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A contrarian perspective on the markets

May 7, 2018

contrarianThe stock market is on a 7+ year tear & real estate prices are exploding. The contrarian investor in me sees some red flags popping up.

Red flags are what I look for that say shit might hit the fan.

Examples of flags:

  1. Unsophisticated Involvement: Is everyone at the family reunion talking about stocks and options (2000), or getting into real estate (2005-2007) or Bitcoin (2017-2018)?  When people are investing in something they often think they understand but really know nothing about, there’s often a huge transfer of wealth coming up.
  2. Debt/Credit levels:  How leveraged up are people, particularly the least sophisticated people?  I tend to think debt can be positive and useful, but too much is toxic and dangerous.  Keep your radar open for news articles on auto debt, household debt, student debt, credit card debt, home equity loans, etc.  When everyone is maxed, the room for error went to zero.
  3. Debt/Credit criteria:  For banks to create more loans, as a market cycle gets later, loan criteria will progressively worsen.  Lower credit scores, less money down, less qualified people for larger amounts. It used to be put 10% down on real estate  then 5%, then 3% now over ask price, no money down and raise the price to wrap in closing costs.
  4. Explosive pricing:  At the end of most “bubbles” are often a ramp up in price in a short period of time.  In a weird (but understandable) way, the huge price run up confirms the mental story the public has bought.  Dot-com will change the world, buy any house and it’ll be up 25-30% in months because that’s what it keeps doing; Bitcoin will change the world and look, it’s up 1,900%.  In a year. Again.  And the run up confirms peoples’ story/”logic.”
  5. Fear of missing out:  Watch for when people stop being afraid of risk and what could go wrong and are only afraid of missing out on the profits.  When “nothing can go wrong,” that’s when it usually does.
  6. Everyone is an expert:  When people who a year or two ago knew literally nothing about an area, but are now telling everyone around them the secrets of getting rich… that’s a flag.  There will be tons of books telling you how to get rich in this area.
  7. Rich, on paper:  These same speculators don’t have money in the bank.  Those stock market riches, or the highly leveraged real estate millionaires, or turning $10k in BTC into $250k in a year – people who mostly made money doing nothing but sitting— unless they cash out, it’s all “paper wealth.”  And those same people that got lucky rich from being involved in a market run up… won’t sell.  That’s how they got rich in the first place. Doing nothing. Not selling. So they ride it up, then ride it back down.
  8. Media coverage:  When all the websites, when all the “experts,” when all the media channels are pontificating about on a single “investment” (that they weren’t covering two years ago), that’s a flag.  Remember all the TV shows about flipping? Right before the market crashed? And then when it was the best time to buy, no TV shows. It’s a flag/counter-flag.

In late 2017/early 2018, in Bitcoin, I see MOST to ALL of these flags.  I see huge levels of unsophisticated people putting money they can’t afford to lose, often borrowing money, to “invest” in BTC.  Pricing has been textbook bubble (literally, I expect to read about it in future textbooks).  Everyone is baller rich – on paper. Most of that wealth was created in a very short period of time.  Lastly, I was in Vegas for a best friend’s birthday and everyone was talking about different cryptocurrencies and crypto theories.  I turned to my buddy and said, “Notice what everyone is talking about at this party.  Remember this moment.” That was January 11th, 2018 (2 weeks after the market peaked).  That said, if it goes from $20k to a million a BTC, this article will be proof I was wrong.

Counter flags.  When it comes to flags, it’s also useful to be aware of the opposite, of “counter flags.”  Limited media coverage, the public deathly afraid of an area (like stocks in 2001, or real estate in 2009).  The general public “experts” are now quiet (and often broke). No one sees profits – everyone sees risk and downside.  Blood in the streets. Etc. Those counter flags often encourage a different set of actions.

Truth is, at any moment, the current environment in an investing area is often a mix of flags (ie, not all of them are up on one side).  So there’s what I like to call, “lean.”

Lean is how aggressively you lean into the the investment.  When something is good, you lean forward in your seat. When it’s not so good, not so interesting, you lean away.  Think of it as a continuum from 1 (lean waaaay back) to 10 (lean in, hard). Easy to write, emotionally much harder to do in practice, especially to be contrarian when everyone is hopped up on how good something is.

Example in my own life:  In 2004-early 2007, I was leaning hard into real estate.  Then I saw realized I was seeing flags everywhere (all the above) and sold my real estate.  All of it. After the market crashed in 2008/2009, I leaned in. HARD. Like a 10. I’ve stayed leaning in at a level 7.5-10 for years.

However, in the last couple months I’ve shifted my lean.  I’ve cut my debt levels 85% from their peak. Right now my lean is more like a 3.5-4.  That’s a huge shift of a lot of money and risk adjustment.

Truth is, I’d like to have a few more properties, but I can’t find many deals that make sense.  I’ve become a lot more careful. I’m still in the game, but I’m leaning back more and more.

Calling perfect market tops is a fool’s errand.  But it’s a worthwhile endeavour to analyze when it makes sense to lean into a situation and when it makes sense to lean back.  It makes a huge difference in managing risk and maintaining wealth over a long period of time.

The present environment:  The US stock market is on its second longest, second biggest bull market in history, and greatest run depending on if you’re comparing the Dow or S&P.  That should scare the shit out of investors since markets always reverts to the mean.  The real estate market has been on an explosive tear in the last 3-ish years and especially the last year.  In many cities, buyers are often offering 10-15% over ask price, just to try to win! I’ve seen prices jump 5-10% … in a MONTH.  (Imagine if I was telling you that was the likely future 4 years ago…) As a point of reference, the average appreciation of real estate is 3%.  That’s 3 years of appreciation – in a month.

In my humble opinion, after that kind of run up, it’s definitely not time to lean in hard or double down.  Lots (but not all) flags are up. In my opinion, it’s a time to shift and start to lean back.

Summary:  if you want to be a contrarian, long-term investor, look at “flags” and adjust your “lean” accordingly.  As a cycle progresses, you’ll see more and more flags pop up. When that happens, consider shifting how you’re leaning with your investing.  When everyone is doing a thing, think strongly about doing the opposite. Presently, I’m shifting from leaning in hard to leaning back, de-levering, and being cautious.

More advanced thoughts/flags:  In real estate, there are definitely flags I’m not seeing – like stupid horrible lending standards, taxi drivers buying 5 homes on stated income loans, everyone talking real estate at parties/reunions, the general public trying to retire overnight by flipping, etc.  In short, I’m not seeing the levels of ridiculous that indicate a huge bubble. That said, I’ve seen a lot of run up, definitely more looseness in the lending side, all the fear is on scarcity – not getting a deal vs is it a good deal (a la, huge run up).  And I see people making money by doing nothing other than waiting 4-5 months and before they can finish a remodel the market has gone up a bunch. There have been bubbles in stocks (2000) and real estate (2007). I don’t tend to see that kind of crazy bubble in either now.  But I do think we are due for a pretty decent pullback overall in both as part of the cycle of rising (and falling) around the average. Real estate is a very non-linear business. There’s a time to slam hard and make money, and a time to chill more. I’m starting to see this as more the latter.

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