It’s been ten years since the housing and mortgage bubble began to unravel. While the exact date is debatable, I remember July 2007 as a very important month. It was when Bear Stearns announced two of its funds holding subprime mortgages lost most of their value. Shortly after, the marginal buyer or borrower discovered it would become more difficult to obtain a mortgage. It was the beginning of the end for the housing bubble and the 2002-2008 market cycle.
The housing bubble was an important time in my life and career. As home and stock prices soared, I was again forced to invest very differently from my peers and benchmark. As a result, performance lagged throughout most of 2003-2006, while the credibility I gained during the previous cycle began to fade (apparently past bubble cred is nontransferable!). I went from being one of the portfolio managers who got the tech bubble right, to the manager who was getting the housing boom all wrong.
Although my positioning and message wasn’t very popular, I tried to convince as many people as possible that we were in a bubble. The first person I tried to convince was my wife. Our modest house in Florida appreciated 55% in only two years! I wanted to sell before the bubble popped, but wasn’t sure if my wife would agree.
Initially she thought I was nuts. “We just bought the house,” she explained. “You’re right, but these gains aren’t real – it’s all one big bubble,” I argued. While you won’t hear this from Dr. Phil, one of the keys to a successful marriage (and parenting for that matter) is mastering the art of bribery. After doing some cost/benefit analysis, I bribed my wife with a deal I thought she’d buy into – and she did! Our house sold almost immediately.
After we sold and began to rent, home prices continued to march higher. I couldn’t help but wonder if we (or I) made a huge mistake. Our rental was near the beach where the market was booming. Living in a real estate hot spot was a constant reminder of my poorly timed decision to sell.
My neighbor bragged to me about how he just paid off his car with his home equity line. A friend told me how much he was making on his third investment property. A banker literally laughed in my face as we debated the merits of housing. “You’re throwing your money away by renting,” he said. It was a difficult time to be a renter and nonbeliever in the perpetual housing boom.
Despite the seemingly endless real-time data points suggesting I had lost my mind, I firmly believed the economy, stock market, and housing market were all one giant bubble built on unsustainable credit growth. I was confident in the facts and my analysis. All I needed to do was be patient and survive the constant narrative from the media and financial markets that I was wrong and this time was different (sound familiar?).
In addition to selling our house and renting, I avoided bank stocks and allowed cash to build. Furthermore, I was careful not to extrapolate peak earnings of cyclical and consumer companies benefiting from the easy credit environment. Given how credit spilled over into many areas of the economy, profits for most industries were high and growing. Instead of normalizing profit margins and cash flows, investors appeared to be valuing businesses as if the good times would never end.
As a strong believer in economic, credit, and profit cycles, I was confident the excesses of the boom would ultimately result in a bust – it was only a matter of time. In addition to attempting to protect myself and clients from the risks of the housing bubble, I continued to spread the word to anyone who would listen.
I’ll never forget the day my wife and I were riding bikes and I noticed a realtor escorting buyers into a new luxury condo. Suddenly and unexpectedly, I yelled, “Don’t do it, it’s a bubble!” The look the realtor gave me was priceless! And my poor wife was so embarrassed, but not me. I laughed and laughed all the way back to our rental.
Of course, the end of the housing bubble wasn’t funny. When it imploded millions of people were hurt and many institutions failed. Just as with today’s asset inflation, the last cycle’s excesses were founded on easy money and the widely-held belief that prices would never be allowed to fall. There are many similarities this cycle versus last cycle and the cycle before it.
Given the parallels between the current market cycle and the past two, it’s logical to ask if we’re currently in another bubble. Depending on your preferred valuation measure, equities are as expensive (more expensive on some measures) than they were in 2000 and 2007. If valuations are similar or higher than past bubble peaks, how can today’s cycle not be considered a bubble?
Regardless of how the current market cycle is labeled, I’m confident my opportunity set is the most expensive it has ever been, including 2000 and 2007. As such, I’m comfortable calling small cap stocks a bubble, but more important, I’ve positioned myself accordingly.
While selling our house and renting worked very well during the last bubble, this cycle I’m more focused on avoiding overvalued equities than overvalued real estate. Although home prices currently appear expensive locally, I haven’t bribed my wife to sell our house again. There are several reasons. First, the only bribe she’d accept today would be moving into a bigger house! Second, we have kids now which makes moving less practical. And third, given the broadness of overvaluation this cycle, our investment positioning is different with a larger allocation to liquidity and patience.
Considering the potential risks of central bank asset purchases, I continue to believe holding some form of hard asset, such as real estate, makes sense (at least in our situation). Once earnings season concludes, I plan to write a post discussing one or two asset heavy companies on my possible buy list that may be interesting cash hedges. I recently bought one, added another to the list, and continue to consider others I’ve owned in the past. Having a barbell portfolio consisting mostly of liquidity and patience, combined with a cash hedge, or central bank insurance, seems rational to me. And if I can find a cash hedge trading at a discount to its net asset value, that’s even better. More to come in the following weeks…
Have a great weekend!