The Key to Surviving a Speculative Mania

Editor's note: Value investor Dan Ferris says we're in the midst of a speculative mania...

And many investors are taking on more risk than they realize.

To guide you through this dangerous time in the markets, we're featuring some of our favorite commentary that Dan has written over the past several months.

In today's Masters Series – updated and adapted from a four-part DailyWealth holiday series – he shares several traits of speculative manias... and explains why today's "safest" investments are likely to become tomorrow's toxic waste...

The Key to Surviving a Speculative Mania
By Dan Ferris, editor, Extreme Value

Stocks are super-expensive right now.

Yet everybody thinks it's easy to get rich owning them.

That's always a recipe for disaster.

At about 2.25 times sales, the benchmark S&P 500 Index is just the tiniest bit under its all-time high value of 2.35 in early 2000 – the most expensive single moment in U.S. stock market history. Historically, stocks have performed poorly 90% of the time when they've been this expensive.

In short, we're in the middle of a speculative mania. And understanding the components and behavior of a mania is key to surviving it...

This weekend, I'm going to share seven traits of speculative manias that we've found in our research, starting today with the first five.

It's not an exhaustive list. And not every trait is present during every mania. But you can expect to find most of the traits we've identified when investors start bidding asset prices to dangerous levels.

I hope you'll use these insights to bolster a conservative, long-term, value-oriented investing viewpoint...

1. Something new

New technologies and new financial innovations are key ingredients of speculative manias.

For example, optimism about technological innovations caused the dot-com boom in the late 1990s. The S&P 500 price-to-earnings (P/E) ratio hit 44 times earnings before that mania topped in early 2000. It is still the single most overvalued equity market valuation in history.

Similarly, financial innovation in mortgage-backed securities led to an enormous debt-fueled housing bubble, which finally blew up in 2008. That implosion caused the worst financial crisis since the Great Depression.

When technology and financial innovation combine, mania-watchers pay attention. We've seen that recently with bitcoin...

Bitcoin is a digital currency, a technology-driven financial innovation. It exists only in electronic form. Regular currencies are created and controlled by a central authority like a central bank. Bitcoin is "mined" by anyone who knows how to use software to solve a cryptographic puzzle.

The value of a single bitcoin unit rose as much as 2,000% last year, hitting nearly $20,000 in late December. But bitcoin is incredibly volatile, and no one knows what it will do from day to day. In my experience, an asset that can rise that far and that fast can plummet 90% or more even faster... Asset prices tend to take the stairs up and the express elevator down.

Either bitcoin is the biggest thing since money was invented thousands of years ago, or a lot of folks are taking risks they don't understand. You can guess which one I'd bet on.

2. A mergers and acquisitions (M&A) boom

Speculative manias are generally marked by an increase in the rate of mergers and acquisitions.

In the 1920s, publicly traded investment trusts consumed one another, until most went belly up in the crash.

The "Go Go" 1960s saw the rise of conglomerates. Ling-Temco-Vought (LTV Corporation) had its fingers in aerospace, electronics, steel manufacturing, airlines, meat packing, sporting goods, and even car rentals and pharmaceuticals. It grew revenues via acquisitions from $36 million to $3.8 billion in just five years – more than a 100-fold increase.

Mergers are perhaps the least salient feature of the current mania, but it's worth noting that all-cash deals are hitting record highs these days. Pharmaceutical company Bayer's (BAYN.DE) $66 billion all-cash offer to purchase agribusiness leader Monsanto (MON) will become the largest cash deal in history if it closes. At $128 per share, Bayer is offering 25 times earnings for Monsanto.

In December, drugstore chain CVS Health (CVS) offered $69 billion in cash and stock for health insurer Aetna (AET). Charley Grant at the Wall Street Journal reports CVS will need to take on $45 billion in debt for the purchase, raising its debt to $70 billion.

By our calculations, CVS is paying about $205 per share for Aetna, or 4.4 times book value. That's more than double the intrinsic value of the best insurance companies in the world (like Berkshire Hathaway, W.R. Berkley, or Markel), which I'd peg in the ballpark of two times book value.

These two deals have "sign of the top" written all over them, for sheer size and valuation. I expect you'll see at least one or two more of these mega deals in 2018.

3. A credit boom

It's impossible to miss the bubble in bonds. Many Swiss, German, and Japanese government bonds are trading at negative yields. In other words, investors paying those prices are guaranteed to lose money if they hold the bonds to full maturity.

Many large financial institutions continue to buy these bonds simply because they're restricted from holding most other types of securities...

Some large financial institutions, whether for regulatory or business reasons, can't buy junk bonds. They're restricted to higher-quality bonds – like so-called "investment grade" corporate bonds.

The lowest major "rung" that still counts as investment-grade is BBB. With "junk" status just one ratings notch lower, you'd think there'd be no way a BBB-rated bond could trade at a negative yield (indicating a high price and untarnished optimism about the prospects of repayment).

The assumption would be as wise as it is wrong.

Paris-based conglomerate Veolia recently issued 500 million euros' worth of three-year bonds at a yield of -0.026%, rated BBB. The issue was oversubscribed by four times. That means it only sold 500 million euros' worth, but investors offered to invest more than 2 billion euros in the bond issue.

In other words, so many investors wanted in to a bond issue guaranteed to lose money if held to maturity that their 1.5 billion euros had to be turned away.

A crazy situation can always get crazier. How long will it be until a junk-bond issue (rated BB or lower) is brought to market at a negative yield? In November, the Financial Times reported that European junk-bond yields were around 2%. They've come up slightly since then, but they still hover around 2.8% (according to the BofA Merrill Lynch Euro High Yield Index).

Always avoid insanely priced assets. I'd much rather hold cash than most bonds today. I take it as a sign of the grave distortions in the financial markets that bond investors think slow suicide is the best choice.

This is why you almost always see a credit boom during an equity boom. Investors seek more risk in equities as bond yields get low... And higher equity valuations make bond investors believe it's just as safe as it was before when both debt and equity valuations were lower (and objectively less risky).

Bonds worldwide are more expensive than they've ever been in 5,000 years of recorded history. It's not unreasonable to conclude that stock prices will continue to rise as investors take more and more risk in search of less and less return. Eventually it must end, but nobody knows when.

Prediction is unnecessary. Preparation is mandatory.

4. A reasonable fundamental taken to unreasonable extremes

This trait could double as the definition of a speculative mania.

Most times, a reasonable financial or economic fundamental remains reasonable until too many investors discover it. Then purely by too many people acting on it, the fundamental deteriorates into its opposite...

At one time, it was conservative to invest in housing and mortgages. Then investors noticed that U.S. housing prices hadn't fallen in living memory. They took that to mean housing prices would never fall. That helped create a massive bubble, ending with the S&P 500 down 58% from its October 2007 highs by March 2009.

The same thing is happening with passive investing today.

Index funds are often referred to as passive investment vehicles. Passive investing makes fundamentally good sense for most investors. You won't always be able to beat the market, so just own the market. Index funds are how you do that. They're one of the greatest ideas in finance.

However, experienced investors will automatically ask, "So what's next?" They know that in financial markets, success tends to sow the seeds of its own destruction...

Wall Street research firm Bernstein Research predicts 50% of all U.S. assets under management will be passively invested by early 2018. In a 2016 report, it called passive investing "worse than Marxism," and said it "threatens to fundamentally undermine the entire system of capitalism and market mechanisms that facilitate an increase in the general welfare."

This is not as ridiculous as it sounds. Steven Bregman, co-founder of investment adviser Horizon Kinetics, says passive investing has two big problems.

First, passive funds buy baskets of stocks as new money comes in, without any reference to the fundamentals of the businesses they're buying. When money comes into the fund, they buy. When it goes out, they sell. No due diligence required.

The second problem is that many active managers are penalized for taking contrary positions against the passive buyers. This is because over time, they command fewer and fewer assets relative to the passive herd. So their influence on the marketplace shrinks as the mindless passive herd of buyers grows... and experiences less and less pushback from more rational actors in the marketplace.

Passive and active buyers and sellers ought to balance each other out over the long term. It's how the market tends to gravitate toward fair value for most securities, even if it takes a long time and a lot of irrational pricing to get there.

Bregman complains that the destruction of this kind of "price discovery" and the herding effect created by exiting active managers spells real trouble for financial markets.

With passive investing approaching 50% of total U.S. assets under management, it's starting to feel like the tipping point is growing near. When nobody is left to buy the indexes, they'll top out and start falling.

The market can go up for years more, higher than any rational person would ever expect. But passive investing has the potential to go horribly wrong, precisely because it's so widespread and assumed to be so safe and conservative, which leads us to Trait No. 5 of speculative manias...

5. A risky scheme sold as a safe investment

The only way an asset can turn to toxic waste and wreak widespread financial havoc is if enough people accept it as safe and start piling in.

The widespread acceptance of assets as safe and conservative makes it more likely they'll see more investor interest and wind up in more investors' portfolios. The act of everybody buying them because they're safe makes them unsafe, amplifying their flaws and weakening their strengths.

That's the key: Today's safest investments are most likely to become tomorrow's largest pool of toxic waste.

For example, in the 1920s, publicly traded investment trusts were supposed to be diversified equity portfolios like today's index funds. They became highly leveraged speculative vehicles. At one point, a new trust was floated on the public market every day. Many disappeared completely in the 1929 crash.

Let's go back to our index fund example... One strength of indexing is that you can easily hold a diversified portfolio in a single fund. But how diversified are you if everybody else owns the same thing you own?

If Bernstein is right and 50% of all U.S. assets under management are in passive vehicles by early 2018, what will happen when the stock market starts heading the other way? Will index selling turn a 10% correction into a 50% bear market?

Indexing is a strategy solely based on buying. Selling is not part of the deal. When selling goes into overdrive, indexers will feel less like they're making a safe, conservative bet and more like they're juggling flaming chainsaws.

Of course, we can't know exactly what will happen if indexers start selling. Maybe enough of them will hold on for the long term that we'll have nothing to worry about.

What I do know is this: What the wise do in the beginning, fools do in the end.

Indexing was wise for decades – an easy, low-cost, efficient way to get decent long-term investment results and prepare for retirement. But now that it's the most popular strategy in the world, with the biggest index fund provider (Vanguard) taking in $2 billion a day, I bet there are more fools than wise folks getting in today.

Good investing,

Dan Ferris

Editor's note: We're nine years into this historic bull market, and cheap stocks are tough to find. But Dan has found one stock he calls his brand-new No. 1 recommendation. "If I had to pick one stock to put every penny of my life savings into... this would be it," he writes. "I'd bet my cash... my retirement savings... all of it... all on this single company." Learn more about this stock – which Dan predicts will become the first 20-bagger in Stansberry Research history – right here.