All crises have involved debt that, in one fashion or another, has become dangerously out of scale in relation to the underlying means of payment. More often, even a semblance of innovation is absent. In the 1920s, as we shall see, great holding companies were created. The owners, that is to say the stockholders, issued bonds and preferred stock in order to buy other stocks. As the latter appreciated in value- for a while- all the increase accrued to the owners. This was proclaimed one of the financial miracles of that age. It was, in fact, leverage in, at most, a slightly different guise.

-John Kenneth Galbraith, A Short History of Financial Euphoria


In late cycle bull markets you start to see strange things crop up. I was reading the above excerpt last night and couldn’t help but immediately think of the rise of ARK Invest and how Cathie Wood, the founder, is widely cited as a genius stock picker and tech visionary.

I subscribe to a few schools of thought when it comes to the market, maybe the most important being that when opportunity is present, many are drawn in, few survive, and even fewer thrive. It is a sad fact of life that there can only be a few true visionaries- Edison, Jobs, Ford, etc. When you start to see many people cited as genius visionaries at once, there’s a good chance there’s some willful delusion at play.

The reason I felt it appropriate to start this piece with that excerpt is that I think it serves as a strong reminder that when bubbles are in effect, people are willing to part with reason and things that they probably fundamentally understand about the world at some level. Cathie Wood is 65 years old. She founded ARK in 2014, roughly six years ago as I write this. ARK really seemed to hit its stride when Tesla’s stock started moving up. ARK continued to be perfectly positioned to ride the growth stock ascent. As ARK’s reputation (and the price of its stock holdings) rose, it launched more ETF’s. So what’s happening now is that you have investors buying stock in an ETF run by someone with a reputation as a visionary, which then uses said inflows to buy shares of high-flying growth stocks, which, after it being reported that ARK has initiated or increased its stake, rise as a result, further lifting the shares of ARK’s ETF’s in a virtuous feedback loop.

This has all the makings of a bubble within a bubble. One can hardly deny that there is at least massive correlation at play here where ARK’s success is closely tied to Tesla’s share price and the growth stock complex as well as investors’ seemingly insatiable appetite for risky stock issues. If you peruse any Twitter thread in which someone asks the question “what stocks are best to buy right now?” You will almost certainly see the majority of responses mention ARKK, the ARK Innovation ETF. It is consensus in the retail crowd that this is not only a smart investment, but should really be a cornerstone of any responsible portfolio. And this is not hyperbole. I read comments like this about once a week.

All the ingredients are here for a market top- overnight visionaries who’s star has risen with the market. Wood is not a lone exception, there are many others. One example being Chamath Palihapitya who has recently gotten fully involved with the SPAC craze, launching something like five or six SPAC’s in the past year. As the public has bought these up hand over fist, Chamath has become quite arrogant and unshy about promoting his own genius, despite not having much in the way of wins beyond a successful exit as an early employee at Facebook and selling shares to the public in businesses that at best, have yet to show sustained success at actually operating as a going concern.

Other problem signs- mega cap tech stocks look to have topped in early September prior to the correction that occurred around that time. Even though they certainly haven’t been in a down trend, their character has completely changed from leading the bull advance to simply treading water on low volume. I’ve seen many assume that this is a healthy consolidation, forming a nice long base that will resolve with a massive rally to the upside. And why shouldn’t they? The past five years have engrained in investor’s minds that every dip should be bought. I believe there is a very important time element in markets to wash away widespread fear and skepticism born in a lengthy painful bear market to setup for another. While we have had minute corrections from time to time, none have lasted more than a few months and in every case though doubts persisted early about how wise it was to buy the dip, history showed that if you had done so on any of those you’d be up significantly a few months later. I think we are at a point now where the bulls have enough confidence in their abilities and delusion about the lack of basic need for a company to earn more money than it spends to setup for a devastating bear market. The question is, what would that look like?

I have heard it consistently said that the market won’t really go down until the Fed tightens again which isn’t likely to be for at least a couple of years. The latter part of this I agree with. I do not, however agree with the premise that you can’t have a bear market emerge with a Fed as unambiguously accommodative as this one. The Fed’s positioning in 2019 and 2020 gave rise to a market that was completely unconcerned about Fed policy. This has led to extraordinarily stretched valuations, positioning, and sentiment. When these conditions occur what is required to bring about a devastating move lower becomes less and less significant. That’s why it’s all the more confounding when massive selloffs happen.

There’s an interesting common thread to every major crash of the past century- 1929, 1962, and 1987. Each began with pretty mild downward trends which quickly accelerated into crashes. I believe that the market has risen to a position of extreme weakness where it could easily lose its footing and start a similar move down and because of this anything at all can cause it.

Other warning signs I have been writing about since September- the number of secondary offerings spiking (similar to the launch of additional ARK ETF’s and SPAC’s) shows a public willing to by any old thing that moves. I believe this also explains the recent rally in Bitcoin. Maybe the most damning is the simple fact that so many have seen absurd returns by speculating in equities in recent months. And I’m not talking about 20% gains which the investing public would consider extremely boring today, but 300, 400, even 700% gains in eight or so months.

There is little doubt to me that in 2021 we will see a major correction in sentiment and price as always must happen when masses with little demonstrated talent suddenly believe themselves to have found a secret gift and should continue to make more money the same way.

Now to the question of when and how? I mean, who’s to say that even if the market does turn bearish that it isn’t a prolonged, soul-crushing bear market or just a sideways market? Why am I so convinced we will get a crash? It has to do with market levels including valuations, sentiment, and extreme levels of speculation. There have been few (perhaps no) instances where levels got so extended and we didn’t get a major crash. However, many think a correction will come in January. While this could certainly happen, I actually won’t be that surprised to see the market continue this sideways churn for another couple of months to really convince the market that no crash is coming and to not be invested is folly. I’d expect even more IPO’s along the way. More than anything I am looking for a sustained down trend in the market (I use the VALUG on a 4-5% weekly close to define the trend) that looks fairly normal and I would use that to initiate put positions.

My favorite short ideas are IBM, INTC, DIS and the QQQ’s (within the QQQ’s I’m most bearish on AMZN, MSFT, and CRM). IBM and INTC may seem like odd choices given that this market is defined by extreme speculation in growth stocks, and that given my prior statements I should short shares or buy puts in ARKK. But one thing I learned in the correction in February/March was that stocks exhibit relative weakness for a reason and it isn’t the stocks that rose the most in the bull advance that see the greatest setbacks when the market turns nor the most reluctance to buying on dips. When you are in a major bull market as we have been for the past year or so, stocks like IBM and INTC which have well-defined and understood fundamental problems get buoyed to much higher prices than they probably otherwise would. Additionally, these two stocks have some of the lowest implied volatility making the upside for put options in a crash event much greater than a stock like TSLA or AMZN where the IV is much higher. You can make good money in those as well but your timing has to be exactly right and you may be surprised to learn that you would’ve made even more being positioned in “boring” stocks. In the midst of a crash the high flyers with high IV’s can yield good results if you short counter-trend spikes as people rush in to buy on the dips, but overall these tend to be better tactical very short-term plays. DIS I’m bearish on for a variety of reasons I’ve written about over the past several months ad nauseam so I won’t recount them all here, but one additional factor at play now is the massive rise the stock has seen over the past month on very little fundamental news except for them proclaiming to have won the streaming wars. I’ll believe that when I see it.

One final point- I don’t believe as some do that we will see a prolonged rotation into small caps or financials with underperformance in megacap tech in 2021. The main reason I continue to point to the fact that megacap tech topped around Labor Day and has been fairly range-bound since is that these stocks defined the bull market of the past several years. I simply don’t believe that the market can have a major advance without them returning to a place of leadership. Small caps have underperformed for years for good reason- they are inferior businesses with inferior leadership. Megacap techs have fantastic fundamentals, ROC, the smartest leadership and the largest TAM’s. When they underperform it’s a major red flag to me. I believe bull markets are strongest when everything works on a relative scale with the best companies leading, particularly at the beginning of a new bull market that few have faith in. That is simply not where we are now. The investing public can make outsized returns for a while but basic laws of survival show that it can’t last and that when it’s going on it in and of itself is a sign something is out of balance.