What the wise do in the beginning, fools do in the end. -Warren Buffett
Only a fool learns from his own mistakes. The wise man learns from the mistakes of others. -Otto von Bismarck
The Greater Fool Stage
We have now crossed over into the Greater Fool stage of this bull market. Does that mean you should get out? No. The Greater Fool stage can last months, or even years, as history has shown us repeatedly. So why bring it up at all?
I’ll tell you why. If you’re a smart investor, you should be making preparations now for the inevitable storm that’s coming. If that sounds to you like garden variety fear mongering, and you reject it out of hand, then you can stop reading now and go back to the Sunshine Pumpers who have convinced you that this time is different, or the Fed will prop up the stock market, or Trump is the second coming of J.P. Morgan. I have some bad news for you. Happy Days are NOT here again.
Here’s what Forbes (a stodgy old magazine that still publishes some of the best market commentary available today) had to say about Greater Fool markets back in 2015:
The 2000 stock bust and the 2007 housing bust have their roots in TGFT. Both ended badly when the markets ran out of fools. Today’s stocks are again showing symptoms of this affliction but unlike in housing, it is an ever present market force. In fact, market liquidity depends on it.
The current market bubble is due to the Federal Reserve Bank’s asset purchase program under which fixed-income investments were taken out of the market forcing yields down and driving money into stocks. This was intended to create a wealth effect for investors that would translate into increased consumption and thus, greater economic growth. We certainly got greater stock market wealth the last two years, but the wealth effect appears to be more theory than fact.
The Fed is now signaling that it plans to begin raising interest rates as early as June from the current near zero in order to give itself room to again lower rates in any future crisis. That’s the official line. A more likely reason is that Fed Chairwoman Janet Yellen fears that the asset purchase program has created the same stock market “Irrational Exuberance” former Chairman Greenspan warned about in 1996 and then did nothing to head off the inevitable result. Having learned this hard lesson, she does not want to see a new financial crisis, begun by a severe stock market correction. In short, she wants to take the exuberance out of stocks before the bubble gets any bigger.
(Read the Forbes article here.)
A teachable moment
What does this 27 month old Forbes article tell us about what’s happening today? It tells us that investors who jumped the gun and got out of stocks in April 2015 were wrong. Bailing out prematurely would have cost them 16.5% (so far). It’s possible that some of these Nervous Nellies realized their mistake and got back in, truncating their potential loss from poor timing. But most have been out of the market ever since.
In fact, many investors have been out of the market since 2008. These Uber-Nellies have forgone a profit of 215% since the bottom in 2009. Other investors bailed out during the market scare of August 2015. You get the idea. Bailing out too soon can be just as painful as staying in too long.
John Maynard Keynes had it right
Whatever you think of Keynes’ political leanings, there’s no denying that he was a giant of economic thinking. It was Keynes who laid the groundwork for the Greater Fool Theory, when he observed:
The Market Can Remain Irrational Longer Than You Can Remain Solvent
Keynes knew that it wasn’t enough just to recognize that the stock market was overpriced, or even in a speculative bubble. He correctly pointed out that when investors believe that the prices they pay today are irrelevant because someone will surely come along and pay them even more, the belief in an endless supply of Greater Fools overwhelms the fear of getting in at the top of the market.
How irrational can a Greater Fool market get?
At the last market peak in October 2007, investors were willing to pay $27 for $1 of earnings. (The long term average is $16.) The bubble before that, in August 2000, saw investors paying $100 and more per share for startup technology firms that had no sales, no earnings, and no tangible book value. It was all about clicks and eyeballs.
And of course, who can forget the Mother of all Greater Fool markets – Dutch Tulip Mania in 1637. Tulip bulbs had become so attractive as an investment that investors were willing to spend the equivalent of the price of a new home to buy one bulb. In today’s dollars that would be roughly $200,000 for a single tulip bulb.
What should a rational investor do now?
- Recognize that we are in the Greater Fool stage of the current bull market.
- Don’t panic and sell out now, because the market is still making new highs.
- Write down some trading rules. For example, “If the S&P touches 2,500 I will take 20% out of stocks and put it into Treasury bonds. If it touches 2,600 I will take another 20% out of the market.” Etc.
These trading rules should not be arbitrary. They should fit your financial circumstances. If you are in or near retirement, you should be more aggressive in playing defense. If you are highly sensitive to losses, you can be more aggressive. If you believe that the bull market is going to continue for another year or two, then use any meaningful pullbacks to buy more stocks.
The Greater Fool stage of a bull market is fraught with danger. Jump out too soon and you could leave a sizable chunk of your wealth on the table. Hang on too long and you could get caught in a downdraft from which there are no clear exits. That’s why I advocate a rules-based approach to handling this kind of market environment.
You want to remove as much emotion from the process as possible. Rules do that, because when you write them you are in a rational frame of mind. When you’re executing your rules, you are probably in a less rational frame of mind. It’s critically important that you trust your rules and follow through on them regardless of how you are feeling in the heat of battle.