Where the Risk Flows

(The following content is not a personal recommendation to buy any of the following companies as I am not taking your personal financial situation into account.)

On Saturday night we had a dinner party with some close friends, including our TM Chairman David Skillen (who was formerly the Chief Operating Officer for Barclays Bank in London). 

Also joining us for dinner were our neighbours. The husband is currently the Australian Managing Director of a global investment and retail bank and his wife, not long retired from an executive position at Visa. 

We discussed many subjects over dinner but inevitably someone always brings up the Crypto market given its recent popularity. 

Although I am not an investor in the Crypto market, I think it’s important to keep an open mind in financial markets and listen to what others have to say. And given the executive positions our dinner guests held, their insights and views on financial markets were going to be valuable. 

I kept telling myself. “Do your best to shut up and listen AB.”

Whilst they all had varying views on the Crypto market and what may or may not happen in the future, there were a few points that everyone seemed to agree upon… 

The number of Crypto currencies being mined and offered, and the rapid rise in popularity, particularly amongst millennials, was likely creating a bubble that will eventually burst. And when it does, those traders with the least amount of knowledge will incur the greatest risk and likely downside. 

Whether it is in the Crypto currency space, the equity market, or the housing market, inexperienced traders and investors lack the knowledge to recognise a bubble when it is forming and sadly are always the ones to lose the most when the bubble does burst.

Financial markets have a history of taking new products and new market opportunities to excess. They stretch the boundaries. Brokers, bankers and market participants get more and more greedy until something gives. And when it does, the risk always flows to the person with the least amount of knowledge. 

Over the course of the last 120 years, every major financial market crash has been caused by the same thing, greed. 

In the late 1920’s Americans were being offered the opportunity to buy stocks using leverage. Brokers and bankers were left unchecked and the stock market exploded in popularity until the bubble finally burst and contributed to what is now known as the Great Depression. 

In the early 1970’s another stock market bubble formed when unsuspecting investors were enticed to buy what was being called the Nifty Fifty. A group of 50 large-cap stocks on the New York Stock Exchange. 

The Nifty Fifty performed very strongly in the 1960s and early 1970s, becoming symbolic of the spirit of the times. The companies, which included household names like McDonald’s and Polaroid, traded on crazy valuations over many years. 

The Nifty Fifty defied gravity for a while, enticing tens of thousands of inexperienced investors to believe if they just bought the Nifty Fifty, they were buying blue chip quality stocks that would earn them above average returns. These fifty stocks propelled share market valuations to eye watering levels until the bubble finally burst. Greed was the driver and the biggest risk and loss flowed to the investors with the least amount of knowledge.

Between 1982 and 1987 the share market was on fire once again and everyone wanted to join in the party. The bull market seemed unstoppable and between January 1st 1987 and August 31st 1987 the Dow Jones Index rose by a whopping 69% in just 8 months. 

A bubble had been steadily forming for over 2 years prior and the bubble was about to pop. 

On October 19th 1987 in a single trading day, eight of the world’s biggest stock markets fell between 20% to 29% in one trading session with the Australian market falling by 40% in less than 8 hours.  

Worldwide losses were estimated to be around $1.71 trillion and once again the risk and losses were mostly felt by those with the least amount of knowledge.

The next stock market crash was in 2001 when the dotcom bubble burst. This was caused by excessive speculation of internet related companies in the late 1990’s. At the same time as the bubble was forming interest rates were being lowered making credit more easily available so investors could make larger and more speculative investments. 

The use of the internet was exploding and between 1995 and 2000 the Nasdaq rose by 400% creating another giant bubble, mostly created by unsuspecting investors with very little knowledge of what they were doing. 

But the bubble ultimately burst and by October 2002 the Nasdaq had fallen 78% and the vast majority of the hot internet stocks that had zero earnings and did not even deliver a service were gone, never to be seen again. 

The unsuspecting uneducated investor once again lost their money.

By around 2002 US investment banks had invented new ways to package up tens of thousands of US mortgages and sell what was called Credit Default Swaps, a way for banks to lower the amount of money they needed to set aside for credit risk. And that freed up the banks to lend more money with less restrictions. 

Due to Credit Default Swaps being a synthetic product and unregulated, the banks were left to their own devices and authorities had no idea how many of these synthetic products banks were selling. In other words, the authorities had no idea how much risk the banks were taking on. Between 2000 and 2007 banks had created a housing and mortgage market like the wild west with consumers being able to buy a house without a job, without a genuine credit check and without a deposit. 

Nobody believed the theory that the housing market could go down. They all believed it would keep going up forever, including the banks. 

Naturally the housing market and the US economy exploded between 2000 and 2007 creating the greatest global credit bubble in history. It was not just the US enjoying what seemed like a free ride, I personally at the time was able to borrow over $1 million dollars for a property deal via a “low doc loan.” The mortgage broker arranged it so I didn’t need to put down a deposit and presto… a $1 million dollar, interest only loan.

By September 2008 the housing bubble was bursting. First with a run on the investment bank Bear Stearns, which resulted in the US Federal Government paying JP Morgan billions to agree to merge the broken Bear Stearns into its bank. 

Some months later the market went after Lehman Brothers that had sold trillions of dollars’ worth of Credit Default Swaps and the financial industry started to realise the game was up. 

The housing market collapsed as there was a run on the banks. And financial markets froze, causing the global financial crisis which resulted in the S&P 500 losing 50% of its value between September 2008 and March 2009. Once again, the unsuspecting investor with the least amount of knowledge bore the greatest risk and ultimately the greatest loss.

Between 2010 and 2019 stocks markets recovered and banks were saved mostly thanks to the injection of trillions of dollars from Central Banks and Governments and 0% interest rates. 

The S&P 500 rose over 300% between 2010 and 2019 and once again the money flowed for the asset giving off the highest return. Brokers were offering easy to obtain leverage and credit facilities so traders could increase their bet sizes… and share prices continued to rise. 

A bubble was forming and what pricked the bubble this time was not greedy bankers or an unregulated market, it was a global pandemic, something the world had not seen since the Spanish Flu of the early 1900’s. 

The S&P 500 and stock markets around the world fell by 35% – 40% in a matter of 6 weeks between February and March 2020, the fastest correction ever seen. Investors were panicking and those that were losing the most money were those investors who had taken on the most risk, had the least amount of knowledge and knew very little about the companies and markets they had bought.

Given what I know about the history of financial markets, the resemblance of what I am seeing in the Crypto market is uncanny and is unsettling to those of us that have been around long enough to recognise when a bubble is forming. 

Just like the bubbles of the 30’s, 70’s, 1987, 2000 and 2008 there is once again a new innovation, new technology, excitement, FOMO and of course a huge amount of greed is flowing. 

Add to this an environment whereby billions of people have been stuck at home because of a pandemic, nowhere to spend their money, bored and surfing the internet. The result is millions and millions of new trading accounts have been opened. Millions of new investors wanting to bet on the latest fast money-making opportunity. 

Many brokers have made it so you can open an account on your phone in minutes, fund the account with your credit card and place your first trade immediately. The brokers App also appears to look like a game, giving the illusion of fun and excitement to uneducated newbie.

I don’t know when the next bubble will burst and I don’t know the catalyst that will prick it but the financial market system, which includes housing, stocks and Crypto is right now building the next bubble. In 2019 the S&P 500 rose by 28.88%, in 2020 it rose by 16.26% and in 2021 it is up by 24.67%. When I look at the history of the stock market and the bubbles that have burst the resemblance is uncanny. The S&P 500 returns in the 5 years leading up to the 2000 crash were 1995 +34%, 1996 +20%, 1997 +31%, 1998 +26% and 1999 +19.53%.

Every financial market crash in the last 120 years has been preceded by excessive and well above average share market gains in the years prior, excessive market risk taking, mostly caused by uneducated investors betting on a new innovation or market offering, promoted and driven by a financial industry that is full of greed.

The allure of easy money and excessive risk taking is what causes bubbles. And if there is one market that is creating this allure right now it is the Crypto market. The stock market will at some point build its own bubble. And individual companies are constantly being driven to excess, creating their own little bubbles that burst each year. 

The bottom line is you cannot afford to stick your head in the sand. You must continue to build your knowledge and education, because the more you learn the greater the probability of lowering your risk and increasing your earning potential.

But you can’t just invest your money in a company on the stock market and expect it will automatically grow.  

Protecting against risk and enjoying higher than average returns comes from investing in companies: 

  • with certain performance characteristics 
  • with outstanding management 
  • with superior competitive advantages 
  • that have high returns on capital  
  • that have shown over many years to grow their earnings.  
  • and, ensuring you pay a fair price 

Most investors don’t understand how to seek out these key characteristics.

So, to help you build a strong investing foundation, I’ve got 2 special resources for you:

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