Michael Burry, hero of Michael Lewis's book, The Big Short (which I reviewed in 2010), has recently been in the news discussing the bubble in passive investing. His main thesis is that large cap stocks are overpriced and small caps are very attractive.
Nearly everyone remembers his huge success when his analysis of synthetic mortgage securities proved correct. No one remembers how long it took, as he lost clients and listened to complaints about his sanity.
In the 2000 bubble nearly all of my professional trader friends shorted the market -- sometimes repeatedly. I know only one who had a successful short; it worked mostly because of good guessing and an impulsive move. Robert Shiller's famous Irrational Exuberance was published just as the bubble burst. This was a fortunate result of the multi-year publishing process. Dr. Shiller was actually very, very early in his call.
What can we learn from this?
For one thing, logic and analysis eventually prevails. Every day we hear about signals of economic weakness. I expect this to continue through the election season. Left out of the analysis is the trade war, which the Fed is now estimating as generating a 1% reduction in GDP. Unless your economic model included this factor, it was mis-specified. Such models look good for a bit but then fail dramatically.
Another lesson is that traditional indicators might have more noise than signal. The ten-year note yield, for example, reflects European economic weakness more than the US data. The huge bond rally was extended by negative convexity. (One of my sources opines that any bond analyst who does not mention this effect should not be taken seriously).
Put more simply, investors have piled into bonds and bond substitutes because of perceived safety. The tendency to emphasize recent past performance has reinforced the stampeded into these investments.
I am not a "bubble specialist." Bubbles are not well-defined and often a matter of perception. That said, fundamental valuation methods provide some insight into whether the price of an investment is overly extended. People have no idea how much money can be quickly lost in bonds and bond substitutes. For utilities, the estimates are overvaluation of 25% or so. Bonds could make a similar move.
In a crowded trade, the exit may start slowly. At some point average investors will see that the safety they sought was illusory.
When and How?
I don't know exactly when this will end, nor does anyone else. One catalyst might be some genuine progress on world trade issues. We saw this week how even a hint of activity can have a big effect.
How to Invest
I am doing two things:
1) Carefully following the best sources on the trade issue.
2) Checking out and investing in the stocks and sectors that will benefit most. I'm thinking of calling it The Strong Long. 😀