Are we in another financial bubble? It feels this way with stock valuations at all-time highs, interest rates starting to creep up, and demand for housing extremely strong. With the pandemic slowly getting under control, we all expect a tremendous unleashing of consumer spending. But what if earnings don’t meet high expectations? A financial bubble could ultimately form.
One of the biggest reasons why I believe we could be in another financial bubble is the incessant amount of stock tips I’m getting from people with no experience. For example, my preschool teacher friend won’t shut up about Tesla. Another another guy in marketing won’t stop talking about Bitcoin.
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.
A Financial Bubble In The Making
Even after 20 years of investing and working in the finance industry, I still feel uncomfortable giving any sort of investment advice. There is no certainty when it comes to investing.
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 a financial bubble 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 or during the March 2020 sell-off 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 financial 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 financial bubble will eventually burst. In fact, that’s exactly what happened in March 2020, about two years after I originally published this post. It is a certainty we will go through another 20% correction again.
When Will The Financial 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
REAL ESTATE
Whoah! San Francisco median home prices have skyrocketed by 100% since 2012. The median household income in San Francisco is about $80,000 while the median home price is now $1.7 million. In other words, the median house costs 21X 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.
A financial bubble tends to occur. when home prices rise faster than rents. See examples below.
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.
We’re now 10 years into a bull market, and 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.
Check out the latest Case-Shiller P/E Ratio for 2021. 2021 corporate earnings need to rebound by at least 30% for the S&P 500 not to be in a financial bubble.
Maybe We’re Not In A Financial 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 after companies like Uber, AirBnB, Pinterest, and Slack 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.
The Financial Bubble Will Eventually Bust
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 financial bubble 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.
- 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 like How To Make A Lot Of Money In A Downturn, 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%.
- Diversify into real estate through real estate crowdfunding and rental properties. Real estate is a laggard asset class and is more stable. Given real estate produces income, the value of cash flow and real estate has gone way up because interest rates have come way down.
Below are some more detailed recommendations on what to do during a financial bubble.
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?
Diversify Into Real Estate
Real estate is my favorite way to achieving financial freedom because it is a tangible asset that is less volatile, provides utility, and generates income. Stocks are fine, but stock yields are low and stocks are much more volatile. The -32% decline in March 2020 was the latest example. However, real estate held steady and appreciated in value then.
At this point, I think it’s better to invest in a laggard asset than in an expensive stock or stock market that is priced to perfection.
Take a look at my two favorite real estate crowdfunding platforms that are free to sign up and explore:
Fundrise: A way for accredited and non-accredited investors to diversify into real estate through private eFunds. Fundrise has been around since 2012 and has consistently generated steady returns, no matter what the stock market is doing.
CrowdStreet: A way for accredited investors to invest in individual real estate opportunities mostly in 18-hour cities. 18-hour cities are secondary cities with lower valuations, higher rental yields, and potentially higher growth due to job growth and demographic trends.
I’ve personally invested $810,000 in real estate crowdfunding across 18 projects to take advantage of lower valuations in the heartland of America. Real estate crowdfunding comprises of about $100,000 out of my $300,000 in passive income. Always be building passive income for financial freedom!
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