Juggling Dynamite

A house on our street recently sold for $8 million to a buyer in his early 40s. Our mutual tradesperson had the scoop: the guy made his money in Bitcoin. This is his summer house; he lives in Hawaii. On closing, he installed lifts in the garage, stacked them with exotic cars, and put a $400,000 golf simulator in the basement. Wow. Congratulations.

I have some questions.

Did our new neighbour sell enough Bitcoin to pay for these things in cash, or did he sell just enough for downpayments and use loans and leases for financing? If so, how much are the payments on these?

The property taxes on this waterfront property would be around 50k a year, and then there are all the insurance premiums, utilities, upkeep, and maintenance of expensive things. How much does that add up to annually? Is he spending less than 30% of his annual income on carrying costs for his homes?

Does Mr. Bitcoin have active employment or business income, or is he living off withdrawals from his portfolio? Bitcoin produces no income. What percentage of his life savings is still in crypto? Does he have most of his net worth in a diversified portfolio providing capital security and income? How much income are his assets producing compared with how much he is spending? What is the cash flow and risk management plan for when crypto and other risk assets enter their next major loss cycle?

The trouble is that when people suddenly come into money, they often make poor financial choices. They commonly think they are winners due to smarts and financial acumen rather than good luck. They often quit their jobs and other efforts to earn active income.

They typically spend too much on consumption items, ratcheting up carrying costs. They often make downpayments and finance the rest. Rather than cash out, they frequently leave the bulk of their winnings in the asset that paid off (not wanting to sell and trigger tax is commonly cited as the rationale for this, along with the belief that the winning asset will keep doing more of the same).

People around the ‘new money’ often help perpetuate destructive choices. Those receiving sales, fees, commissions and other benefits from the association are incentivized to go along for the ride—friends, associates, consorts, and family, too.

Winning can be great fortune that sets one up for life—it’s rare but possible, so long as sober risk management and financial discipline drive the decision-making.

More often, however, big wins are a gateway to mental illness and destructive choices that leave scars for years thereafter. Yet, few talk about this reality. If they do, it is only after the fall when there is plenty of blame and finger-pointing to go around.

One of the surest signs that we are in a financial bubble is the growing complacency and belief that frothy valuations don’t matter, prices can only head higher, and ‘volatility’ is not a concern. This thinking is a reliable setup for pain in the human world of finite time horizons and daily cash needs. And it’s not just crypto-betters or precious metal lovers in danger here.

Bubble asset valuations and an impending or ongoing retirement can lead to hellish real-life outcomes. The Gl0be’s Ian McGugan connects the dots well in Some investors should worry about bubbles. Here’s a taste:

If you don’t need to touch your money for the next 30 years or so, stock market bubbles are just a passing annoyance. They can be safely ignored. Like any calamity, they tend to fade into the background once enough time has passed.

The problem, though, is what happens if you need to tap your portfolio for income over the next few years. In this case, a popping bubble can seriously disrupt your plans.

McGugan goes through some real-life numbers; the whole article is worth reading.

Twenty-four years ago, I was studying to become a financial analyst while working at a stock brokerage. Equity markets and animal spirits were soaring; the Nasdaq doubled in 1999 alone. Nortel was Canada’s pride and joy, accounting for over a third of Canada’s TSX stock index. In September 2000, Nortel was trading at C$124 a share; two years later, it was trading at 47 cents. And that was just one of many such examples.

In the stock brokerage, we were not taught how to value assets; investment firm training tends to focus on creating and selling investment products, not worrying about their risk-reward prospects. As a financial analyst, I learned about discounted cash flows and how to calculate a company’s present value and compare that with the market price of its shares and debt.

It was then that I noticed a problem. Almost all the most historically informative valuation calculations produced fundamental value numbers miles below the market prices in 2000, and they made no mathematical sense.

When I pointed this out to those around me, including the certified financial analysts (CFAs and MBAs) who worked on the ‘advisory’ team at the head office, they told me that those measurements were old school and irrelevant in a ‘new economy’ that was being transformed by the internet and technology. It was a forceful argument when confidently delivered by those decades older than me, but I wasn’t convinced. Why study to be a financial analyst if fundamental measurements no longer mattered?

Case in point: a company’s book value is theoretically the amount of money it would pay its shareholders if it were liquidated and paid off all its liabilities. In the spring of 2000, the average S&P 500 company traded 5 times its book value (shown below since 1946, courtesy of The Daily Shot).

The long-standing historical rule of thumb was that a price of 1x book value was reasonable, and a price to book of less than one has traditionally signalled a bargain. Five times? That was just unprecedented. Nowhere in the CFA textbooks did it even contemplate such extreme market pricing.

Price to book was just one metric—price to sales, price to earnings, market cap to Gross Domestic Product, dividend yield, equity risk premium, and on and on—and they were all at illogical levels. Few people knew, and even fewer cared.

It turns out it wasn’t a permanently high new world. As the masses went all in and then some, the bubble finally burst into a three-year drubbing that saw tech stocks tumble 80% and ‘conservative’ dividend-paying shares halve. It then took many years of holding and hoping to grow back losses.

Today, we are back at 2000-era valuation levels for the third time in the last century (market cap to corporate gross value-added multiple shown below since 1929). Once more, conventional wisdom is asserting that valuations no longer matter. I recall a similar sentiment in 2007, and I remain less convinced today than ever. As John Hussman points out in the Financial Times this week, in the last century, valu­ations have seemed least reli­able pre­cisely when they were most extreme and prescient, see Forgotten history reveals new eras but same bubbles:

The only way valu­ations could reach the heights of 1929, 2000 and today was for the mar­ket to advance tri­umphantly through every lesser extreme. Yet peaks such as today’s speak volumes about future returns. A secur­ity is noth­ing but a claim on a future set of cash flows that will be delivered to investors over time.

Regard­less of short-term out­comes, the higher the price investors pay for a given set of future cash flows, the lower the long-term return they can expect. A reli­able valu­ation meas­ure is simply short­hand for such an ana­lysis.

Sim­ilar to its pre­de­cessors, this spec­u­lat­ive epis­ode has been accom­pan­ied by exuber­ant sen­ti­ment about innov­a­tion­led growth, per­petual expan­sion in profits and a tend­ency among investors to root expect­a­tions about eco­nomic and invest­ment pro­spects in optim­ism.

As The Busi­ness Week observed in 1929: “This illu­sion is summed up in the phrase ‘the new era’. The phrase itself is not new. Every period of spec­u­la­tion redis­cov­ers it.”

The latest new era is only part of an endless cycle. Extremes such as the present have been extraordinarily rare in history, and provide investors with the opportunity to examine their exposure and tolerance for risk. At such moments, it may be helpful to exchange extraordinary optimism for a calculator.

Human nature is prone to self-harm in financial bubbles. In 2000, the baby boomers were 35 to 54 years old and primarily still working. Today, they have the highest stock market exposure ever and are aged 60 to 78. Financial recovery time will not be their friend. Fear of capital losses should trump fear of missing out on fleeting gains.

I regularly hear about people thinking of selling their Florida real estate due to escalating costs. An aged population increasingly feels the same way, and the weak loonie is a final catalyst for many Canadians. Who will be willing to buy from all those looking to sell?

After the deadly Florida condominium collapse in Surfside back in 2021, state lawmakers required condos that are at least 30 years old to do inspections, make repairs and gather reserve funds for future repairs. CNBC’s Diana Olick joins ‘Squawk Box’ to discuss the impending ‘condo cliff’ in Florida. Here is a direct video link.