I am taking care to warn my followers about the notion of bubbles and the consequential crash. 

What’s a bubble?

Occasionally Mr Market (8. Mr Market) tends to become too exuberant about the future of the market or more often one specific sector.

The most recent and known bubble was the dotcom bubble. At the end of the 90s it became evident that informatic technology was going to be a game changer. People start to lose their mind about every company that rhymes with .com or dot or @ or every other synonymous of computer science. Lose their mind = Paying high price for unprofitable companies that maybe will provide cash in a far future 

Noting that most of the dotcom darlings never return to the previous level (in other words a lot of investors lose tons of money). It’s important to understand a simple, but sometimes not correctly understood, principle: If you lose 50% you must gain 100% to return to the previous wealth status. 

How to avoid being caught in a bubble? 

Stick with fundamentals and your circle of competence (10. Circle of competence). Invest in a company that you know and that generates cash now. The problem with bubbles is the exuberance generated by future expectations. What I see today is a exuberance about electric vehicles.(Case Study 1 – Tesla) 

“Now, there’s just so much money injected into the markets and the economy that the markets are like a casino with people playing with funny money. They’re buying all sorts of things and pushing yields on everything down. Now you have stocks that have gone up, and you have classic bubble dynamics in so many different assets.”

Ray Dalio – Why in the World Would You Own Bonds

Peter Lynch cocktail party theory 

Stage 1:

At the party, the markets have been down a while and people are not talking about stocks. There’s little interest in talking to an equity mutual fund manager like Lynch about it. When folks generally seem inclined to talk about plaque with a dentist than about stocks it’s likely the market is about to head higher.

Stage 2:

People may talk about stocks long enough to say they’re risky but would still rather not talk about it. Party conversations are still more plaque than stocks and the market’s up roughly 15%. Few care.

Stage 3:

Market is up 30%, people start asking a professional money manager like Lynch what stocks to buy. Most have now bought a stock or two.

Stage 4:

People are crowded around Lynch but now they are telling Lynch what stocks to buy. Dentists are now offering stock tips. This stage is a good sign the market is near the top. 

Look around you, if you see this pattern, start to worry. Especially if you find yourself in the role of party guest.

“Whenever you find yourself on the side of the majority, it is time to pause and reflect.”

Mark Twain

Why does the bubble happen?

“The symmetry between prediction and explanation is destroyed because the future is genuinely uncertain, and therefore cannot be predicted with the same degree of certainty as it can be explained in retrospect.”

George Soros

Bubble is a good example of Soros’s Reflexivity. The Stock Market is a forecast machine, the agents involved in the machine constantly try to predict the future (or define it?). If Mr Market sees a disruptive technology coming, pheraps is not wrong in the direction but in the magnitude and timing. Sometimes, after a bubble, the sector consolidates and only the fit survive, companies that will thrive after the bust. It’s even possible in accordance with Soros’s principle that when a huge amount of capital is directed to a specific sector, the future of this sector becomes a self-fulfilling prophecy. Capital inflow + media coverage in a specific sector or company allows the company to grow more strong and pave the way to a increased number of investment prospects that would be impossible if Mr Market doesn’t become irrational about it.

However, fulfilled or not, this exuberance anticipation of events doesn’t pay. Remember that someone is still waiting to regain the money lost during the dotcom bubble. 

“Rule Number One: Never Lose Money. Rule Number Two: Never Forget Rule Number One”

Warren Buffett

We are rational investors, we want to grow our wealth, we invest in businesses which generate great returns for us. In order to do that, we don’t need to anticipate the future, but we are going to invest when the future comes. We will lose $AMZN at 2 usd/share? Maybe, but we are going to avoid losing 100% of our wealth in any of the other hundreds of companies lost in the dotcom collapse.

Our duty, as Super investors (9. Value investing), is to buy companies that already generate profit, and because of their MOAT, those are going to generate more organic profits in the future. 

“Yes, but my neighbour is becoming rich thanks to an innovative EV company. His stock skyrocketed and he told me to buy it now!”

Average Joe

Remember the Xerox chart and the chart about GoPro I presented in the article Case Study 1 Tesla, remember Peter Lynch analogy. 

There is no free lunch in investing, do your due diligence. 

“The market is a pendulum that forever swings between unsustainable optimism (which makes stocks too expensive) and unjustified pessimism (which makes them too cheap). The intelligent investor is a realist who sells to optimists and buys from pessimists.”

Benjamin Graham

Remember, when the market collapses, and the bubble deflates, it’s possible that even good companies follow the price trend, don’t go panic mode, revisit your investing thesis and if the facts about fundamentals are solid, go out and buy the discounted shares of your favourite business. 

“Every decade or so, dark clouds will fill the economic skies, and they will briefly rain gold. When downpours of that sort occur, it’s imperative that we rush outdoors carrying washtubs, not teaspoons. And that we will do.”

Warren Buffett

As I have predicted in the article Article Case Study 2 – Berkshire, Buffett did what every great CEO must do when his stock undervalued, that is repurchased his own share creating value for shareholders.

This means I’ve to invest only when bubbles pop? 

Nope, your duty,  as an investor, is to find bargains in every market condition, but in the meantime avoid being caught in the fad of the moment. If you can’t find a bargain tied to your circle of competence, there is nothing wrong with sitting on your cash waiting.

“All human unhappiness comes from one single thing. Not knowing how to remain at rest in a room.”

Blaise Pascal

At the end, a crash is only a chance to take more shares in a business we love for a discounted price. 

Is it possible to forecast a bubble or even better a bust? 

No. I read tons of articles about bubbles and more in general the possibility to predict the market, the reality is that is impossible. 

“Time in the market beats timing the market”

Old saying

Or, as said by Peter Lynch 

“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”

Peter Lynch

Applying the occam’s razor my advice is simply:

Try to find a bargain, if you don’t find one, stay in cash. 

To do that you need to understand the business stories and numbers (11. Stories and numbers).

“The first rule of an investment is: Don’t lose. And the second rule of investment is: Don’t forget the first rule. And that’s all the rules there are. I mean, if you buy things for far below what they’re worth, and you buy a group of them, you basically don’t lose money.”

Warren Buffett

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