities and sectors that look potentially overvalued versus ones that don't. And yet, by all means, avoiding the cultural moment of a bubble. I hope it's useful. I thank you for listening to and watching the

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