My Comments: This is a little more from Jeffrey Dow Jones, the writer who started a conversation recently about a bubble no one had yet heard about.

Many of us in the investment world are expecting a market correction soon. The overwhelming question is when and how severe. But there is little question that it will happen. So here are some thoughts about bubbles and how to identify and manage them.

Nov 07, 2013 | Jeffrey Dow Jones | Cognitive Concord

Unsurprisingly, I’ve had a lot of pushback on what I wrote recently about our beloved U.S. blue chips. But there’s been a bit of support as well. Seems I’m not the only one out there who’s intrigued by what’s going on. This exercise has revealed an unexpected and unexpectedly passionate debate.

Because this is a “big picture” blog, today let’s take a step back and talk a little about bubbles more generally.

First, some background. When it comes to bubbles, investors return in droves, generation after generation, to the ur-text on bubbles, Charles Mackay’s Extraordinary Popular Delusions and the Madness of Crowds.

This book was originally published in 1841. 1841! Investors have been fascinated by market bubbles for pretty much as long as markets have been around. There’s no reason why you shouldn’t pick up a copy of this book, it’s only $0.99 on Amazon and you can probably find it somewhere out there in the public domain for free. But even if you don’t read it, the fact that somebody published a book about market bubbles 170 years ago ought to tell you that these things are general in nature and are caused by primal market forces and the whimsy of human nature.

The other bible on the topic is Charles Kindleberger’s Manias, Panics, and Crashes: A History of Financial Crises. Kindleberger is something of the modern master on the topic of bubbles. But it bears mention that Hyman Minsky has done a lot of significant work in this area as well and Shiller’s Irrational Exuberance is probably one of the more approachable works on the subject.

Those guys are all smarter than I am. The below is basically a boiled-down version of some of their major points.

The Five Phases of a Bubble

1. Displacement. All of these bubbles are born in reality. Many times it has to do with technology, and in this case the now-ubiquitous term “disruptive” could also serve as substitute for “displacement.” The reason why “disruptive” is such a sexy term these days is because it’s one of the common denominators. Everybody wants to catch the assets that eventually turn into bubbles and, more often than not, the ones that do are the ones that have made a meaningful impact on the world around them.

It doesn’t always have to do with technology, though. The real estate bubble is still relatively fresh in our minds. Many factors contributed to that one, but the biggest was an environment of historically low mortgage rates and historically lax lending standards. If you want to call a subprime CDO a disruptive technological innovation that helped inflate an asset bubble, I certainly won’t argue you.

Policy can cause bubbles, too. Low interest rates, anyone? The point is that all bubbles are born in reality and the notion of reshaping the way everything functions around them.

2. Boom. Displacement attracts sophisticated investors. Like sharks in the Tasman Sea, they swarm for a piece of the kill. If the kill is large enough i.e. the disruptive asset has the power to displace a meaningful chunk of the economy, it will attract more and more investment. Prices go up, and the very act of prices going up creates momentum to go up even further and attract even more investors from more locales. It’s a virtuous cycle of awesome, and the positive psychology of this phase of the bubble creates its own feedback loops and halo effects. Other (non-disruptive) assets can get swept up in the boom.

This is where the fear starts to develop. But it isn’t a fear of loss or a bursting of the bubble. It’s a fear of missing out. Disruptive technologies, businesses, and events have an inherent “once in a lifetime” quality to them. We knew that the birth of the internet economy in the late 90′s was only going to happen once. During the housing bubble, we were afraid that we’d never again be able to buy a house with 0% down and a 0% introductory APR. I know that there’s the old maxim about how the markets are driven by fear and greed, but really, I think that fear is the only one that matters. It’s not just in the markets, either. Before you go to bed today, take a moment to reflect on your day. Ask yourself how much of what you did was motivated by fear.

Disruption is powerful. Fear is powerful. These might even be two of the most powerful forces on earth, or certainly those connected to economies and markets. They are the reason why bubbles are never to be trifled with.

3. Euphoria. This is phase in which the bubble has fully permeated the culture. This is when your cab driver was talking to you about his .com stocks. This is when Flip this House premieres. It’s when you meet your buddies for drinks at the club and realize that everyone is talking about one thing and one thing only: how much money they’re making.

The psychology of this is incredible. Nobody wants to get left behind. Nothing makes us want to mow, fertilize, and water our lawn more than seeing how green our neighbor’s lawn is. Nothing makes us want to drive a BMW more than watching our coworkers roll into the parking lot with their luxury cars. And nothing makes us want to invest in a bubble asset more than watching our friends do it and get rich in the process.

In a technical perspective, this is where valuations really get out of hand. And this is also where the critics come out of the woodwork. “The PE of the market is 30x! It’s way too expensive,” shout the critics. “Whatever,” says the market, as valuations rise to 35x, 40x, and then 45x. Most interestingly, this is where you see all sorts of new metrics created to justify the action of the bubble asset. These new metrics don’t matter. In the euphoria phase, psychology is the only thing that matters. We humans have this bit of code in our psychologies where we feel a need to have a chain of reasoning that explains why things are the way they are and why they’re doing the things they’re doing. Our brains are wired to rationalize. Euphoria is the phase where rationalizations get creative.

4. Profit taking. Unfortunately, the euphoria phase doesn’t last long. Since that’s the stage during which the largest numbers climb aboard, the price increases are the sharpest. Profit taking eventually starts to take place. And just as most participants missed out on the early days of the asset bubble, most participants miss out on the early days of profit taking. Sometimes there are specific events that can catalyze this phase. A bad earnings call, an untimely rate hike, or even a broader economic contraction can all act as pins. The pricking of the bubble isn’t always obvious, either.

This is where prices start to go down and this is where psychology starts to change. Our fear of missing out transforms into denial. Denial is the only appropriate response for our backwards psychologies. Accepting that prices may go down and that the old regime may be over and that everything we knew during the euphoria phase may be totally wrong is far too painful to deal with. We need time to process those emotions, and unfortunately, time is the one thing we don’t have as bubbles begin to burst.

5. Panic, Revulsion, and Despair. This is where everything completely reverses. Psychology becomes relentlessly bearish. News headlines are non-stop negative. All of the crazy new metrics we dreamed up to justify the bubble valuations die quiet deaths, replaced by stories of rampant fraud and abuse. We start blaming other people — our brokers, the Big Banks, Alan Greenspan. We invent new narratives for why we invested in the bubble in the first place.

At various points along the way, investors capitulate. Eventually every last participant throws their hands up in the air and says, “I quit.” We each have our own pain thresholds and when the pain of having lost all that money finally outweighs the pain of admitting that we were wrong, we sell. When enough people have finally done this, the bubble asset bottoms out.

This phase can last a while or it can happen quickly. The one thing that every bubble and bubble-bursting has in common is that by the end of this phase, the price declines overshoot fair value. Just as markets go too far on the upside they fall too far on the downside. There are technical factors that exacerbate this as well. Not every bubble involves leverage, but most do. Unwinding that debt, whether it’s a margin call from your brokerage or negative equity on your house, tends to be forced rather than performed at the investor’s leisure. Many investors who sell during this phase have no choice but take whatever prices that the market is giving them on the day they get that phone call. By definition, in a market with extensive forced selling there are fewer buyers. These factors and categorical revulsion are what send asset prices irrationally low.

That Bubble in Blue Chips

To the extent that certain blue chip U.S. equities are in a bubble, I think it’s safe to say that, along these guidelines, there’s still a little ways to go.

Let’s look at these phases one by one.

Displacement — There is zero question that, fundamentally, there was major displacement surrounding these specific companies. A variety of factors have come together in the post crisis years to lay a foundation upon which these companies can legitimately outperform for tangible reasons. Low interest rates, low taxes, a massive psychological shift in the market. Remember that scene in The Goonies when Mikey says, “down here, it’s our time. It’s our time down here.” Right now, it’s blue chip time. The market and the economy have changed in real ways during the last few years, to the great benefit of a certain collection of firms. It’s all over if policymakers reel up their bucket.

Boom — There is also no question that these blue chips are booming. First it was people like me singing their praises in the early years of 2009-2011. Since 2012, more investors have climbed out of their shells and back on board.

Euphoria — Blue chips may have displaced the economy and the market and they may be booming, but there probably isn’t a state of euphoria in these things yet. It’s possible, I suppose. If there is indeed a bubble here, it certainly isn’t a systemic one. Investors may be euphoric about blue chips relative to the market as whole. But they clearly are not euphoric about either in an absolute sense.

Profit Taking — There may be some of this going with certain stocks. But other blue chips are still making new highs every day, not just in terms of price but valuation. Either way, this definitely is not happening across the board. If it does — and it could — it’s hard to imagine it won’t take place in a fairly measured way, especially given the fact that euphoria hasn’t fully taken hold.

Panic, Revulsion, and Despair — Still a long way off and difficult to envision at this point without a broader “risk off” style market shock.

What this means is that we’re now at a fork in the road.

PATH ONE — Blue chip stocks continue to soar, real euphoria ignites the market. If euphoria does truly take hold, you can better believe that stages 4 and 5 will follow. The bubble will be pricked, a few investors will take some profits, and it’ll all eventually end in panic and despair. Who knows where it peaks along the way.

PATH TWO — Euphoria never develops and it becomes clear that these things won’t travel along the latter stages. Here, investors are faced with the awkward notion of treating these businesses like any other i.e raw functions of earnings growth, cash flow, and price. When you cover up the names of some of these stocks and just look at the fundamentals, how much better are some of these businesses than others that aren’t as big or have less-ubiquitous ticker symbols?

Look, if you’re betting on these unquestionably expensive blue chips right now, you’re betting that the psychological boom continues. You’re not betting that they’re in a bubble, per se, but rather that they soon will be. This could very well happen! Years ago I loaned my crystal ball to an upstart hedge fund manager and he never gave it back. I’m in the dark here just like you.

If you own these expensive blue chips and you don’t think that a series of progressively greater fools will come along and continue to pay higher and higher prices (and higher multiples of earnings/sales/cash flow/assets/etc.) for these companies, then why do you own them? Do you own them because they’ve outperformed the market?

Maybe you’re a really long term investor and maybe you just believe that these companies are still good bets to do well over long cycles of time. That’s totally cool, and for the record, I do agree with you that extremely-expensive, historically-boring stocks like Disney, Home Depot, Johnson & Johnson are great businesses to bet on for the long run. But can you handle a prolonged period of underperformance? Do you truly believe that, in the cycle of the next few years, today is as cheap as it’s ever gonna get for these companies?

Let me ask you an uncomfortable question: are you afraid you’re going to miss out while these blue chips climb higher still?

I don’t mean to pick on Big Orange. Home Depot is an awesome company and a great business. I’ll still be buying stuff there in 2023. But do you really believe that the price of their stock justifies a valuation that’s 50%-100% more expensive by nearly every metric than it was during the peak of the housing boom? Analysts project nearly a doubling of earnings by 2017. Hey, could happen. The market is counting on it happening, though. There’s no margin for error. As of this morning HD trades at nearly 14x the 2017′s earnings which are nearly double what they are today. To put that into perspective, that’s close to how Facebook was priced at their IPO. Surely we will not have had a recession by 2017!

Why are we so attracted to these things? Is this simply a natural function of the types of places we want to go when we are simultaneously afraid that the world will fall apart and that we’ll miss out on the party in the meantime? Is that why we’re willing to pay for quality at any price?

I honestly don’t know. And it’s cool if we disagree on these blue chips. But let’s not disagree that there are tons of other stocks in the market (and foreign markets) that may not be as widely followed and beloved but are just as good and, when you break down the fundamentals, even better quality in some cases.

As long as there’s no euphoria in those names there’s opportunity with a better balance of risk and reward.