How to Avoid Being Bubble Rubble

Chapter 17, Part II

The most valuable — and expensive — lesson I’ve ever learned.

One of my main contentions about the current US investment environment is that the classic buy-and-hold uber-strategy that has worked spectacularly well for the last four decades is now a non-starter–and even more of a non-finisher. This tightly relates to the probable ineffectiveness of the traditional balanced portfolio where, as described above, an investor is likely to lose money, after inflation, on both ends of their asset allocation.

If I’m right, and I’m highly confident about that, a much different methodology will be needed in order to earn returns above inflation. Basically, investors will need to become traders, at least in the U.S.  I can hear the howls of protest even with my PC speakers on mute!  But let’s get real — as in real returns, i.e., net of inflation.  After over a decade of U.S. stock market performance far above the normal 9% per year, despite an economy that consistently underperformed, we’re due for a decade of flat prices.  If inflation averages 5% or more, as it easily could, it’s going to be that Seventies Show all over again.  

Accordingly, open-minded investors need to have a process that works in trading range markets, those that rally hard, sell off suddenly, and, when the smoke clears and the dust settles, you’re back to where you started.  In other words, much like the US stock market from 1966 to 1982.  Then, there is that pesky matter of inflation which, even after dividends are factored in, makes it hard to maintain purchasing power when you start from the kind of nosebleed valuations that pervade in the U.S. today.

This subject elicits a moment of true confession:  One of the worst mistakes I’ve made over my career was in not paying closer attention to major breakouts and breakdowns.  The two charts above are classic examples of massive breakouts.  The reason for the superlative characterization is that it’s my repeatedly proven experience that the longer the trading range has held, the more important the breakout or breakdown.  Here’s an example of a critical breakdown, in this case in the US Energy Midstream (Pipeline) sector when Covid hit:  

Figure 6

And here’s the one I still kick myself over, showing the crucial breakout above the 2000 high by the S&P 500 in the spring of 2013.  At the time, I was worried the market had risen too far from its 2009 trough and that it had become overvalued (which, in many ways, it had).  But I should have paid attention to the breakout and also realized the Fed’s constant QEs had changed the rules of the game.

Figure 7

On a much a happier note, one of my firm’s biggest positions gave us a great heads-up back in 2013 when it, too, broke out of a thirteen-year trading range.  It’s hard to imagine now, after so many years of stellar performance, how reviled Microsoft was by most of the investment community a decade ago.  In the wake of the Great Recession, it often traded in the 10 to 12 times earnings range. 

In fact, as late as 2013 you could still pick up its shares for a P/E of just 10. This was despite growing its earnings per share at a 15.7% EPS annual rate from in the thirteen years after the tech crash, absolutely gushing cash, possessing a fortress balance sheet and one of the world’s most enviable franchises.  It had those attributes for years, but it was dead money… until the 2013 breakout told us something was changing for the far better. 

That decisive breakout was destined to lead MSFT to achieve every contrarian investors’ dream scenario:  a value stock that is re-rated up to growth stock status.  The reason this is so lucrative is that this rerating means a higher P/E is applied to its earnings growth.  Over the last decade, its earnings per share have tripled — aided somewhat by well-timed buybacks — and its stock has risen 10-fold.  Considering how little downside there was in buying the world’s greatest software company at a 10 P/E in 2013, this has to be one of the greatest risk/reward outcomes in stock market history. 

Figure 8

It's further embarrassing for me to admit that in my personal long/short account — in other words, a truly hedged portfolio in the traditional sense of the term — I have far too many times failed to cover my short positions when they have made new multi-year highs.  It would have saved me substantial amounts of money had I long ago followed this discipline.  The good news is that you don’t have to make the same mistakes I have.  It’s always far better to learn from someone else’s screw-ups than your own!

Because almost everyone reading this book would never dream of shorting, the much more relevant application of this insight is to buy companies that are breaking above long-term trading ranges.  In my experience, even more critical is to sell those that are cracking below a price level that has been downside support for at least three years.  Again, the longer the trading range has been in place, the more meaningful the breakout or breakdown.  Many great investment careers have been ruined, or at least seriously harmed, by dollar-cost-averaging into stocks that are experiencing major breakdowns.  In some cases, these falling former stars finally find durable support at zero.  The list of previous blue-chips that have ended up in bankruptcy is a surprisingly long one. 

Hedge fund legend Paul Tudor Jones, truly one of the best in the business, also tracks these but he calls them “range expansions”.  He has pointed out that when a long-term trading range is broken, either up or down, the security in question typically keeps running in that direction for a while.  How long?  Well, that’s the hard part.  Often there’s a 20% spurt, and that’s all she wrote.  As noted above, the best breakouts are out of the longest bases like the S&P’s 13-year trading range shown above; this is particularly the case when they are also supported by improving fundamentals, like attractive valuations and accelerating earnings.  (Ironically, that wasn’t really the case with the S&P in 2013 though it was true for many large cap tech issues such as MSFT).

Whether you call them breakouts, breakdowns, or range expansions, if you pay attention to them, I’m confident you will receive an exponential return on the time you invested in reading this book.  By the way, I have been amazed by how well they work across all kinds of real-life situations including macro-economic (big-picture) forecasting.  The Fed would have been well advised to pay attention to this chart on the Producer Price Index (PPI) in early 2021.  It could have saved them having to wear a three-egg omelet on their collective faces over the whole “inflation is transitory” fiasco.

Figure 9

The point is that by paying close attention to breakouts, breakdowns and/or range expansions, you’ll have a critical leg up on most investors who don’t follow them in the least.  In fact, these days, most money is just mindlessly shoveled into no-think index products, as I’ve continually pointed out through this book.  Trust me, there is that Forrest Gump “stupid is, a stupid does” moment coming for this brainless — and gutless — investment “strategy”.  Move away — far, far away — from it as quickly as you can.  Channel your Rhett Butler and not your cookie-cutter financial planning asset allocator. 

Please allow me to close this chapter to reiterate this simple yet essential message:  Don’t rely on what’s worked for your portfolio since 2008 – or 1982, for those old folks like me.  Conditions are changing drastically and, consequently, you need to radically alter your portfolio strategies and allocations.  You’ve been given a sneak preview on how quickly asset prices can evaporate with the sudden and stealthy breakdown of so many U.S. growth stocks in the closing months of 2021 and into early 2022.  In my view, there is much, much more to come in this regard.  The great news is that there are rational steps you can take to protect you and your family’s wealth from this paradigm shift… unless someday you want to be on a street corner saying “Brother, can you paradigm?