Historians regularly identify market bubbles and manias, but their insights provide market participants little value after the fact. This letter will try to explain how we identify bull markets, asset bubbles, and manias. We believe each is unique in its origin, evolution, and expiry. We will also try to highlight some of the tells those bubbles and manias often exhibit. Hopefully, the following can save you a lot of pain and suffering in the future.
The following conditions are common in bull markets, asset bubbles, and manias:
Asset bubbles tend to emerge in equity markets when absolute valuation models (based on discounted future cash flows) no longer indicate positive expected returns. Speculation on future economic and corporate performance also becomes excessively optimistic. Experts are forced to use relative valuations to justify their equity target prices. This means using one company’s elevated (or, in the later stages, grossly elevated) value to justify elevated expectations for another. At Caravel, we refer to this methodology as the greater fool approach. By the time most people begin questioning valuations, they are excessively high, and the quality of the company’s prospects are typically deteriorating. A bubble of this nature can persist for a long time. Many don’t remember, Greenspan’s famous quote “irrational Exuberance,” describing the 1990s internet bull market, was spoken in December 1996, more than three years before the market topped. Those markets tend to top when bears cover their short positions, and the office shoeshine boy is offering you stock tips. Maybe your Uber driver buys a Tesla.
An investment mania is entirely different. These tend to emerge when many participants come together, united by their disregard for the traditional value of a dollar. Mania does not use any rational valuation methodology. It relies on F.O.M.O. (Fear Of Missing Out) and the madness of crowds. The players suspect there is no terminal value in their assets, but don’t care because the money they started with was free, and they want to put it to work somewhere. Most of us have seen this behavior in games of chance on television and in casinos. We have watched people gamble multiples of their income on game shows because the audience (the crowd) encourages them to “go for it.”
When it comes to the stock market, this behavior is infrequent. I saw this occur for the first time in decades in 2020, during the pandemic. Governments poured trillions of dollars into people’s pockets, most of whom were still earning their regular income working from their homes. Soon after the cheques arrived in the mail, the meme stock frenzy began. With “free money”, twitter, chat rooms etc the games began. People paid outrageous prices for what soon became known as the “Meme Stocks”. These companies were not ones analysts were touting. The home gamers ran up the prices on companies destined for bankruptcy. They thought it was a game to force those short the stock to cover. What they eventually learned is these companies can issue more shares…an unlimited number of shares. Never pick a financial fight with a guy who owns a printing press (AMC still +1700% YTD, GME +960%...?). But as the saying goes, a trillion here and a trillion there, pretty soon you’re talking serious money.
Those are some of the markers used to identify bulls, bubbles, and manias. What separates the best traders from the herd is having the knowledge to recognize the first and the skill to insulate your portfolio from the latter two.
Over the past five years, major North American stock markets have twice incurred a 20%+ correction. TWICE! Over that same period, the Caravel Capital Fund Ltd’s worst monthly decline was -2.5%, and its worst cumulative decline was -6.5%. Coincidently, the negative return period of -6.5% occurred while North American markets rose 8%. We recognized a problem that arose from exogenous forces and paused. We did not check, raise, or go all in. We mucked our hands and waited for the next opportunity, armed with more wisdom. The most common question we are asked from sophisticated investors is: “How do you insulate the portfolio so well during market corrections?” The simple part is explaining what we do. The tricky part is having the skill, knowledge, experience, and discipline to do it. We hope you enjoy our insights. We enjoy sharing with you what goes through our heads before we check, raise, or fold.
In our last letter, we neglected to mention that the employees of Caravel Capital reinvested 100% of their performance fees for the quarter ending September 30th back into the fund. We apologize and hope this did not cause concern. Jeff redeemed $200,000 from his holdings to pay for the build of his house.
It is finally starting to look like the architect’s original renderings from two years ago. Target move-in is Jan/Feb.
We thank you for your confidence and capital.
Jeff and Glen
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