Jim Iuorio appeared on Larry Kudlow’s show on CNBC this week and said something profound. To paraphrase, Jim said that bubbles don’t happen while people talk about and worry about bubbles. Bubbles happen, he said, when people deny bubbles and struggle to reassure themselves that things could not be better and that there isn’t any real downside. Bubbles occur when investor arrogance is at its height. I actually wrote a book about this called The Arrogance Cycle.
Stock prices have risen dramatically, and valuations appear full. Alan Greenspan talked about “irrational exuberance” in 1996 when the Dow Jones Industrial Average had just touched 6,000. He was saying that stocks were expensive, and he wasn’t wrong. He wasn’t wrong in his value judgment, but he was horribly wrong if he thought investors, collectively speaking, would care. The Dow was at 8,000 eight months later and over the next few years rose to 11,500.
There is a great lesson in this. Markets often go to excess, and trends often last far longer than most expect. We have been through these periods in the past and have learned two important lessons: these moves cannot be timed, and you better understand what you own and be sure it is high quality.
Janet Yellen’s nomination as Chair of the Federal Reserve was approved by the Senate Banking Committee. While the minutes from the October meeting show a clear inclination to reduce or taper the Fed’s $85 billion in monthly bond purchases, Dr. Yellen (Yale PhD 1971) is clearly dovish. She has been clear that low rates and an accommodative posture will be with us a long time. While the Fed’s messaging is muddled, a move toward tapering is inevitable, and markets don’t like it. This is a negative for bond prices and will likely result in a deliberate flight from more speculative stocks.
While investors may miss some of the upside because of a more defensive posture, we are most focused on guarding against downside moves. Former Citigroup Chairman and CEO Chuck Prince famously said of an earlier bubble that ‘the party may have gone on too long but as long as the music was playing, you had to get up and dance!’ Several financial firms collapsed or nearly collapsed when that music stopped. While the musicians don’t sound tired at present, we want to make sure we have a seat when the music stops. Though it may be quite a while from now, the music always stops.
Our strategy is simple and consistent. We strive to own shares of companies with solid balance sheets, high returns on equity, strong cash flow, consistent earnings increases, and experienced management teams. Mae West said, “Too much of a good thing can be wonderful.” We hope that things continue in wonderful ways for a long time to come, but we will be ready when they change.
Hang in there!