We are in the greatest bull market in history. More and more retail investors come into the markets and get used to the idea that markets only go up.
The current market conditions are irrational. There's the meme stock frenzy, investors taking financial advice from Tick Tok, Youtube videos, or Reddit threads. More and more IPOs get listed with insane valuations. People seek the next 10x stock and bet their entire life savings in highly leveraged out the money options.
It's a hard truth, but this sounds like the perfect recipe for a market bubble that's about to pop.
Yes, I may be wrong. It's also true that by trying to predict a crash, you eventually get it right. The most important thing to do is to have patience and not make irrational decisions driven by greed or fear.
I don't like to induce fear. The main purpose of this writing is to send a wake-up call to anyone out there thinking that this can go on forever.
Crazy Behavior
People on Reddit or Tic Tok betting their life saving for the next big momentum play like GameStop or AMC. Everyone is seeking to make quick profits. If a stock doesn't gain 100% in a few days then it's boring. Here's how it looks like:
Do you wonder how can you lose so much money in this short amount of time? The common reason is highly leveraged out-of-the-money options that expire in just a few days. This is literally identical to calling the bank and telling them that you want to wire a few thousand dollars to them. The funny thing is that this would actually take longer. Buying options is not the same thing as buying stock, and you should definitely have a deep understanding of how options are priced and how volatility can be a silent killer in those situations.
These people are playing blind, investing in unpredictable things like the next crypto token or a random penny stock they heard about on social media. They all think that they can make easy money. Money is not free.
Don't think even for a second that if you do make a lot of money out of those plays that you are the next best investor. It was pure luck.
The IPO Rush
What is an IPO? An Initial Public Offering is the first time a company is publicly listed where shares are sold to institutional investors and also retail investors. Companies often go public and offer shares of the business in an attempt to raise capital.
We are at the peak of the IPO mania. More and more companies are rushing to go public at a rate of almost one per day. What is more interesting is that we have not seen this much IPO activity since the .com bubble. Seems surprising, isn't it?
Coinbase, Airbnb, Deliveroo, DigitalOcean, UiPath, Affirm, GitLab, Rivian, are just a handful of companies that come to markets in 2021 and the list goes on and on. It's hard not to get excited when we see a company that we use every single day is getting listed. But there's always a catch...
It's no wonder that Benjamin Graham, the father of value investing, has said, “Intelligent investors should conclude that IPO stands for Initial public offering. More accurately it is also a shorthand for – It's Probably Overpriced, or Imaginary Profits Only, or Insiders Private Opportunity".
Understanding that the only reason a company goes public is to raise cash and that this represents the once-in-a-lifetime moment for that business to raise more money, then it's also clear that the business owners and the early investors want as much money out of the business as possible and that they are not going to sell it for a discount. If you as an investor want a cheap company that goes up in value, the business owners want the exact opposite.
Knowing that to become public there's a big opportunity for a lot of money to be made by all the involved parties, it's also apparent that one should go and raise money when it's available. This is why we see more and more companies come to market in times when there's a bubble or the market is overheated.
We've seen the same thing happening during the .com bubble and this is because investment institutions and smart people know that right now it's really easy to sell businesses.
Retail investors don't stand a chance of getting a good price when a company IPOs as the best deals have already been done by the institutional investors, however, people still pile up rushing to buy shares of those companies just because they think the price can "go to the moon". But they also miss the fact that because they pile up to buy the shares, the stock becomes overpriced and returns even worse.
Take Rivian's IPO example. This company was just listed a few days ago and the market has decided that this new company is worth 110 billion dollars. This price tag is outrageous. In fact, this is the first company to have a 110 billion dollars valuation while it barely makes any meaningful revenue.
Feels like the year 2000 again when companies like this with no assets and revenue went to the dust shortly after. Of course, there's no reason to panic, but the most important thing to do as an investor in those market conditions is to be careful, do your due diligence, and try to avoid hype.
Irrational Valuations
The market valuations right now are so extreme that most investors out there are very likely to be disappointed even if the earnings expectations are correct. As prices go higher, the returns inevitably will be lower.
Stocks have unrealistic valuations, the numbers don't lie.. the stock prices have shot up literally vertical in the past year after the pandemic crash. Just take a look at the NASDAQ chart.
From the bottom of the pandemic crash in March 2020 until now the Nasdaq index gained 140% in value. It doesn't take long to realize that this could be the craziest market we ever lived through.
It's no wonder people jump into the penny stocks and meme stocks. As prices go up, higher-quality companies are already expensive yielding considerably lower returns.
As long as the FED continues to maintain a relaxed monetary policy and print more money, this could very well continue, but for how long can this continue until the inflation gets out of control and they are forced to hike interest rates and everything collapses.
The Bubble Theory
Meme stocks, more retail investors coming in the markets, large trading volume in penny stocks or people dumping their life savings in options, high leverage, flashy headlines on news front pages, daily IPOs...
We've checked off all the boxes for having a market crash. Now when will it happen? When does the market peak? We can't tell for sure but the main problem is that as prices rise, the risk for the market to fall to the mean 'fair value' gets larger making it more and more painful when it happens.
The market tends to be at a peak when you have the highest level of optimism and enthusiasm. When the economy looks perfect and you are extrapolating it forever. Relaxed monetary policies, high level of borrowing. And here we are, the economy looks great, interest rates are as low as they can ever be, the amount of leverage increases day by day, and expectations grow higher and higher. This doesn't last forever, it never does and the reason is simple.
The current momentum will fade in time. People borrow more money as enthusiasm grows, however the enthusiasm gradually decreases in time. As days go by you steadily end up having no money left to borrow and buying power slows down. That's when the bubble pops.
This euphoria will end soon, and when it does, it will be bad.
Having the right mentality
Everyone has their own way of investing. Sometimes the best strategy is to sit tight... do nothing... and then wait some more. This is going to happen most of the time and this is how it should be for the rest of your investing career.
It's important to keep adding some extra money every month if you have any but more often than not it's best to hold and wait for the right opportunities. It is very important to control your emotions, be patient and do your research. No need to feel like you are missing out. Something will happen eventually. There will be a moment of panic, everything will turn red and crash. Nobody knows what the catalyst would be but that's when you should start playing the game.
Be fearful when others are greedy and be greedy when others are fearful.
