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Going into a stock market bubble


giofranchi
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If the Shiller P/E of the S&P500 gets to 29-30, I truly think we will be in the midst of a stock market bubble… Today the Shiller P/E is slightly above 27.

 

As it seems we are slowly but inexorably going into a stock market bubble, I have decided to concentrate my capital in the hands of 3 people:

- Prem Watsa: 36% of my capital

- John Malone: 17% of my capital

- Sardar Biglari: 17% of my capital

With cash at 30% of my capital. And more cash coming in every month through my own businesses.

 

To weather the consequences of what inevitably follows a stock market bubble, I want to be very concentrated, and to hold a significant amount of cash.

 

Gio

 

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Yes maybe... But imagine if investors will accept 1 %age lower yeild on equity in SP500... to the SP500 yeild level that occured during IT bubble... then we have another 65% to go on SP500.. not saying I think it will happen just saying that unchartered territory might come with unchartered price action..

 

Flipping it to a technical viewpoint, all g-forces are still in place and would not do too much until we see a monthly close under 12m moving average, or until the shorter averages crosses the longer ones.. But that doesnt help me much either since I have seen my cash reserves ticking up since beginning of this year.. 

 

My two cents

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gio, don't you think the various Malone securities and BH will get slaughtered in a downturn? Both got slaughtered more than the market in 2008 (granted, I don't believe Biglari was in full control at the time).

 

That’s why I hold lots of cash! ;)

 

Anyway, I don’t know of anyone better than Malone at taking advantage of any market crash that might await us. I will be much more willing to double down in the Liberty family of businesses than in any other company, because I know Malone is working on some incredible bargain. And don’t forget LMCA today is almost debt free! In 2008 it was not so, and that could be a great advantage this time around.

 

As far as Biglari is concerned, the fast food industry generally behaves much better than the general market in a downturn. Furthermore, he hold lots of cash, which could be deployed opportunistically. And he surely knows how to do that!

 

Last but not least, both LMCA and BH are among the cheapest stocks I know today (at least in the North American stock market).

 

Gio

 

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Yes maybe... But imagine if investors will accept 1 %age lower yeild on equity in SP500... to the SP500 yeild level that occured during IT bubble... then we have another 65% to go on SP500..

 

Yes, of course! But in that case I have 70% of my capital invested in three businesses that might do very well (Fairfax might do very well, even if the stock market doesn’t crash, like it has proven so far this year!)

 

Gio

 

 

 

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i'll just play devil's advocate here. Not sure that we are or are not in a bubble, but i'll make a case here that we aren't in a bubble. 

*Using the 10 year E/Y, stocks are yielding now about 100/27.14 = 3.7%. 

 

*10 year treasuries are at 2.31%

 

so we have a decent spread here..about +1.4%.  Not a ton, but to give perspective, 2006 and 2007 actually saw bonds yield about 1% MORE than equities (negative 1% spread or so).

 

Obviously if interest rates went up to 4 or 5%, then the market at these prices would look expensive...but seems to me it all hinges on interest rates.  Is there at least a case to be made that interest rates will remain low (below 4%) for the next 5-10 years??  I've been reading dalio's beautiful deleverging whitepaper over and over the past month or so.  Hard to predict exactly what will happen, but seems to me theres a decent chance that over the next 5 years the major economies all get into a currency devaluation competition and keep rates low.

 

Look at the continual deleverging in terms of TOTAL credit to GDP.  we peaked at 360% or so, and we are down only to 330%...as much as people complain about the govt debt, we as a society have actually reduced our debt slightly.  If that continues on down to below 200% over the next 10 years, that would seem to imply lower rates as the govt keeps interest rates below GDP growth.

 

i've found the UK beautiful deleverging (mentioned in dalio's paper) very helpful.  It took 20 years or so, but shows it is at least possible.  interest rates in the UK during that time remained low there for most of those 20 years.

 

finally, not saying it will happen, but lets say 10yr rates are at 2.7% in 2019...a true bubble at that time would be an 10 year E/Y yield of about the same number or even slightly higher (making the spread zero or slightly negative).  So that means a 10 year CAPE ratio of somewhere in the mid/high 30's.  Again, not saying in anyway this will happen, but just trying to work through all scenarios

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If you look at schiller's PE, you are basicly saying that history will repeat itself. Which is not a bad argument. But you can also easily argue that this time is different. Competitive dynamic could be different (higher profit margins due to consolidation), and more conglomerates. Also Asia, and the rapid rise of the middle class world wide. We are not just selling most goods in Europe and the US now, but also various asian and south american countries.

 

In the last 60 years, there has not been a case where over a billion people are working their ass off to get to the middle class and higher. They were mostly held back by opressive regimes and communism.

 

I don't think there will be another lost decade.

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The Shiller PE includes earnings from one a period including one of the worst recessions we've ever had. I think that makes it a little less accurate for this time period than it would be otherwise. You could replace the earnings from the recession with an average of the earnings from the other ten years, but with a proper % hair cut like you would get from a "typical" recession. That should get a lower and more relevant number, unless of course you think our next recession will be like 2008-2009 all over again. Me, I don't see anything on the horizon that could cause that kind of recession to happen anytime soon.

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The Shiller PE includes earnings from one a period including one of the worst recessions we've ever had. I think that makes it a little less accurate for this time period than it would be otherwise. You could replace the earnings from the recession with an average of the earnings from the other ten years, but with a proper % hair cut like you would get from a "typical" recession. That should get a lower and more relevant number, unless of course you think our next recession will be like 2008-2009 all over again. Me, I don't see anything on the horizon that could cause that kind of recession to happen anytime soon.

 

Well to be fair it also includes earnings from the housing/finance excess years, particularly 05-07.

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i'll just play devil's advocate here. Not sure that we are or are not in a bubble, but i'll make a case here that we aren't in a bubble. 

*Using the 10 year E/Y, stocks are yielding now about 100/27.14 = 3.7%. 

 

*10 year treasuries are at 2.31%

 

so we have a decent spread here..about +1.4%.  Not a ton, but to give perspective, 2006 and 2007 actually saw bonds yield about 1% MORE than equities (negative 1% spread or so).

 

Obviously if interest rates went up to 4 or 5%, then the market at these prices would look expensive...but seems to me it all hinges on interest rates.  Is there at least a case to be made that interest rates will remain low (below 4%) for the next 5-10 years??  I've been reading dalio's beautiful deleverging whitepaper over and over the past month or so.  Hard to predict exactly what will happen, but seems to me theres a decent chance that over the next 5 years the major economies all get into a currency devaluation competition and keep rates low.

 

Look at the continual deleverging in terms of TOTAL credit to GDP.  we peaked at 360% or so, and we are down only to 330%...as much as people complain about the govt debt, we as a society have actually reduced our debt slightly.  If that continues on down to below 200% over the next 10 years, that would seem to imply lower rates as the govt keeps interest rates below GDP growth.

 

i've found the UK beautiful deleverging (mentioned in dalio's paper) very helpful.  It took 20 years or so, but shows it is at least possible.  interest rates in the UK during that time remained low there for most of those 20 years.

 

finally, not saying it will happen, but lets say 10yr rates are at 2.7% in 2019...a true bubble at that time would be an 10 year E/Y yield of about the same number or even slightly higher (making the spread zero or slightly negative).  So that means a 10 year CAPE ratio of somewhere in the mid/high 30's.  Again, not saying in anyway this will happen, but just trying to work through all scenarios

 

So US debt is down from 360 to 330, but take a look at Japan and Europe, add up the total, and you can see that overall we are levering up in the developed world. 

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If the Shiller P/E of the S&P500 gets to 29-30, I truly think we will be in the midst of a stock market bubble… Today the Shiller P/E is slightly above 27.

 

As it seems we are slowly but inexorably going into a stock market bubble, I have decided to concentrate my capital in the hands of 3 people:

- Prem Watsa: 36% of my capital

- John Malone: 17% of my capital

- Sardar Biglari: 17% of my capital

With cash at 30% of my capital. And more cash coming in every month through my own businesses.

 

To weather the consequences of what inevitably follows a stock market bubble, I want to be very concentrated, and to hold a significant amount of cash.

 

Gio

 

I agree Gio. If we are not in a bubble, we are very close. When it bursts, who knows... maybe the central bankers will start buying stocks (like they have in Japan).

 

The "E" in the P/E is at an all time record high as a percentage of GDP, however this may be due to government deficit spending which may persist for some time yet...so we may not get reversion to the mean, or partial reversion, in terms of earnings-to-GDP for some time which keep us at these high valuations for a few more years, who knows...

 

A portfolio of 20% stocks, 70% short-term bonds/cash and 10% precious metals (silver and gold miners at this point for me rather than gold) makes sense to me. Of course if I see a deal on a stock, I would buy (reducing the cash position) but hedge that buy with market puts.

 

I would consider FFH cash, so your portfolio is something like 34% stock and 66% cash which is very close to the above (main difference is you no longer are exposed to precious metals whereas a while back I remember you having some silver). 

 

 

 

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So US debt is down from 360 to 330, but take a look at Japan and Europe, add up the total, and you can see that overall we are levering up in the developed world.

 

You could make the argument that in order to develer, Japan and Europe actually need to print money.  Ray Dalio makes this exact argument.  print enough money to get GDP to grow at a good rate, and keep interest rates below that GDP growth rate...and over a 10 year period or so, if you're lucky, you will have a "beautiful deleverging".

 

That being said, i'm not guaranteeing this will happen. Plenty opportunities for road bumps going forward. 

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I would consider FFH cash

 

Hi original mungerville,

well... "cash" that has appreciated more than 30% this year and which pays dividends! Not bad, right? ;)

 

Gio

 

Exactly, its good cash. As other stock prices fall, intrinsic value at FFH would remain stable and maybe even go up a bit. So in that sense, its like cash but with a better return. (Of course FFH stock will temporarily drop a bit along with other stocks in a crash, but that should only last a year or two or three because intrinsic value would stay stable).

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So US debt is down from 360 to 330, but take a look at Japan and Europe, add up the total, and you can see that overall we are levering up in the developed world.

 

You could make the argument that in order to develer, Japan and Europe actually need to print money.  Ray Dalio makes this exact argument.  print enough money to get GDP to grow at a good rate, and keep interest rates below that GDP growth rate...and over a 10 year period or so, if you're lucky, you will have a "beautiful deleverging".

 

That being said, i'm not guaranteeing this will happen. Plenty opportunities for road bumps going forward.

 

If Japan can beautifully delever (ie no precipitous fall in its currency or bonds) at 260% debt to GDP, taking in only something like 12% of GDP in taxes and spending double that currently - I'll shit myself.

 

Beautifully delevering would seem to work better if the other major economies did not also have to do the same. Its like a druggy going to a rehab clinic when the nurses there are also druggies trying to detox and the doctor is a pusher...its probably not going to work as well as a clean rehab clinic is it? And in the case of Japan, its going to be trying to do that in a drug infested rehab clinic for a few decades. Anything is possible, sure - but the odds of a successful exit seem so minute to me that they are not worth considering.

 

So not that I am an expert, but with those numbers, its over for Japan - they are going to default on their bonds (direct default) or on their currency (indirect default).

 

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gio, don't you think the various Malone securities and BH will get slaughtered in a downturn? Both got slaughtered more than the market in 2008 (granted, I don't believe Biglari was in full control at the time).

 

That’s why I hold lots of cash! ;)

 

Anyway, I don’t know of anyone better than Malone at taking advantage of any market crash that might await us. I will be much more willing to double down in the Liberty family of businesses than in any other company, because I know Malone is working on some incredible bargain. And don’t forget LMCA today is almost debt free! In 2008 it was not so, and that could be a great advantage this time around.

 

LMCA is not nearly debt free. And their biggest investment is highly levered.

 

You have to be comfortable with leverage to invest in a Malone entity b/c you are  most likely buying a levered equity that owns a levered equity.  That's one reason for me having a Malone basket rather than a single stock.

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LMCA is not nearly debt free.

 

Well, they have $0.5 billion of net debt, with a NAV of $13.7 billion… Doesn’t seem levered at all to me…

 

And their biggest investment is highly levered.

 

But it is also a growing cash machine, isn’t it? ;)

 

Gio

 

1. You're right, I double checked LMCAs leverage and its lower than I thought.

 

2. SIRI is doing about ~1b in FCF compared to >4b in debt. Also, if you believe the economy is going to fall then auto sales will slow which would be negative for SIRI. I think SIRI definitely has a lot vol/ST price movement risk given the debt and that it's tied to a cyclical industry.

 

I know you probably don't care too much and trust Malone. It's not an investment that makes too much sense to me given your outlook and the fact you are positioning yourself around that outlook.

 

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I would consider FFH cash, so your portfolio is something like 34% stock and 66% cash which is very close to the above (main difference is you no longer are exposed to precious metals whereas a while back I remember you having some silver).

 

I would not consider FFH cash. To me, one of the benefits of having cash is to be able to pick up bargains as they occur in a downturn. In a market crash, FFH will probably go down as well.

 

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Also want to raise a counterpoint to economic bears: http://www.calculatedriskblog.com/2014/06/the-future-is-still-bright.html

 

In the near term, the reasons for a pickup in economic growth are still intact:

 

1) the housing recovery should continue,

2) household balance sheets are in much better shape. This means less deleveraging, and probably a little more borrowing,

3) State and local government austerity is over (in the aggregate),

4) there will be less Federal austerity this year,

5) commercial real estate (CRE) investment will probably make a small positive contribution this year

 

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I would consider FFH cash, so your portfolio is something like 34% stock and 66% cash which is very close to the above (main difference is you no longer are exposed to precious metals whereas a while back I remember you having some silver).

 

I would not consider FFH cash. To me, one of the benefits of having cash is to be able to pick up bargains as they occur in a downturn. In a market crash, FFH will probably go down as well.

 

Ya, but Gio could part with his cash in a crash before he parts with his FFH. This will give time for FFH to stabilize, and differentiate its stock price movement relative to the falling market - like I said, after a year or two in a crash, FFH will be like cash. (You need to read my post - I did acknowledge FFH would fall with the market initially - the difference though is it won't stay down 50% for long when its earnings are rising. Over a couple years the market will differentiate)

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I agree strictly speaking FFH is of course not cash! However, given the choice of holding 70% cash at this point vs half of that in cash and half in FFH while waiting for a drop, Gio has chosen the latter which makes sense because he doesn't know if/when a market fall is coming. So while waiting he can make combined returns on his "cash / cash-like FFH" of maybe mid to high single digits annually.

 

So he is trading off a bit of flexibility in a crash for higher returns on his "cash" now - this makes a lot of sense to me. In a market fall, its not like he is going to want to go all in all at once anyway - he may want to average into a full equity position, he can start by using his actual cash first, then once FFH stabilizes start selling that for more undervalued stocks. So the flexibility trade-off is not that much of a loss compared to what he gets now in terms of higher yield on his cash/cash-like FFH.

 

That's my point.

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2. SIRI is doing about ~1b in FCF compared to >4b in debt. Also, if you believe the economy is going to fall then auto sales will slow which would be negative for SIRI. I think SIRI definitely has a lot vol/ST price movement risk given the debt and that it's tied to a cyclical industry.

 

I know you probably don't care too much and trust Malone. It's not an investment that makes too much sense to me given your outlook and the fact you are positioning yourself around that outlook.

 

Jay,

for what I can see that $1 billion in fcf is growing quickly and steadily. EBITDA is higher: I think SIRI long term debt is circa 3 times EBITDA (maybe a bit more), which is not too aggressive imo.

 

Furthermore, we are at a S&P500 Shiller PE of 27, while I said I would call a bubble when it reaches 29-30… I am not positioning my whole portfolio as if a crash would be just around the next corner!... I must be prepared to see a S&P500 Shiller PE of 32-33, because you never know when a bubble is going to finally burst, right? Another year… Maybe even two… Who really knows?

 

And given how it is priced today, I think LMCA might perform very well during the next two years… If the bubble doesn’t burst!

 

Later, LMCA might have become something completely different… Maybe SIRI will have been acquired and spun-off… And Malone might be onto something completely different!

 

My point is this: if the S&P500 Shiller PE goes from 27 to 32, before the bubble finally burst, I need something to keep making money: cash won’t be useful, Fairfax might be, but with obvious limitations we all know… BH and LMCA must really do the job! ;)

 

Gio 

 

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So US debt is down from 360 to 330, but take a look at Japan and Europe, add up the total, and you can see that overall we are levering up in the developed world.

 

You could make the argument that in order to develer, Japan and Europe actually need to print money.  Ray Dalio makes this exact argument.  print enough money to get GDP to grow at a good rate, and keep interest rates below that GDP growth rate...and over a 10 year period or so, if you're lucky, you will have a "beautiful deleverging".

 

That being said, i'm not guaranteeing this will happen. Plenty opportunities for road bumps going forward.

 

If Japan can beautifully delever (ie no precipitous fall in its currency or bonds) at 260% debt to GDP, taking in only something like 12% of GDP in taxes and spending double that currently - I'll shit myself.

 

Beautifully delevering would seem to work better if the other major economies did not also have to do the same. Its like a druggy going to a rehab clinic when the nurses there are also druggies trying to detox and the doctor is a pusher...its probably not going to work as well as a clean rehab clinic is it? And in the case of Japan, its going to be trying to do that in a drug infested rehab clinic for a few decades. Anything is possible, sure - but the odds of a successful exit seem so minute to me that they are not worth considering.

 

So not that I am an expert, but with those numbers, its over for Japan - they are going to default on their bonds (direct default) or on their currency (indirect default).

I hope that Japan will end horribly,  and will be a wake up call for the rest of the world.

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