The Key to Surviving a Speculative Mania

Steve's note: As regular readers know, I believe the real push higher in stocks is still ahead of us. I call it the "Melt Up." But after it's over, the "Melt Down" will follow… And if my colleague Dan Ferris is right, it could be your first opportunity in years to pick up incredible values. This week, we're sharing his view of what comes next in the markets…
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 week, I'm going to share seven traits of speculative manias that we've found in our research, starting today with the first three.
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're seeing that now 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 has risen as much as 2,000% so far this year, recently nearing $20,000. 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 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 (M&A).
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 acquisition 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.
Early this month, 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? A little more than a month ago, the Financial Times reported that European junk-bond yields were around 2%. They've come up slightly since then, but they still hover around 2.6% (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.
Good investing,
Dan Ferris
Editor's note: When stocks are this expensive, it's hard to find a good value. But Dan has found one company whose shares are set to skyrocket starting on January 1, when a little-known new law kicks in. The mainstream media isn't talking about this yet… But once it does, Dan says this company could take off.
Dan recently put together a brief presentation detailing this opportunity. For the next few days, you can view it – and take advantage of an incredible offer to his Extreme Value newsletter. Get the details here.

Source: DailyWealth

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