You need to understand what a mania looks and feels like to survive it.
That's why I've spent the past two days detailing the traits of speculative manias.
I continue to believe several years' worth of stock-price gains will evaporate quickly when the current mania finally ends. But human nature is perverse. Following the herd into expensive stocks gets more attractive as it gets more risky.
Don't let the mania tempt you to overpay for stocks to make a quick buck.
But also, don't let it deter you from investing in attractive securities and assets whenever and wherever you find them. That will be our strategy as growth stocks begin to significantly underperform value stocks during a new "Golden Age of Value Investing."
I'll explain more on that subject tomorrow. Today, let's go over the final two traits common to speculative manias…
6. 'This time is different'
The most famous example of Trait No. 6 was days before the 1929 crash, when economist Irving Fisher said stock prices had reached "a permanently high plateau."
Today, anybody who does not acknowledge that U.S. equities are trading near their highest valuations of all time (second only to March 2000) is as blinded as Fisher. U.S. equities have always performed poorly from current valuations.
Even famous investors try to convince themselves and others that "this time is different." Jeremy Grantham published a report saying exactly that, titled "This Time Seems Very, Very Different."
Warren Buffett appears to have abandoned his primary metric for gauging the value of the overall market (U.S. total market cap divided by gross domestic product) to a nebulous statement that stocks are cheap as long as interest rates stay low.
And the bitcoin bulls are also convinced this time is different. Here's a recent Twitter post that smacks of Irving Fisher…
| I believe [bitcoin] has "sticky prices," which means no matter what happens it'll gravitate back to [its all-time high]. I think if you theoretically embrace that it does that, and it does so for very specific and important reasons, it'll give you the right mindset when vertical whacks happen. – @parabolictrav
The author of this quote says he's a bitcoin "spirit guide for the journey to $100,000 and beyond… FUD dies here." FUD means fear, uncertainty, and doubt. It's my experience that English philosopher Francis Bacon was right… Those who begin with certainties shall end in doubts, and those who begin with doubts shall end in certainties.
This guy is too certain he's right. Markets love to reward hubris, right up until the minute they destroy it. Only overconfidence and lack of experience could lead anyone to believe banishing fear and doubt is possible. It's not. Living with it and managing it is possible and necessary for investment success. And the bitcoin hyper-bulls will have to do that eventually.
7. Financial shenanigans
This trait describes the nuts-and-bolts reasons why investors lose money in individual stocks during a financial mania.
As equity markets rise higher, the incentive to keep reporting good results grows stronger, compelling management teams to report better numbers than business reality might dictate.
The worst financial shenanigans are the ones that affect entire swaths of the stock and bond markets. They tend to go on – detected or not – for a long, long time. Then one day, the chickens start coming home to roost, and investors suddenly find themselves deep underwater.
Today, there's an enormous underlying problem affecting the overwhelming majority of U.S. public companies: the increasing use of non-GAAP accounting in quarterly and annual financial reports.
GAAP stands for generally accepted accounting principles. It's the standard for reporting financial results. Sometimes, a business might feel the standard doesn't accurately portray the true financial performance of the business. So instead, it will publish figures not supported by the GAAP standard to portray the business in a more accurate light.
Non-GAAP figures aren't inherently bad. Free cash flow (FCF) – our favored earnings metric – is a non-GAAP number. The problem comes when differences between GAAP and non-GAAP numbers grow larger. That's what's happening today, as noted in an October 26 blog post by State Street analyst Michael Arone…
| Today, the difference between GAAP and non-GAAP earnings is very wide. In the second quarter, the average difference for companies in the Dow Jones Industrial Average reporting both GAAP and non-GAAP earnings was a whopping 20%…
Eventually, when the spread gets too wide, earnings and [stock] prices are likely to come crashing down, resulting in smaller differences between the two accounting measures.
Financial data and software company FactSet also recently noted that…
| The fourth quarter marked the 18th time in the past 20 quarters in which the bottom-up [earnings per share] estimate decreased during the first two months of the quarter while the value of the [S&P 500] index increased over this same period.
The per-share intrinsic value of a business can only increase if its earnings per share (EPS) also increases. This statistic suggests that the market is either OK with all the unpublished abuses of non-GAAP accounting, or that a reckoning may be at hand.
Lastly, a June 2017 article in the CPA Journal studied non-GAAP adjustments for six large social media companies (Facebook, Groupon, Pandora, LinkedIn, Twitter, and Yelp) from 2011 to 2015. The authors concluded: "The magnitude of non-GAAP adjustments increased over time for all the companies in this study."
So… what can increased non-GAAP reporting do to your returns?
Just look at General Electric (GE). It was once the bluest of blue-chip stocks, but its share price is down more than 40% this year. GE's comeuppance was years in the making…
Especially during the tenure of former CEO Jack Welch (1981-2001), GE became a notorious earnings manipulator. Welch fostered a highly competitive make-your-quarterly-numbers-or-else corporate culture. The culture might not be as competitive now, but the financial reporting hasn't improved and investors are fed up.
An October Bloomberg article said as much a couple months ago, noting that GE reports four separate EPS numbers, each excluding various expenses. Bloomberg said GE is one of just 21 S&P 500 companies to report more than one EPS figure – though nearly all S&P 500 companies report some form of non-GAAP metrics, up from 58% of S&P 500 companies using non-GAAP reporting 20 years ago.
I suspect that when the current mania ends, many companies will suddenly get religion about GAAP accounting again as the deficiencies they're hiding finally become unavoidable. This will send many share prices sharply lower… likely reflecting enough investor revulsion to push prices well below reasonable intrinsic values.
Non-GAAP issues could lead to thousands of stock prices falling 50% or more from their ultimate tops, whenever those tops finally arrive.
It may take more than a few years for such a top to arrive, or it may not. Remember, we don't bet on predictions. We simply prepare our portfolio for the widest possible range of outcomes.
That includes the likelihood that good businesses purchased at cheap prices will generate acceptable long-term returns. More on this tomorrow…
Editor's note: No matter what the crowd is doing, it pays to buy good businesses when the time is right. Today, Dan is seeing a rare setup that will soon give one company a virtual monopoly. Investors could make triple digits as this situation plays out… But you must get in before January 1 to see the biggest gains. Click here to learn more.