This post is was originally published on Financial Mentor

All Major Asset Classes Are Crazy Overvalued. It’s Time For Risk Management

It’s time to get concerned.

It’s not natural for the U.S. stock market to march relentlessly higher into extreme overvaluation with almost no volatility. It’s one sided. It’s abnormal.

A healthy market rotates up and down within an overall trend because there’s a balance of buyers and sellers.

It’s not natural for bonds to trade at negative interest rates in many parts of the world with U.S. interest rates approaching zero. It’s also not natural for the yield curve to invert (hasn’t happened yet, but very close) where the short end has higher interest rates than the long end.

A healthy credit market pays interest for the use of money and charges a premium for the extra risk of lending over longer periods of time.

It’s not natural for people to exchange the equivalent of a new car for bits and bytes in the internet ether (otherwise known as cryptocurrency) created out of thin air by some unknown guy in the dark recesses of his computer. Nor is it natural for any sound “currency” to rise by thousands of percent in a year, or for common citizens to “mine” thousands of new “currencies” in a year to cash in on the crypto-mania.

Even worse, I can’t show you what a healthy currency looks like because all currency today is “fiat” explaining the unhealthy economic backdrop that gave rise to Bitcoin (and all of these other financial bubbles) in the first place (more on that below…).

I could add real estate to this list of speculative frenzies because it certainly qualifies, but everything else is so crazy-extreme that it makes the real estate bubble pale in comparison. Obviously, that fact isn’t healthy either.

Something is wrong today.

Seriously wrong.

As Warren Buffett said, “be fearful when others are greedy, and be greedy when others are fearful”.

Greed is in all the major asset classes.

I’t’s time to be fearful.

I Didn’t Want To Write This But…

This bubble bothers me more than the last three (stock market in 2000, real estate in 2007, bond market from 2013 to current).

This one is bigger, badder, and disturbingly different.

I provided written warnings to subscribers about each of the last three bubbles prior to bursting. In the past, I welcomed them as government manufactured buying opportunities for smart risk managers.

But there’s something wrong with today’s bubble that makes me more cautious than usual (not that asset bubbles should be “usual”, but that’s the reality of the government manipulated markets we live with today).

Until now I’ve been passively observing the escalating overvaluation in all the major asset classes enjoying the increase in values like other investors. It’s been an amazingly profitable ride.

I even ignored the Bitcoin speculative mania as an interesting sideline – a curious, little pet-bubble if you will – until I had a disturbing realization during December as prices pushed the $20,000 per coin level that prompted this article (Yes, I’ve been sitting on publishing this for two months because it bothers me so much).

Something very important is happening, Bitcoin is a symptom, and the conclusion is not what you would expect. Let me explain…

How To Identify A Financial Bubble As It Peaks

I get interviewed by various media channels a couple times a week. For the past three months every interviewer asks my opinion about Bitcoin. Also, my coaching clients and course clients are all asking me about Bitcoin.

This has only happened twice before in my career…

  1. The first time was the two years leading up to the 2000 final valuation top in the U.S. stock market. Every client wanted hot stock tips for the dot-com bubble. Companies with no business model and no clients were being valued in millions. The NASDAQ sold for an insane 200 times earnings. Everybody involved in tech stocks was getting rich, and it was a “new era” because the internet was going to change all valuation rules for business (sounds a lot like the the blockchain and cryptocurrency today, doesn’t it?). I started getting cautious in 1998 (two years too early), sold my hedge fund investment management business to manage risk exposure, and wrote public warnings (before this site was a blog it had a newsletter). Typical of all true manias, the emotion was so strong and the beliefs so deeply entrenched that people literally can’t see the obvious. In this case, the canary in the coal mine was when one of my early coaching clients, who built his fortune in tech stocks, fired me in frustrated anger when I had the gall to advocate risk management to preserve his fortune in preparation for the bubble bursting. He believed tech stocks were in their infancy and disliked my message so he killed the messenger. Unfortunately, he suffered life-changing losses when the bubble burst.
  2. The second time it happened was during the two years leading up to the 2007 top in the U.S. real estate market. Every new coaching client wanted to get rich in real estate. People were so blinded by the consistency and reliability of the gains that the conventional wisdom was that real estate never went down. Seriously! Nobody believes that today, but that was investment truth back then. My wake up call for that bubble was when tenants for my C-class apartment buildings with credit history so bad they didn’t even qualify to rent a $600 per month apartment were buying $300,000 houses with no down payment loans (they were called “liar loans” back then). I began the process of liquidating all of my investment real estate in 2005 to manage risk and it took 2 years to unwind the portfolio before the eventual decline. The canary in the coal mine demonstrating the emotion driven blindness of the time was when I was publicly ridiculed for my decision to sell and pay the taxes rather than 1031 the gains to newer, bigger properties. I’ll never forget the verbal abuse by certain real estate professionals calling me “stupid” with one in particular so emotional that he was yelling at me with spittle coming out of his mouth. The subsequent decline cost many of his clients their entire life savings.

The Bubble Du Jour

I share those stories so you can see what investment bubbles look like as they occur and how people invested in those bubbles emotionally react to warning signs of problems when the bubble is in late stages. The setup in order of occurrence has been:

  1. Extreme overvaluation sets up the condition for extreme downside risk.
  2. Next, a speculative mania causes a final price acceleration phase resulting in an emotional peak as participants get rich. This attracts media attention and crowd psychology results.
  3. Third, participants who are financially committed to the bubble become emotionally irrational and aggressive to contrary opinion.
  4. And finally, certain technical indicators break down (specifics depend on the market that has bubbled) signalling the decline has begun.

I have been getting progressively more cautious over the past few years based on cycling overvaluation extremes in different markets (since all the major markets except commodities are overvalued now), but I’ve continued to dance while the music played because the other three warning signs weren’t in place… yet.

My first word of caution came via this post announcing the bond market bubble back in early 2013. I declared in that post there was no positive mathematical expectancy (net of inflation) remaining in the bond market and that the only sensible decision from an expectancy investing framework was to exit the asset class. While some embraced the idea, others ridiculed it because it violated firmly held tenets of asset allocation/diversification. They were blind to reality, even though the math behind the conclusions was obvious, provable, and has stood the test of time.

Overall, the response to that article was muted. The negative comments were rational indicating no emotional extreme had been reached even though the math was unequivocal. Subsequent market movement have proven the thesis (so far) with interest rates remaining today in the range where they were back on publication date supporting the best case scenario conclusion in the article (so far) and proving investors would have been better off to reallocate to competing assets and away from bonds.

The longevity and depth of this credit market bubble reaching a 5000 year extreme is the key to understanding why all asset classes are at a price extreme now. The credit boom is what’s driving the equity and real estate booms because investors are forced to chase risk assets in search of yield resulting in risk being mis-priced.

That’s why the stock market has continued marching to new all time highs with the most amazing, record low volatility. As of this writing, the only time the U.S. market has been more overvalued as measured by the CAPE ratio is the narrow window of months preceding the final 2000 top. Other measures of valuation besides CAPE are reaching new all time highs. Worse yet, valuation levels lower than today’s comprise a Who’s Who of the worst times to invest in stocks.

Not only that, bonds, as already stated, are in uncharted territory after years of ZIRP (zero percent interest rate policy). This is important because conventional asset allocation relies on bonds moving opposite to stocks during a decline as the Fed lowers interest rates in the face of economic turmoil, but that may be difficult to achieve from the currently low interest rates.

Additionally, real estate has risen to extreme bubble valuations (but remains beneath the 2006-2007 record valuations).

Finally, commodities are hitting record low valuations relative to equities. This is also extreme, and rare, but in the opposite direction of all the other asset classes.

The point is that all major asset classes are at (or near) an extreme in valuation at the same time. That’s important.

Three Ways To Value Any Asset

To understand the implications of that statement let’s first establish a common base of understanding by looking at the three ways to value any asset:

  1. The Greater Fool Theory: In real estate they call it “comparable sales”, and in paper assets like stocks and bonds it’s the most recent transaction. The implication is the current market price represents fair market value because it’s the price willing buyers and sellers are trading at. The problem is it’s absolutely useless for indicating bubbles because it really only tells you what other fools are willing to pay for something.
  2. Assets: In real estate this would be replacement cost analysis, or how much it would cost to rebuild the structure net of depreciation. In stocks it’s book value or Q-ratio as a measure of the underlying assets per share. This is a very important measure of risk because it tells you the premium or discount you’re paying relative to what the underlying asset is worth. Extreme premiums are associated with periods of irrational exuberance delivering high risk, and extreme discounts are associated with periods of fear, lower risk, and higher subsequent investment returns.
  3. Income: In real estate income it’s measured as NOI (net operating income), or in retail residential it’s often measured as gross rent multiplier. In the stock market it’s the P/E or price earnings ratio, commonly measured through CAPE, or cyclically adjusted price earnings ratio. Income is my favorite valuation measure for indicating risk because ultimately the value of any asset is the discounted present value of its cash flows. That’s fancy economic jargon for saying an asset is worth what it earns. It measures present worth based on the future benefits of ownership.

Each of these three methods separately provides a different objective measure of valuation for any asset. Interesting conclusions develop when you compare and contrast all three together.

There are two key points to keep in mind with valuation analysis:

  • Extremes in valuation provide the most information value. Strong statistical significance occurs that effects mathematical expectancy at valuation extremes (like today).
  • The second important point is that price and investment value are two separate and distinct things that should never be confused. Failure to make this distinction will eventually cost you money.

Despite academic rumblings about Efficient Market Hypothesis and other theoretical frameworks supporting buy and hold philosophy, statistically valid investment opportunity occurs when price and investment value diverge in an extreme way. This has occurred at selected times throughout history, and more importantly (and the reason for this article) is occurring again now.

Today’s Investment Bubble Revisited

And so that long-winded analysis of valuation methods sets the context for understanding our current asset bubble.

I safely call it an asset bubble because none of the major assets classes (stocks, bonds, real estate) make any investment sense when judged against the only two valuation criteria that matter – assets and income – as described above. They’re all priced at or near an extreme risk premium relative to both underlying assets and income implying several important conclusions:

  1. Expected returns over 7-15 years will be lower and more volatile than historical averages. That’s politically correct language for saying something unthinkable to the buy and hold crowd. We have entered a period where the risk of owning the U.S. stock market over the next 7-15 years does not justify the reward over the same time period.
  2. The only thing supporting the current bull market in the major asset classes is momentum and “Greater Fool Theory” valuation metrics as described above. As long as momentum prevails the market can’t still rise dramatically over the short term. Momentum is a powerful force. However, mean reversion assures that all short term gains between now and the final top will be given back abruptly… and then some.
  3. A smart investor should be on the lookout for the remaining bubble conditions (as described above) to be satisfied thus indicating the final turning point because valuation and anecdotal evidence are very blunt edged tools that can be wrong by years. Overvaluation is a necessary precursor for a bubble, but it’s not sufficient. Notice how each of the previous bubble top descriptions in 2000 and 2007 discussed a 2 year window. The same is true with this analysis.

So while item 1 states unequivocally that we’ve already entered an unfavorable intermediate term investment horizon of 7-15 years, items 2 and 3 tells us the short term remains indeterminate until the remaining factors narrow the time window.

Stated another way, we are close to the end of this historic bull run resulting in an asset bubble of epic proportions that will ultimately result in life-changing losses to investors, but certain puzzle pieces have been missing… until recently.

The window is getting much closer to closing…

There Was No Mania… Until Now

The most disconcerting aspect of this entire bubble has been how calm it is. That’s not how bubbles blow up.

Most bubbles finish off the overvaluation phase with a rapid price acceleration phase that causes sudden riches for investors resulting in mass media attention and a polarization of public opinion. However, this final acceleration phase usually begins from lower valuation levels than we have today and usually occurs in a single market, not all major markets simultaneously. It’s where all the symptoms of excess appear.

In other words, even though all three major markets have relentlessly marched to record price highs (and record low yields) creating historic overvaluation, there’s been no clear indication of a speculative fever to create a vacuum underneath prices resulting in a collapse. Instead, there’s record low volatility, no animal spirits, no asymptotic growth curves, no crazy stories of sudden riches. In short, until recently we’ve seen none of the circumstantial evidence supporting insane animal spirits taking over the market in a fit of speculative greed.

Every bull market top has it’s poster child of irrational exuberance where proven economic common sense was tossed out the window because “this time is different”.

  • The 73-74 bull market had the “Nifty Fifty”
  • The 2000 top was marked by the dotcom bubble and the internet revolution
  • The 2007 top had insane real estate valuations supported by a belief that real estate never went down.

Which brings us full circle to today – Bitcoin – and the reason for this article warning you that we’ve finally entered the window of time to take risk management seriously.

BitCoin Fulfills The Speculative Mania Criteria

There is a long history of bubbles being marked by the issuance of a new “type of currency” that catches public imagination resulting in feverish trading.

Bitcoin has delivered one of the key indicators of important market tops – an irrational, speculative fever based on “this time is different”.

  • Bitcoin has an asymptotic price climb.
  • Stories abound of ordinary people getting instant riches from Bitcoin.
  • Bitcoin is everywhere in the financial press. I can’t be interviewed without being asked my opinion about it. My friends and clients are all asking about it.
  • Bitcoin completely fails the two primary valuation criteria listed above for analyzing an investment – it has no intrinsic value, and it yields no income.
  • Therefore Bitcoin is purely a speculation, and not an investment just as Tulip Bulbs and Mississippi shares were in years gone by. It could go to a million per coin, or it could to zero. There is no intrinsic value except what human minds decide to give it.
  • Bitcoin is rallying under the “this time is different” moniker. It’s a new currency, free from government manipulation, limited in supply, and part of the digital revolution. It’s different this time, because every bubble is always different every time.

But there’s one problem with this analysis…

The important overvaluation we need to worry about is in stocks, bonds, and real estate; however, the bubble has occurred in a totally unrelated market – cryptocurrency.

That difference bothers me.

If the collapse were to occur in stocks then the normal order of events should be to inflate the bubble in stocks to set up the vacuum under prices for the ensuing decline. That hasn’t occurred yet, which makes this particular bubble so disconcerting.

In other words you have bubble valuations in stocks, bonds, and real estate right now (February 2018), but no final price acceleration phase that polarizes public emotion. The extreme overvaluation level sets up the necessary condition for the subsequent price collapse, but historically that hasn’t been sufficient alone. Also, the fact that all three markets are extremely overvalued at the same time is unusual and risky.

The point is there’s usually an acceleration phase and public mania in the market that collapses. We’ve seen it in Bitcoin, but not in the other major markets.

What Scares Me About Bitcoin

I believe Bitcoin is a symptom of the real problem. It won’t be the cause.

Let me be clear. I believe the blockchain is 100% the revolution that proponents claim it will be. It’s going to change life in ways we can hardly imagine, just as the internet was 100% the revolution it was claimed to be back in the 1990’s. That part of this story is likely real.

But just as investors in the dotcom bubble got wiped out despite the internet fulfilling it’s destiny, investors in the cryptocurrency bubble will face a similar fate despite blockchain fulfilling its destiny.

So the scary part is not the cryptocurrency bubble. That’s too small, too obvious, and too disconnected from important economic fundamentals to be anything more than an interesting distraction.

What worries me is the premise that’s driving the cryptocurrency bubble. It’s anti-government. The speculative fever is driven by the masses distrusting all government economic manipulation and fiat currency. If you aren’t clear about this premise then just try to imagine Bitcoin gaining speculative interest in a hard currency world backed by gold where no inflation existed, a dollar would have the same buying power 3 generations from now as it has today, governments balanced their budgets, and there was no looming debt crisis. When you wrap your head around this strange world order you realize there’d be no crypto-mania because there would be no problem for cyptocurrency to solve.

Stated another way, the string of financial asset bubbles over the past 20 years all owe their underpinnings to fiat currency and government policy manipulation in the economy. The current cryptocurrency bubble is the most overt example.

The fact that the current bubble-du-jour is a new age currency outside of government policy delivers a disturbingly poetic reference to all that is economically wrong today with government policy and the resulting mass psychology driving the animal spirits.

In a perverse way, Bitcoin has become a positive bet against continued government success at fabricating stable economic growth through financial manipulation.

I say perverse because the normal loss-of-faith bet would be to sell risk assets and/or the domestic currency itself (the dollar).

But today’s speculative bubble is so persistent and pervasive across all asset classes that it managed to create a new “long” speculative bubble that’s essentially a “short” position against all the other speculative bubbles happening at the same time.

Worse yet, the public “gets it”. Disbelief in our fiat financial system is now so widespread that it resulted in an anti-government speculative fever among the masses.

Meanwhile, risk assets relentlessly march to new highs like lemmings to the sea.

I’ve never seen anything like it. This time really is different (sort of). But in all the wrong ways.

And now the dollar is finally breaking down, which is what you would normally expect for this emotional back-drop.

Not good…

The Other Missing Ingredient

Another aspect of bubbles that I’ve learned to expect is being personally attacked near the top for advocating contrary opinions that include prudent risk management. It has happened every time and marks the emotional peak where public opinion is so one-sided that the idea of managing risk invokes an emotional, irrational response. Until a few weeks ago it was missing from this bubble, but that changed as well…

I was recently interviewed for a podcast (not listing the name because nothing is gained from pointing fingers) targeted at the FIRE (financial independence retire early) community. In that episode I pointed out how the conventional investment approach to FI (low cost passive index asset allocation in paper assets) lacked adequate investment risk management for the current market environment.

Surprisingly, it was the most controversial and polarizing interview in the show’s history garnering more comments in the Facebook discussion group than any other show. Listeners either loved it declaring it the best episode yet, or they hated it. I was called a “scum bag”, my professional reputation was questioned, and I was personally attacked. People were so emotional that several said they had a hard time listening and others commented how it was “a sucker punch to the gut”.

Seriously? It’s an audio interview where I discussed financial topics including risk management. What gives?

I’ve been on 200 podcasts and never got a reaction like that. The normal response is listeners appreciate an interesting conversation where different ideas are shared. It’s just a conversation.

However, this interview was different because I made a crucial mistake. I failed to reconcile the fact that the market had reached an extreme overvaluation thus polarizing sentiment with the fact that this community was fully invested in this bull market with no serious risk management discipline. Their own survey shows the vast majority hold 90% (or more) of their assets in stocks. Many have recently gained early financial independence, or expect to retire soon, based on their stock portfolios.

In hindsight it’s obvious they’d respond emotionally and aggressively to alternative viewpoints! Dohh! Their financial security and future life plans depend on buy and hold working in the future like it has in the past.

As it turned out, this polarized emotional response was identical to other market tops where in 1999 my coaching client that made his fortune in tech stocks got aggressive and fired me because I advocated risk management to protect his fortune. And the real estate pros in 2006 cussed me out and called me “stupid” for cashing out all of my investment real estate and paying taxes to manage the downside risk. In each situation these people were invested. Their financial security is dependent on the bubble du jour continuing.

That makes their emotional response a key contrary indicator.

The Final Missing Ingredient

And so that leaves us with everything in place (almost) for a historic, final market top of epic proportions (measured in terms of a decade, or longer), except two things…

    1. We have extreme overvaluation. (Worse yet, the overvaluation is in all major asset classes at the same time, except commodities, which are the polar opposite.)
    2. We have a speculative mania that has captured mass psychology. (Worse yet, this speculative mania is anti-currency and anti-governement implying loss of confidence in the system that supports the bubbles in all the other asset classes.)
    3. We have an emotional peak demonstrated by aggressive behavior to contrary opinion advocating risk management.
    4. ?????

But there are still two things missing to make this analysis rock solid.

The first factor missing is for the major markets to actually break down.

Analyzing the “break down” is beyond the scope of this already-too-long article because it encompasses market internal indicators like credit spreads, divergences between equity indices, yield curves, investor sentiment, price momentum, quality indicators, economic indicators, M&A/IPO indicators, and more. However, it’s worth noting that this article is being published at the beginning of February, 2018 rather than months or years ago when valuations were already high implying the market internal indicators are getting “warmer”.

But “warm” is not “rolled over” yet, so until various internal indicators fail we still lack clear evidence of momentum failure. That means the animal spirits remain in control. The clock is ticking, but it hasn’t struck midnight quite yet.

The second thing that’s missing is how the acceleration phase causing sudden riches resulting in mass media attention occurred in an unrelated market – cryptocurrency. None of the major markets (stocks, bonds, real estate) have gone through the sudden price acceleration phase that typifies a final top… yet. That leaves open the possibility for that sudden acceleration phase to still occur.

However, your key takeaway should be how all the other evidence makes it clear how this party can only continue for the short term (from now to less than 2 years on the extreme high side, probably less). We’re now at the point where this is a bubble looking for a pin. Any continued rise just gives further to fall, and any new gains should be rapidly reversed once the downturn begins. This party is on borrowed time, which is why I wanted to give this warning.

Yes, it’s still possible for one (or more) of the major markets to run through a final price acceleration phase to cap things off, which is what would cause the longer time horizon pushing 2 years. But overvaluations are already high enough and there’s enough anecdotal evidence in place that it’s prudent to ring the warning bell and call in the defensive team (risk management) to protect against excessive loss.

How Risk Management Works

Risk management acts like insurance. It’s a complete waste of money when there’s no problem, but when disaster strikes it’ll save you from suffering a life-changing loss.

You intuitively understand how this works with homeowners insurance where you hope that every renewal is a small waste of money, but when that rare fire strikes insurance will be the only thing that saves you from financial disaster.

Smart investors who practice risk management have been renewing their policies without so much as a spark (market volatility), not to mention a fire (bear market), for years. It’s been a complete waste.

That’s about to change.

Nobody has a crystal ball so I can’t tell you exactly when mass psychology will sober up, or if we’ll go through a final acceleration phase in the major markets before they collapse, but mean reversion assures it’s far closer and will be far uglier than any investor wants to endure on a buy and hold basis.

There’s enough evidence in place that it’s prudent to get cautious. Yes, it would be normal to experience price acceleration from here first before collapsing which could extend the time frame up to a maximum of 2 years, but the breadth and depth of the overvaluation is already abnormal. This isn’t just one market that’s overvalued. It’s all the major markets (except commodities).

And the cryptocurrency mania reaching mass consciousness is a warning of possible loss of faith in government economic policy solutions (“The Fed Put”), which is particularly worrisome because belief in omnipotent Fed policy is the only thing that’s shortened each of the prior collapses resulting in ever increasing bubbles.

For these reasons, it now makes sense to error on the side of caution by getting your risk management strategies in place. Proper risk management will allow you to still participate if the party continues, but give your portfolio downside protection when the bubble bursts.

To help you I have a 100% free mini-course on investment risk management coming out in a few months. I’m working on it right now and it’s my top priority. I’ll announce it in this newsletter when it’s ready. However, if you don’t want to wait that long you can get all of that instruction (and a lot more) in my advanced wealth building course here. It will show you how to structure your portfolio to better manage risk, including extreme event risk.

While I can’t explain all the risk management strategies covered in the course, a few actionable ideas include:

  • “Deep diversification” (where you diversify by strategy and source of return, not just asset class, by identifying sources of return that inversely correlate with the stock market)
  • Diversify into certain business and real estate assets where the outcome is driven by a micro-economy.
  • Diversify into alternative assets.
  • Switch to an investment process that includes an exit discipline.
  • Diversify into favorably valued assets like domestic value plays, certain emerging markets, commodities, and commodity producers.
  • And much, much more.

There are many risk management strategies to consider that can help you protect your wealth, but you can’t wait until everything rolls over before you put them in place. Once the tide goes out, everyone can see who’s standing naked.

The current extreme in valuation (and other anecdotal evidence) makes it clear that an equally extreme mean reversion is a fait accompli. It’s only a question of “when”, not “if”. You don’t have to predict the final outcome to benefit; you just have to prepare in advance.

I hope this warning (and this course) help you think through the issues so you aren’t caught by surprise.

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