Updated for 2017 and beyond.
Of course we are in a bubble! When you’ve got people with no professional financial experience giving investment advice, you better believe we’re in a bubble. Online investing advice by non-finance professionals is the modern day version of shoe shine boys giving stock tips prior to the crash of 1929. Always understand the background of those who give investment advice before considering their counsel.
Even after 20 years of investing and working in the finance industry, I always feel uncomfortable giving any sort of investment advice because I’ve had way too many losses partly thanks to multiple boom and bust cycles. Furthermore, everybody’s risk tolerance and money making abilities are different. The best thing we can do is have an appropriate asset allocation to ride out the waves.
The good thing about bubbles is that the greater fool game can last for much longer than expected because we humans are GREEDY, GREEDY, GREEDY!
The largest criers of the word “BUBBLE!” are those who have the least amount at stake. Perhaps they sold their real estate, stocks, or businesses before 2012 and are now kicking themselves. Maybe they are still graduate students with a lot of student loans to repay. Or maybe they are retirees or early retirees who can no longer take full advantage of a heated economy. Whatever the case may be, when the largest complainers of a bubble start getting back in, you know danger is imminent.
Let’s at least all agree that we’re in the second half of a bull market and the bubble will eventually burst. Maybe we’ll only correct by 15%-20%, unlike 2009’s 50% ass-kicking. But eventually, that year or three of pain will come!
WHEN WILL THE BUBBLE BURST?
I predict the bubble will burst on October 18, 2016 at 12:48pm. Heck if I know! Your guess is as good as mine. When the bubble bursts, there will be plenty of private companies at crazy valuations going bust because they still won’t be profitable and nobody will give them any more money. We have pre-product, pre-revenue startups being valued for $8 – $12 million dollars all the time nowadays. Furthermore, plenty of private companies are trading at 15-25X revenue with the expectations of never ending triple digit growth.
The private equity market is completely out of control compared to the public equity market. It’s been eye-opening these past two years consulting in startup land. Once the private equity market collapses, it will pull down every other asset class with it. At least the Fed will think about cutting rates again.
If we can hold on through the downturn, and continue to dollar cost average, we should be fine in the long run, especially since most of us don’t have access to such private equity companies.
The goals for all of us are to:
1) Recognize when we are in a bubble.
2) Maximize our returns during a bubble.
3) Slowly minimize risk and exposure the larger the bubble grows.
4) Try to exit as much as possible before pandemonium sets in.
5) Have enough cash once the bubble bursts to buy everything in sight.
Remember, you must convert some of the funny money into real assets or fantastic experiences. Otherwise, when the bubble bursts, you might be left with NOTHING but regret!
CHARTS SHOWING BUBBLISCIOUS VALUATIONS
Whoah! San Francisco median home prices have skyrocketed by 72% from 1Q2011 to 1Q2015! The median household income in San Francisco is about $78,000. In other words, the median house costs 14X the median income when banks only lend at most 5X one’s gross income (used to be 3X, but rates have come down to more affordable levels).
But who cares about the banks? They don’t lend to good creditors anyway! More people are buying with cash, and more people are coming from “low per capita GDP” nations like China with bucket loads of dough. The San Francisco housing market is a bubble for local residents. Good thing San Francisco faces a strong international demand curve. But when the US bubble bursts, foreign money will disappear.
The real estate charts for Los Angeles, San Diego, Manhattan, DC, New York, Paris, Hong Kong, London, Singapore, Miami, Sydney, and so forth all have similar trajectories. The median home price to median income multiples are also at nose bleed levels.
STOCK MARKET BUBBLE
Check out the slope of our rally since 2009 at a whopping 70-80 degrees. Now get reminded about the crashes in 2000-2002 and from 2007-2009. Most new startup founders don’t recall the pain of 2000-2002 because many are still in their 20s. Some don’t even know how 2008-2010 felt like. This is worrisome.
Everybody has heard of the 7-year economic cycle right? If you haven’t, it’s a theory that basically says things go up for five years, down for two years, up for five years, and then down for two years over and over again. Some interpret the cycle as a 7-year bull run followed by a downturn.
Just look at the chart above. Let’s say the recovery really started in 2010. Five years would be 2010, 2011, 2012, 2013, and 2014. That means 2015 and 2016 will be terrible return years for investors if the 7-year economic cycle theory holds true. But then again, 2016 is an election year, and the public will get their ears full of empty promises that might prop up spending and consumer demand!
Since we’re already way past the 2007 peak for the stock and real estate market in 2017, seeing a 20-30% correction is not out of the question. In fact, I say we should expect a 20-30% correction and only buy things we can afford to lose 20-30% in.
The bond market is clearly in a bubble as well. Reuters reported, “The 1994 bond market massacre is remembered with horror by those who lived through it. Yields on 30-year Treasuries jumped some 200 basis points in the first nine months of the year, hammering investors and financial firms, not to mention thrusting Mexico into crisis and bankrupting Orange County.”
We’ll have higher lows and higher highs over the long run. But over the short run, we could be in a world of hurt. Here’s my current portfolio of stock picks.
MAYBE WE AREN’T IN A BUBBLE?
There is no way any of us will be completely unscathed from a bubble collapse because none of us will be able to perfectly time our exit to 100% cash. I think there’s a good chance this bubble continues to grow for the next three years as companies like Uber, AirBnB, and Prosper go public. They’ll have a lot of money for acquisitions, which will fuel the private market frenzy even more.
Let’s look at another interesting chart to compare today with the internet bubble of 2000. I remember almost investing $20,000 into my college alum’s now defunct company called DormNow. Those were the glory days when Yahoo stock would jump 10% a day!
Thank goodness we’re no longer valuing companies based on “eyeballs.” I still remember my company’s old Internet Analyst, Anthony Noto (now CFO at Twitter), producing an Internet report with googly eyes on the cover. Then there was Henry Blodget who was pumping Amazon to $400. It was nutso and people made a boatload of money! Even I got lucky and made a 40 bagger with one ridiculous company named VCSY that went bust shortly after.
The chart above shows how reasonably valued some of the largest NASDAQ companies are today vs NASDAQ companies in 2000. Apple trading at 15X earning with $150+ billion in cash doesn’t sound like a company that’s ever going bust. In fact, the likes of Apple and Berkshire Hathaway could be our saviors if there’s another correction.
The issue I see is mutual funds, who have expertise in public market investing, seeking 10% returns by participating in late stage private financing for bigger gains. They are investing in what they don’t know and being too cavalier with their assets.
Here’s another chart that shows the Shiller PE ratio of the S&P 500 index. The mean and median Cape Shiller PE ratio is around 16, and we’re currently 11 multiples higher at 27.21. Valuations are clearly stretched, but at least we’re still a long ways away from the crazy valuations of 2000!
THE BUBBLE WILL BURST EVENTUALLY
When the bubble bursts, I pray everyone has a diversified net worth to hold them through for at least two years. And if you end up losing your shirt, don’t worry. The bubble was fun while it lasted! There will always be another bubble to profit from. It’s the American way.
Here’s what I’m doing to help buffer myself from a collapse:
* Raised my after-tax savings rate to 70% from 50% now that my master bathroom project is done (post coming) in order to increase liquidity and build a war chest in case opportunities arise. Goal is to get to $100,000+ in cash by June 1, 2015, and $200,000 by Dec 31, 2015.
* Looking for new online business partnerships so that no one revenue stream takes up more than 30% of total revenue. Client concentration risk is the downfall of many companies.
* Write more bearish articles that help people during downturns in order to diversify traffic on Financial Samurai in case a downturn happens. Part of being a good publisher is properly forecasting the future of what people might be talking about.
* Completely pay off a rental income property mortgage that will free up $1,308 in monthly cash flow, and increase my cash flow by ~$2,000 in the eyes of a mortgage underwriter due to their funny math of discounting rental income by 25% if one has a mortgage. I’m essentially preparing myself for one last attempt at refinancing a primary mortgage just in case interest rates start collapsing again.
* Continue to buy equity via structured notes with 20-30% downside barriers or buffers as part of my monthly investing contribution as opposed to buying naked equity.
* Constantly review my net worth allocation online to make sure my stock market exposure as a percent of my overall net worth is no more than 30%. I’m currently overexposed to real estate with a ~40% weighting due to my home purchase in 2014. All I can do to decrease exposure is to pay down mortgage debt, save more cash, and grow my business as I never plan to sell any property given they are cash cows. It’s easy to do an investment checkup and a holistic overview of your finances once everything you’ve aggregated all your accounts in one place.
RECOMMENDATIONS TO BUILD WEALTH
* Manage Your Finances In One Place: The best way to become financially independent and protect yourself is to get a handle on your finances by signing up with Personal Capital. They are a free online platform which aggregates all your financial accounts in one place so you can see where you can optimize. Before Personal Capital, I had to log into eight different systems to track 25+ difference accounts (brokerage, multiple banks, 401K, etc) to manage my finances. Now, I can just log into Personal Capital to see how my stock accounts are doing and how my net worth is progressing. I can also see how much I’m spending every month.
The best tool is their Portfolio Fee Analyzer which runs your investment portfolio through its software to see what you are paying. I found out I was paying $1,700 a year in portfolio fees I had no idea I was paying! They also recently launched the best Retirement Planning Calculator around, using your real data to run thousands of algorithms to see what your probability is for retirement success. Once you register, simply click the Advisor Tolls and Investing tab on the top right and then click Retirement Planner. There’s no better free tool online to help you track your net worth, minimize investment expenses, and manage your wealth. Why gamble with your future?
* Invest Your Money Efficiently: Wealthfront, the leading digital wealth advisor, is an excellent choice for those who want the lowest fees and can’t be bothered with actively managing their money themselves once they’ve gone through the discovery process. You don’t have to be an accredited investor either, as their minimum is only $500 to get started.
In the long run, it is very hard to outperform any index, therefore, the key is to pay the lowest fees possible while being invested in the market. Wealthfront charges $0 in fees for the first $15,000 if you sign up via my link and only 0.25% for any money over $10,000. You don’t even have to fund your account to see the various ETF portfolios they’ll build for you based off your risk-tolerance. Invest your idle money cheaply, instead of letting it lose purchasing power due to inflation.
About the Author: Sam began investing his own money ever since he opened an online brokerage account online in 1995. Sam loved investing so much that he decided to make a career out of investing by spending the next 13 years after college working at Goldman Sachs and Credit Suisse Group. During this time, Sam received his MBA from UC Berkeley with a focus on finance and real estate. He also became Series 7 and Series 63 registered. In 2012, Sam was able to retire at the age of 34 largely due to his investments that now generate roughly $150,000 a year in passive income. He spends time playing tennis, hanging out with family, consulting for leading fintech companies, and writing online to help others achieve financial freedom.
Updated for 2017 and beyond. I strongly recommend readers get more conservative now that we are at record highs.