The Dumbest Friend Test

Conceptually, cycles might be the most important thing in finance and economics. There are lots of cycles in finance. Probably the most important of these is the credit cycle. If you would like a fun and easy-to-follow primer on the credit cycle you should watch this video from Ray Dalio:

Anyway cycles are pervasive in financial markets and in my view it is as important to watch qualitative indicators as quantitative indicators to mark a cycle’s progress. As an example, I was recently in a meeting with a successful investment manager who said “it was not time” to short stocks again (the last time he shorted stocks heavily was in the early 2000s as the technology bubble collapsed). I asked him what would indicate “it was time” to short again. “When clients are calling me with stock tips,” he said.

I am fascinated by the cryptocurrency phenomenon partly because I have not seen a market run really, really hot since I have been investing (though I sure have seen some faddish silliness). People talk about the S&P 500 being overvalued these days but the S&P 500 has got nothing on crypto when it comes to sheer investor euphoria.

So I propose a simple qualitative test to help determine whether a market is running really, really hot. Ask yourself: what is my dumbest friend doing? If your dumbest friend is “easily” making money hand over fist it is probably safe to say that market is running hot. To illustrate here is Simon Black via Zero Hedge:

I vividly remember having a conversation several years ago with a woman about her real estate investments in the United States.

It must have been around 2005 or 2006… the peak of the property bubble.

She was a psychologist from somewhere in the midwest, telling me about how she was flipping off-plan condominiums in Florida.

Basically she would put money down to secure a condo unit in a building before it broke ground, then sell her contract to someone else at a higher price when the building was closer to completion.

I remember as she told me this story she was practically cackling at how quickly and easily she was doubling and tripling her money, and at one point said, “It is just soooo easy for me.”

Those words stuck.

I remember thinking, “Investing isn’t supposed to be easy. There’s supposed to be risk and hard work involved.”

But she wasn’t alone. Legions of amateur investors were piling into the market doing exactly the same thing.

Everyone seemed to be flipping condos. And everyone seemed to be making money.

It didn’t add up.

I remember one investor explaining to me how he would flip his condo contract to someone else when the building was 30% complete. Then that buyer would flip the contract to another investor when the building was 60% complete. Then another sale when the building was 80% complete, etc.

“But who is the person at the end of the line?” I asked. “Someone has to eventually live in all of these condos and be willing to pay the highest price.”

“Oh there will ALWAYS be plenty of people who will live here,” he told me.

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