Identifying a bubble in real time is difficult, if not impossible, for even the most seasoned of investors. While bubbles differ from each other over time, the psychology is consistent, observes Jim Stack, a leading "safety-first" money manager and editor of InvesTech Research.
It is impossible to deny that there are excesses and speculation in financial markets today — IPOs, SPACs, Reddit trading, cryptocurrencies, NFTs (discussed later in this issue), and even housing prices.
Whether or not this period will ultimately be defined as a bubble is a hot controversy that will only be decided in hindsight.
I’ll be honest in admitting that prior to writing this issue of Investech Research I didn’t even know what a Non-Fungible Token (NFT) was. And frankly, I’m still not certain how to describe it to someone, or place a value on a reproducible image – whether it’s a Beeple, Cryptopunk, or Bullrun Babes.
However, I can say with a relatively high degree of certainty that they would not exist or have the perceived value today without the Bitcoin and cryptocurrency mania fueling them. Which means that if it is a house of cards, they will all — collectively — collapse together.
Every investor chooses their own investment odds. I learned that in my first painful years of the 1973-74 bear market. My lessons were reinforced by successfully surviving the 1987 Crash, the 1990s Tech Bubble, and the 2005 Housing Bubble and resulting Great Recession.
There is a lot that I do not like about today’s market, besides the extraordinary overvaluation. However, I also know that the U.S. economy is emerging from the pandemic and presenting selective investment opportunities. The challenge lies in mitigating portfolio risk and avoiding the minefields, while still capturing upside potential.
Personally, I do not trust the Federal Reserve’s forecasts of tame inflation, with all the pandemic-related stimulus underway. A major reason is that I know Fed officials have a high stake in trying to “jawbone” inflation pressures downward.
If inflation rises, then long-term yields will rise — with or without the Fed’s attempted control. And the near doubling in 10-year T-Bond yields since December — from 0.9% to over 1.7% — is already impacting market volatility.
Another reason that I’m skeptical about Fed officials’ reassurances [see page 4] is because they have been notoriously wrong before.
The serious inflation cycles of the 1960s and 1970s were painful reminders of the Federal Reserve’s inability to forecast, let alone control inflation. And when inflation was out of control at over 10% in 1980, the current Fed FOMC voting members were all under 24 years of age. Not a lot of seasoned inflation-management experience there!
Perhaps one of the most serious, if not humorous, economic mistakes made by Fed officials was during the not-so-gradual popping of the Tech Bubble.
By early 2001, the Nasdaq Index had already lost over 63%, yet three separate Federal Reserve Governors provided reassurances in media headlines that the U.S. was not in recession. It would later be determined that the recession had already started a month earlier — in March.
And so it is, that we are adhering to our own prudent “safety-first” strategy, instead of following media headlines, market hype, or Federal Reserve reassurances.
In the long run, we are undoubtedly leaving some profits on the table with our 80% invested allocation and defensive avoidance of mega-cap momentum stocks.
However, our attention remains focused on portfolio protection and keeping a close eye on potential warning flags as we traverse what we anticipate will be a challenging year ahead.
As you invest your portfolio with a mind for preserving assets in this environment, here are some tips to help you manage risk:
• Remain focused on fundamentals — Quality is important. If selecting stocks, look for strong balance sheets, superior profitability, manageable debt levels, and reliable cash flow.
• Avoid the hype and headlines — If you don’t understand what an investment is or how a company makes money, don’t buy it.
• Valuation matters! — Seek stocks that are trading within range of their historical valuations. Growth is fine, but growth at a reasonable price.
• Use equal weighting for portfolio protection — Rebalance and take profits from winners to avoid the overvalued mega-cap stocks. Additionally, check mutual fund and ETF holdings to ensure assets aren’t excessively concentrated in a small number of risky stocks.
• Maintain a comfortable “cash” cushion — This is your safety net and ensures your ability to sleep at night. More importantly, it guarantees you’ll have dry powder available when the next low-risk buying opportunity arrives.
If this is a speculative bubble, no one knows how long it could last, and in our experience, what you aren’t invested in can be even more important than what you are invested in.
By avoiding what we believe to be the riskiest and most overvalued areas of the market, we can confidently and carefully capture more upside with our 80% invested allocation. We are more than willing to leave the hottest investments to the speculators as we seek better values and more even distribution in the market.
