Posted May 25, 2021
By Zach Scheidt
Are We in a Bull Market or a Bubble?
In late 2006, one of my closest friends took a job as a mortgage broker.
Jeff had no experience in finance, real estate or sales. And yet he was absolutely convinced that this move would help him make plenty of money for his family and set him up financially for life.
I remember sitting at lunch with Jeff and asking him if he thought about what would happen if the real estate market took a breather.
"Zach, they're not making any more land. And the U.S. population is growing every day... So until they find another continent or planet for us to live on, real estate prices will go up and mortgage brokers will make bank."
Little did Jeff know, we were just months away from one of the most spectacular market meltdowns...
A financial crisis triggered by excesses in the mortgage industry that Jeff was so confident would make him money.
Of course, with hindsight, it's easy to see how the housing bubble expanded in the years leading up to the financial crisis.
But as investors, hindsight doesn't help us protect our investments from the next bubble.
So today, we're going to talk about the differences between a healthy bull market that can build your wealth and the red flags you need to watch for that signal a bubble is forming (and could soon burst).
Pay close attention to these different situations. It could make the difference between having a healthy and rewarding retirement, or struggling to maintain your retirement income.
Bull Markets Are for Building Wealth!
The best investors I know didn't get rich by calling a turning point in the market or by using some specialized strategy to day trade tech stocks.
Most investment wealth is created in bull markets by investors who are patient, disciplined and keep their money in the market.
The power of a long-term bull market allows us to invest in great companies and simply sit back and watch the value of those companies grow.
It sounds simple, and frankly it's not very hard to make money during bull markets. But the tricky part is figuring out when those bull markets turn into dangerous bubbles.
How do you know when stocks are becoming too risky so you can protect your wealth from a pullback?
One of the best ways to tell the difference between powerful bull markets and dangerous bubbles is to look at what people who are not in the investment business are doing.
For instance, think back to the dot com bubble when the brokerage E*Trade first came on to the scene.
The brokerage had an ad featuring an employee who quit his job after a successful trade.
And as cliche as it might sound, many employees did quit their job and expected to make a living day trading tech stocks.
Obviously, that situation didn't end well.
And seasoned investors were quick to recognize the peak of enthusiasm from traders who had no experience in the market — suddenly quitting their jobs to become traders.
Similarly, during the housing bubble leading up to the financial crisis, there were many people like my friend Jeff who quit "boring" jobs to be part of this new bull market.
Accountants became house flippers. Lawyers became real estate brokers. And people who weren't involved in the mortgage or real estate industry were often regarded as luddites.
Of course, all these excesses eventually led to a painful transition back to "normal" causing losses for builders, brokers and mortgage investors.
The moral of both of these stories is that when you see excessive enthusiasm in one area of the market from many of the people who wouldn't normally be involved, it's a sign that risks are increasing.
Fortunately, as an investor, you don't have to watch your wealth shrink when these bubbles inevitably burst. By paying attention to where speculative investors are getting too aggressive and having a balanced approach, you can use these bubbles to grow your wealth, and avoid the risk when stocks come back to earth.
Taking Inventory of Our Current Bull Markets (and Bubbles)
The investment landscape today is a curious mix of potential bubbles beside a very strong bull market.
With the economy reopening following the coronavirus crisis, there’s no doubt that businesses will be growing their profits, leading to higher stock prices and larger dividends for investors.
It's a perfect scenario giving investors a wide range of opportunities to buy into growing streams of profits.
In particular, value stocks — companies with reliable profits whose shares are trading at discount prices — are giving investors some of the biggest profit opportunities.
And that trend is just getting started!
By investing in companies that have been overlooked (and under-priced) for the last several years, investors can essentially buy larger future profits for every dollar committed.
Over the past few months, we've been talking about this shift away from growth stocks and into value stocks.
Hopefully, you've been able to take advantage of this transition and are enjoying your accumulating profits.
On the other hand, I'm seeing the telltale signs of a "bubble" in a few of the more speculative areas.
For example, I may have told you about my acquaintance who sold his house, moved into his in-law's basement and is spending every spare dollar he can find to buy bitcoin.
He plans to never sell any of his bitcoin holdings and simply borrow the money he needs to live on.
Aaron believes that he'll continually be able to borrow against his bitcoin balance, the way some people take out a line of credit on their homes.
It's a dangerous strategy and the perfect example of how some people get caught up in a bubble environment.
Similarly, I've noticed an alarming number of friends opening small brokerage accounts and taking some very speculative positions.
Some are investing in options (without any market experience).
Others are buying hot cloud computing or "new economy" names that have been so popular during the coronavirus crisis.
And of course many are also enthusiastically buying cryptocurrencies.
These speculative investors have sent shares of certain stocks sharply higher.
And for many of the underlying companies, stock prices are now at an absurd level compared to the company's earnings — or prospects for future earnings.
So if we step back and look at the situation with a bit of perspective, it's clear to see that there are risks of a bubble bursting for some of the most popular tech and crypto plays.
And there’s a strong, sustainable bull market in place for stocks with solid fundamentally sound companies backing them up.
Make sure you're investing on the right side of this ledger.
That way, you can grow your wealth, protect the money you've worked hard to save, and you'll be able to focus on the things that really matter in life.
Here's to living a Rich Retirement!
Editor, Rich Retirement Letter