Nitroglycerin
Photo by Marian Kroell on Unsplash
“a high explosive that is so unstable that the slightest jolt, impact or friction can cause it to spontaneously detonate”[i]
In years gone by, one of our great friends and inspirations would use the word “nitroglycerin” to talk about markets that were ready to explode upwards. Every year he would dream of a bubble forming in his long book. Many times it did in some sub-segment. In the 14 years or so since we started, 12 of which we worked together, we had never actually seen a fully-fledged “nitroglycerin” market despite the many significant attempts at one. Until now.
Scrolling through the feeds of many of Twitter’s top financial market “experts”, one can’t help notice the warnings (and articulately constructed arguments) for why being involved in stocks is more dangerous than ever. The hashtags and quotes are fantastic and these warnings tend to centre around some truly relevant points. They include:
“The fastest recovery ever”
“Biggest divergence from the 50 day moving average since 2000”
“The world is in a depression”
“The market is disconnected”
On the face of it, all these arguments are 100% correct. The problem with them is that the market does not care.
When managing money, there’s only one thing that matters, and that is delivering returns. When the sun is shining, you’d best capitalise on the good conditions, as you never quite know when it will set for an awfully long time. It goes without saying one must be careful and one can only really achieve success if you’re aware that the sun can set at any minute!
The “most hated bull market of all time” applied to the recovery from the 2008 financial crisis (and still isn’t over), but the bull market is hated more than ever today (by fund managers that is, not young acolytes of Dave Portnoy who are partying like it's 1999).
We have written at length about why we suspect the structure of the market has changed and how markets have shifted beyond the tipping point of the active vs passive tug of war (well, it's no longer really a tug of war). The consequence of this is the concentrated and accelerated manner that passive flows magnify trends and narratives. Throw on top of this a retail driven frenzy with an extraordinary financial stimulus, and one can understand why the tech space is bubbling over as we speak. Without trying to be flippant, this is the type of market that most fund managers dream of.
Is this dangerous? Of course it is, but to pre-empt the end of a bubble (if that is what this is) is practically impossible. As the momentum accelerates, each day or week early that one chooses to exit proves costlier and costlier. Bubbles always inflate more than anyone can ever imagine. As the very famous George Soros quote (it’s been floating around Twitter over the past week or two) goes:
“When I see a bubble forming I rush in to buy, adding fuel to the fire. That is not irrational.”
Since the 2008 financial crisis many mini bubbles have come and gone: from 3D printing stocks to the crypto bubble and cannabis stocks, yet all these were niche and esoteric. The very investors who have dopamine-laced access at their fingertips, see and interact with these companies every single day. This is not speculation about how a product or industry may become mainstream. It is fervent hope about how something that is already mainstream will dominate even more. The narrative is aided and abetted by the COVID-19 crisis, which has certainly accelerated adoption in many cases. We’re talking about companies which DOMINATE already. The bubble is in the biggest sector in the biggest market in the entire world and many iterations and derivatives of these companies. This means the potential to bubble may be significant.
If one looks at the breadth (or lack thereof) of the market move, most of the move up is clearly in the tech space. Other sectors like banks, physical retail and many traditional industries have not seen their stocks rocket at all. Sure, they’re all reasonably higher than the March lows but that makes sense when one thinks about underlying narrative. There is no narrative to buy a bank, and a restaurant group simply doesn’t capture the imagination of investors.
When presenting the case for risk, one often reads about downside protection and it is clearly critical in fund management to build that into one’s investment process. So much so that our process here is always based, first and foremost, on how much we can lose from each individual position, and for the entire portfolio at any point in time. However the most successful managers in history understand that it is in the asymmetry of risk and reward where the biggest returns are made.
The processes by which we run our fund aim to maximise our chances of capturing unconstrained upside (run our winners) and minimise our potential for losing positions to snowball (cut our losers early).
What is often not emphasized in money management is this asymmetry. Sure, everyone wants to minimize losses; but what about maximizing winners. One of the common human investment biases is to sell the winners due to an innate human anxiety that these gains may be lost. Kahneman and Tversky’s Prospect Theory shows how we’re all susceptible to this bias as we choose to take certain gains rather than the very high prospect of even higher gains versus a small chance of losing them all.
Having the gumption to stay long is arguably as critical as having the self-discipline to cut one’s losers early.
We constantly repeat our mantra at Three Body Capital: that we invest in stocks and NOT companies. The difference is in the imagination of the collective market consciousness. And the market is always smarter than any individual who tries to pre-empt where it may go and when and how.
And so yes, it will end in tears, just like every bubble. Of course, this time may be a bigger disaster than any before. But until then, this is providing a wealth creation opportunity for investors the likes of which we haven’t seen for some time. It could all fall down tomorrow or it could go on for another year. Whatever the case, we must be prepared for either path to unfold. And we must acknowledge that the risk of not participating in the nitroglycerin is at least equal to, if not greater than the risk of not cutting positions in time.
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[i] https://www.ch.ic.ac.uk/rzepa/mim/environmental/html/nitroglyc_text.htm