The Precedents
Beyond surviving the uncertainty of our fragile financial system, capitalizing on it requires a combination of unique traits. These include a deep, experience-based understanding of how businesses are valued; an uncompromisingly skeptical mindset; and emotional acrophobia (a condition in which high and rising prices cause acute discomfort). By contrast, high-price euphoria is the prevailing emotion—at least of the moment. This is one of those uncommon times in history that will once again prove the adage that it’s easier to make money than keep it.
Comparing with the Past
We know that history doesn’t repeat itself exactly, but there are certain patterns—often rooted in the cyclicality of human emotions—that in some form or fashion replicate themselves. Thus, we turn first to the archives, looking back in time for applicable precedents.
Is there perhaps a telltale form implicit in the movements of markets themselves? From the lows in March 2009, the Dow Jones Industrial Average (Dow) has risen over fivefold. There are only two comparable bull-market episodes the last 100 years: the Dow in the 1920s, which rose fourfold, and Japan’s Nikkei 225 index in the 1980s, up 4.2 times. Examine Figures 1, 2, and 3.[1]
Driving Toward the Peak
We will briefly examine what we believe were the principal drivers of these three extraordinarily rare bull markets, looking for evidence of patterns they may have in common. Be forewarned. Even though we know with the certainty of hindsight how the first two episodes ended, the patterns from the past may well lead to faulty assumptions about what might lie ahead.
In all three episodes, the underlying domestic economies were expanding.[2] Governmental economic policies were uniformly accommodative throughout the three expansions—until, in 1928 for the Dow and 1989 for the Nikkei, they suddenly weren’t. In terms of price-to-value relationships, regardless of which metrics one chooses to apply, all three bull markets ascended from the bedrock of acute risk aversion to the end game of rampant speculation. Troublingly, these exponential gains (4–5 times over roughly a decade) have an internal rate of return greater than 15% before dividends. That exceeded the real GDP growth rate, see Figure 4, in all instances by a factor of 5 or more. Such rare, unchecked advances are problematic. In the absence of periodic reboots of expectations, rising asset prices become exponential as investor expectations tend to create a self-fulfilling prophecy.
The unimpeded buildup of speculative excesses in each bull run essentially followed the same template, but the particular circumstances were obviously quite different. The earliest episode, the 1920s bull market, was born out of the last unfettered, 18-month depression in 1921. Investors gained confidence in the self-righting capacity of the economic ship.
As the decade shifted into second gear, innovation keynoted what emerged as the “Roaring Twenties.” Henry Ford’s mass-produced Model T transformed U.S. life in ways theretofore unimagined. Similarly, the invention of “wireless telegraph”—the radio—became a fixture in American living rooms. Post-war prosperity visited other areas of the home as well with the production of consumer goods like washing machines, vacuum cleaners, and refrigerators. Silent movies became the third largest industry in the country. In those heady times, the public engaged in trading “on margin,” a further manifestation of pervasive optimism. Absent any economic or other impediments, considered investment insidiously morphed into wanton speculation.
A similar dynamic took hold following the economic success of post-war Japan (albeit a different war). Japan’s impressive GDP growth at 4% through the 1980s was dubbed an economic “miracle.” Though exports boomed and pundits worried Japan would take the lead among global economies, it was largely commercial real estate and stock-market asset speculation that were to distinguish the island nation’s decade-long bubble. An oft-used hyperbolic example of a niche market attracting speculators like flies to honey, commercial real estate in Tokyo by 1989 sold for more than 350 times that of comparable prime property in Manhattan. The notional value of the land under the Imperial Palace in Tokyo was presumed to be worth more than all the real estate in California at the time.
In an inversion of a pattern that has been evident in the U.S. for some time, during the 1980s the Bank of Japan (BOJ) was criticized for directing its monetary policy toward managing the yen rather than attempting to curb the asset-price inflation.
Unlike the U.S. in the ’20s and Japan the ’80s, GDP growth since the Great Recession has been a tepid 2.3%, and that’s in spite of leading-edge innovations—including DNA sequencing, robotics, energy storage, artificial intelligence, and (as some argue) blockchain technology. Thus far, it appears the digital revolution of the 1990s had an oversized economic effect than the technologies since.
More worrisome is the financial repression of zero-bound Fed interest rates since 2008 and quantitative easing since 2010. The Fed funds rate has effectively been pegged at zero almost continuously since 2008. Meanwhile, its balance sheet has exploded from under $1 trillion in 2008 to $8.5 trillion today. Rather than promoting above-average growth, that policy has become progressively more destabilizing. Savers, denied traditional interest-bearing safe havens, are now unwitting speculators in a stock market that has never been more expensive. Perversely, history would indicate that real future returns will be negative for years to come. Borrowers, from homeowners to businesses to governments, incentivized by artificially low interest rates, have become reckless, and malinvestment is in evidence everywhere.
Free money, like a free lunch, is ultimately an illusion. That truism has apparently escaped the attention of lawmakers on Capitol Hill. Not counting the estimated $4.5 trillion in pending infrastructure and social-relief bills, total public federal debt at the end of Q2 2021 was $28.5 trillion, up precisely five times from $5.7 trillion in 2000. As a percentage of GDP, it has risen from 57% in 2000 to 125% today. On the corporate side, junk-bond issuance and leveraged loans have proliferated while investment-grade issuance has waned.
Like the U.S. in the ’20s and Japan in the ’80s, a lack of periodic reality checks has seen investing slide down the slippery slope into speculation. The one-month bear market in early 2020 simply reinforced the belief that the Greenspan put is alive and well. In the face of two subsequent pandemic waves and a recovery spurred by trillions of dollars of transfer payments, the market has nearly doubled since the COVID-19 lows in March 2020. Rising prices themselves have become the bull market’s principal justification.
Epilogue for Those Ravished by the Bear
The Vale of Tears (second stanza):
We toil for wealth, we seek for fame,
And various phantoms we pursue:
This oft brings care, that’s but a name;
At last reflection whispers true—
“Poor murmuring creature,
Weak by nature,
Swell’d by hopes, oppressed by fears;
Proud and ungrateful,
Vain, deceitful,
Man makes life a Vale of Tears!”
History makes abundantly clear that all manias come to an end, often in a vale (valley) of tears. Robert Anderson’s poetry fittingly describes the plight of the grand bull markets of the ’20s and the ’80s. When investors en masse respond to the siren’s call of rising prices themselves, the end is nigh. At the personal level, it is also evident when individual investors sublimate their wills to those of the amorphous and manic crowd; see Beware of the Crowd.
The Aftermath of the 1920s
Despite the success of the laissez-faire policies during the 1921 depression, it was all hands on deck when the storm hit in 1929. We have written extensively on the manifold failed attempts of the Hoover administration to stem the tide and Franklin Roosevelt’s multifaceted programs of economic triage beginning in 1932. The commercial banking system, the principal source of credit nearly a century ago, was among the weakest links in a fragile chain. When the banks failed, there was no safety net to mitigate the most pernicious of the feedback loops. In those days the Fed was not the manager of markets. Ultimately, though, it was a newly acquired acute risk aversion that plagued and thus hobbled investors and the business community for the next decade.
Since readers are likely to be less familiar with Japan in the 1980s, we’ll cover it in slightly more detail. Having skyrocketed over fourfold in less than 10 years, the Nikkei 225, paralleling the upward-sloping trajectory of commercial real-estate prices, was defying gravity. Not unlike longstanding trends in the U.S., Japanese financial intermediaries were themselves victims of disintermediation in the 1980s, as more Japanese opted to shift funding from banks to the capital markets. Squeezed, bankers became more aggressive after 1983, stepping up loans to smaller firms and eventually individuals, virtually all backed by properties. Through what later became known in the U.S. as home-equity loans, many of the Japanese pledged their residences to collateralize stock-market speculation. The “everything” asset bubble induced even more borrowing against ever-rising collateral values. The elevated market value of assets was used to justify more corporate borrowing as well. When asset values collapsed, the worm turned.
The term “zombie company” was coined in Japan. Governmental interest-rate support of failing banks and businesses made it difficult for efficient firms to compete, negatively impacting productivity and capital investment. This practice continued into the late 1990s. And so it also was with households: When asset prices imploded, so did consumption and investment spending. A lost decade eventually became a lost 20 years, with Japanese GDP in 2017 only 2.6% higher than it had been in 1997, a growth rate of 0.13%. That’s in spite of the BOJ imposing a zero-interest rate policy in the late 1990s, to little avail. Quite unlike the U.S. post-2009 bull market, the collapse in Japanese asset prices continued into the ’90s and beyond. There was scant appetite for speculation as investors remained risk-averse.
The epilogue for what has become the most pervasive wealth-threatening speculative bubble of the three will be studied for decades to come. Like its predecessors, commentators will ask: “Why did almost no one see it coming?” It’s a hardy perennial. A Financial Inquiry Commission was convened to do a postmortem on the Great Financial Crisis of 2007–09. This question was asked after every preceding crisis and will be asked after every succeeding one.
Profits Through Uncertainty
There’s only one certain outcome when attempting to capitalize on uncertainty: The greatest cost will be in opportunities lost. Even if, as Nassim Taleb suggests, portfolio losses could end up being catastrophic, the opportunities forgone in the meantime will chafe at investor patience and will likely be perceived as unrecoverable.
The Barbell Strategy
Black-swan episodes defy conventional risk-mitigation safeguards, such as broad diversification. With the exception of short-term U.S. Treasury securities and less predictable gold and longer-term Treasury bonds, an otherwise diversified portfolio can be savaged by rare black-swan bear markets as most asset classes fall in unison. This is particularly apropos today. Like Japan in the 1980s, we have extreme levitation in the prices of virtually all asset classes.
As the name implies, the barbell strategy has two heavy and opposing weights on opposite ends of the bar. Cash and its equivalents, representing typically more than 90% of the portfolio, are offset on the other end by asymmetrical payoff derivatives, often long-term, out-of-the-money, index put options. One end of the barbell protects almost all of the portfolio against black-swan risks, while the other end hopes to capitalize on them.
As MCM applies the barbell strategy in today’s environment, we must manage two distinct negatives. First, the patience required to outlast the seemingly endless bull market is more than most investors can muster. Though we’ve been able to trade against our put positions since the program’s inception so that we have a positive cost to carry, that’s not much consolation in a seemingly forever rising market. Second, option writers, the most sophisticated players in the options market, are not buying the endless-bull-market thesis. Comparatively high-option premiums reflect their reticence. Thus the asymmetrical payoff end of the barbell may require more active management in the future than it has in the past.
Still, the downside to historic bubble tops is the cataclysmic annihilation of investor wealth. The psychology of the moment means that few will manage to avoid the inevitable pain to come. While exposure to the downside through derivatives can offer a short-term opportunity for profit, it is the preservation of capital for redeployment when euphoria has turned to despair that, despite the patience required, offers the real opportunity amid uncertainty. Only history can guide such caution, because those who ignore its lessons are doomed to repeat them.
[1]A logarithmic scale (or log scale) is a way of displaying numerical data over a very wide range of values in a compact way—typically the largest numbers in the data are hundreds or even thousands of times larger than the smallest numbers. Such a scale is nonlinear: the numbers 10 and 20, and 60 and 70, are not the same distance apart on a log scale. Rather, the numbers 10 and 100, and 60 and 600 are equally spaced. Thus, moving a unit of distance along the scale means the number has been multiplied by 10 (or some other fixed factor). Often exponential growth curves are displayed on a log scale
[2] We deem it appropriate to exclude the shortest ever two-month recession in 2020 because of the federal government’s profoundly reactionary monetary and fiscal policies in the face of the pandemic, policies that were aimed at preventing a fragile economy from the vicissitudes of the business cycle, which was already the longest expansion on record.