Musings About Bubbles

The Chinese economy, London’s real estate, Social Media companies, Tesla Motors. What is it with all people calling everything a bubble these days?

There are a thousand definitions for a bubble. Some say it is a huge trend you have not participated in. Others stick to a more conventional description – unsustainable valuation.

One of the purposes of free markets is to correct excesses. If you believe that something is a bubble, devise a plan to profit from it. Don’t just stay on the sidelines. There are several ways to participate:

1) You could become part of the momentum and help early short sellers to part with their money. George Soros loves bubbles: “When I see a bubble, I buy that bubble, because that’s how I make money”.

2) If momentum is not your forte, then short it and see where it gets you. Just because something seems overly expensive, it does not mean that it won’t become more expensive. Hundreds of money managers thought that the housing market in the U.S. was in a bubble in 2004. They ended up being right, but between 2004 and 2006, many homebuilders stocks quadrupled in value. You cannot afford to lose 300% of your clients money. Most will take it back, when you down 30%, so even if you end up being right, you might not even be able to benefit from it. Timing is of crucial importance when you bet against a bubble, because “the market could remain irrational longer than you could remain solvent” – as Keynes pointed out. You could wait for a technical breakdown and short the crap out of the bubble – some say that catching trend reversal are the most favorable risk/reward trades/investments. Keep in mind that the higher the potential reward for each unit of risk you take, the lower the probability that it will actually work. This is how financial markets work. If you could make 10 times your money in a deal, the odds are high that this deal might end up wiping our your entire investment.

3) Wait for the bubble to busts and they pick up the pieces at extremely low prices and sell them during the next bubble. Here’s the thing. You need leverage to create bubble. Financial leverage. Leverage is the main reason why when a bubble bursts, the market over-shoots to the downside and send asset prices to extremely low and some would call them “favorable” prices. Without a big bubble, you cannot have a big bust. And without a big bust, you cannot pick up assets at extremely attractive valuations. So stop complaining. As Peter Lynch likes to say: “ I don’t know what exactly causes big market corrections, but I know that the track record of most successful long-term investors would be impossible without them (the corrections”. To benefit from a bust, you need to have an ample supply of cash, because credit markets are often closed when prices are the lowest. People think in terms of capital preservation, not in terms of making more money.

Most people take the passive approach of side-lined viewers. Everyone has an opinion, but very few have an idea how to turn that opinion into an actionable plan. It is the trading and investing ideas that matter.

If you believe that something is a bubble, you could actually profit from it. Usually, people who point fingers and call something a bubble, do it for one main reason – to declare to the world that they will never put their money there and other people should do the same, because “it will end badly”. And you know what? Maybe it will. The financial history is full of booms and busts and actually both precipitate each other. Learn to live with it. Bubbles are not going anywhere. Neither are busts. But you could make a big difference in your life if you learn how to participate in them.

Is The Market Always Right?

George Soros likes to joke that market has predicted seven of the past two recessions. And he is right. Since the market is forward looking, it will sometimes discount fundamentals that will never become a reality.

Prices reflect people’s expectations about the future, mostly about the near-term future. To say that the market is always right means to assume that people’s expectations about the future always come true. We all know that this is not the case. No one has a crystal ball. People are often wrong.

Is the market always right?

No, but this does not stop people who follow price trends to make a lot of money. The market could remain “wrong” (irrational) for a very long period of time and even become “wronger”.

Is the market always right is not even the right question to ask. As Stanley Druckenmiller says in the book Market Wizards: “It is not important whether you are right or wrong, but how much money you make when you are right and how much money you lose when you are wrong.” And yes. You will be wrong. In this business, being wrong is not a choice, staying wrong is.

Josh Brown has an interesting observation on why trends exist. Here’s what I think on the subject:

Trends exist because discounting the future is a process, not an event. Different people buy for different reasons at the different stages of the price cycle. Some buy, when a company is still losing money, but it has great potential. Another group buys when this company reports its first profitable quarter. A third group buys when this company has had several years of outstanding growth and beats analysts’ estimates. A fourth group buys just because the company’s stock has been outperforming and at all-time highs. Another group, buys because it needs to cover its shorts.

The market is forward looking and it often discounts events that have not happened yet. The market is also constantly looking for feedback – in the short-term perspective from price, in the long-term perspective – from fundamentals. When expectations are met and exceeded, the trend continues.