Bubble Management

The last cycle, or asset bubble, worked out well for me. We sold our house in Florida near the peak and rented for two years. It was equivalent to what I’m doing now by selling stocks and going 100% cash – I wanted out of the market completely. I remember people thought I was crazy, just as I’m sure many do today. However, making the switch from owner to renter was a good move and allowed us to buy at a much more attractive price after the housing market slowed.

The absolute return strategy I manage also performed well during 2008-2009, as I was able to avoid most of the carnage in 2008 by being patient (sound familiar?) and then found considerable value in small cap stocks in late 2008 and early 2009. Getting aggressive when getting paid to take risk paved the way for attractive gains in 2009. Although the cycle was a success in relative and absolute terms, in hindsight, given my views on the real estate bubble, I could have done even better.

In 2006, I felt strongly about what was coming. Signs of the bubble were all around us. In an effort to document the mania, I drove to the beach and took pictures of all of the condos being built. It was stunning – they were going up everywhere. The joke was the new Florida bird was the crane, the construction crane. My neighbor told me he just paid off his car. I said, “Congratulations!” He said, “Yeah, I did it by taking out a home equity loan.” It was a crazy period and I was confident it was a bubble. I tried to convince anyone who would listen. At the peak of the cycle, it seem liked only Jimmy and Pete were listening and even they were tired of hearing the same story walk after walk (they’re my dogs). I had friends laugh at me. They called me names I’d prefer not repeating because they were actually funny and I’m concerned they’d stick! Similar to this cycle, my positioning was unique and unpopular.

Although it often felt like I was alone, there were others who also saw the housing bubble. In fact, a friend, who is a mortgage broker, and I discussed the bubble frequently. He was one of the few people I knew who understood the plumbing of the housing and mortgage markets. One day we both gave each other convincing arguments of why we were near the peak. He gave me examples of how insane things were getting in the mortgage business. I provided broader data such as mortgage debt growth and home prices versus incomes. Together we were very confident the cycle was about to end. While I felt I had already prepared for what was to come, I questioned myself on whether I should have leveraged my beliefs more aggressively. Had I done enough?

I have similar feelings today about stocks and bonds and I’m also asking similar questions as it relates to my positioning. While I feel I’m properly prepared for what’s to come, should I leverage my beliefs further? In addition to going 100% cash, should I short or buy put options on individual stocks or the market? While I’ve bought a small amount of put options and shorted stocks in the past, they’ve been small weights that better resemble a vote against irrational markets than a meaningful short position. I’ve never been aggressively short the market.

While shorting overvalued assets makes sense to me, I think it’s important to acknowledge we’re all investment specialists to some degree and we all have our limits. Knowing exactly when overvalued markets revert is one of my limits. As I’ve acknowledged on several occasions, I’m not a market timer. Although I have a good track record of spotting overvaluation and asset bubbles (this is my third bubble), my observations have come months if not years before the cycle ends. In other words, I have a history of being right, but early.

Being early can work very well with a high quality stock, but it can be disastrous when shorting or buying put options. Nevertheless, when I feel strongly an asset class is overvalued, it’s difficult to refrain from attempting to make a profit from its eventual decline. I believe investors attempting to profit from an asset bubble’s demise have two options. Investors can simply sell and stay liquid (essentially my strategy last cycle and this cycle) or sell short and buy put options. By moving to all cash and remaining patient, the biggest risk is opportunity cost, or missing out on future gains. By shorting and buying put options, an investor assumes timing risk and considerable risk to capital. Deciding which option to take depends on each individual’s investment objectives, risk tolerance, and core competencies. With a good understanding of myself as an investor, my plan remains to be patient, liquid, and ultimately buy small cap stocks at lower prices.

As an absolute return investor, I believe my strategy of patience makes sense. Getting aggressively short and timing the end of a bubble’s life requires speculation – that’s something I’ve always attempted to avoid. Nevertheless, I can’t help but remember the last time I had this feeling and missed “The Big Short”. Even if things worked out very well last cycle, I admit it would have been more fun to make billions off derivatives and then be depicted in a movie! I guess patience isn’t exciting enough for a book and movie deal. But it would be a good bedtime story. There once was an investor named Eric. He sold all of his stocks and waited….zzzzz.