This is the seventh piece in our Broyhill Letter Highlight series, highlighting our thoughts on the psychology of bubbles over the years. You can access other posts in the series here.
For those who would like to revisit our letters in full, we will also be gradually sharing them to our Research Studio throughout the series.
“What is a cynic? A man who knows the price of everything, and the value of nothing.” - Oscar Wilde
Every financial market mania is different. Each has its own unique flavor and speculative excesses that manifest in different ways at different times. But mania also shares many common characteristics. After you’ve seen a few, you notice similarities in investor sentiment, financial market activity, and corporate behavior. They are not always the same and not always apparent each time, but when you put enough of them together, you can get a good sense of where things stand if you’re willing to pay attention. As Henry David Thoreau suggested, “It's not what you look at that matters. It's what you see.” And today, we see exuberance everywhere we look.
Bubbles form when things are good and when it’s difficult to imagine anything but things being good. But sentiment can’t grow more optimistic forever. Bubbles burst when changes in sentiment turn negative. They say that gradually letting the air out of a bubble is like trying to gradually let a fart out at a cocktail party. It’s a risky move with a blemished track record—for party-goers and for the Fed. As a result, like those uncomfortable moments at the cocktail bar, bubbles have a tendency to linger longer than anyone expected and surprise everyone with how magnificently they burst.
Rising prices have a way of lulling us into complacency. Every purchase is a good one. Every sale is a mistake. It’s easy to fall in love with your winners and to stick with what’s working. It’s much harder to deviate from the consensus and stand apart from the crowd. That’s why investors rarely sell what’s working, no matter how expensive it’s become. They hold onto winners for too long simply because those winners have done well. It’s much easier to sell what’s in the headlines, what isn’t working, and what’s disappointing, no matter how cheap it’s become.
The upside is that once a stock reaches a silly price, there’s nothing stopping it from reaching 2x or even 10x a silly price. When sentiment is stretched, and assets are priced for perfection, there is a lot of room for disappointment.
When stocks are rising simply because they have risen, it gets difficult to imagine them doing anything else. But there is some good news when it comes to bubbles. Every one of them eventually bursts. And when they do, investors with both their capital and courage intact are among the few positioned to scoop up the incredible bargains left behind.
The best time to sell what everyone wants is when everyone wants it with little concern for price. This is why peaks in IPOs often occur near major market tops. Insiders sell at the top when confidence is high. Simply put, when the hottest companies in the hottest industries come to market, optimism—by definition—is at its peak. Sentiment can get no better.
Stock prices levitating near all-time highs leave little margin of safety and even less to get excited about. One might even say that the stock market offers a false sense of securities.
Good bargains often become great bargains in bear markets.
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