Risk of Greater Fool Investing

September 12, 2020 Profitable Investing Tips

By many measures the current stock market highs are crazy. We wrote months ago about how the stock market is ignoring the economy. Unemployment is still at historic lows, congress is not coming across with another stimulus, and people are running out of money. This will result in families tightening their belts, buying as little as possible, and driving the financials of many companies downward. Nevertheless, many investors seem to be ignoring the fundamentals and trying to eke out more profits before taking their profits. This approach of trying to hang in for the last bit of a bull market is sometimes called greater fool investing. The investor knows that at some level he or she is a fool for hanging around as the market gets risky but the profits are addicting. They plan to sell to a greater fool at the last moment. The risk of greater fool investing lies in the difficulty of predicting when the hammer will fall and the market will fall like a rock.

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Will Investors Lose Like in the Dot Com or 1929 Crashes?

Market Watch writes about the same issue in their article about a bubble like the late 1990s or 1929.

A “greater fool” stock market might be at hand if a popular valuation measure continues to press higher, potentially kicking off another bubble to rival the late 1920s and 1990s, warned a Wall Street veteran who called the market’s rally off the March lows.

Barry Bannister, head of institutional equity strategy at Stifel, noted that the cyclically adjusted price-to-earnings, or CAPE, ratio was at or near levels last seen in the final two years of the 1920s and 1990s rallies. The CAPE ratio, devised by Nobel laureate economist Robert Shiller, measures the price of the S&P 500 SPX, -0.81% divided by average corporate earnings over the previous decade. By taking such a long view, its proponents argue that it smooths out cyclical variations and gives a better view of where valuations stand versus history.

We believe that the CAPE underestimates the problem because earnings have been excellent over the last decade and earnings going forward are highly suspect as the Covid-19 virus continues to damage the economy. Many businesses will not come back to previous levels and that will come back to haunt investors who seem to believe that the big tech companies can keep making money when all of their customers run out of cash and quit buying!

We previously quoted Warren Buffett when he compared the pre-dot com crash market to folks planning to dance until midnight at Cinderella’s ball but failing to notice that the clock on the wall had no hands.

At some point, smart investors will follow Jim Cramer’s old advice which is that you do not have a profit in the market until you take a profit. Those that start taking a profit now will have done quite nicely since the Covid-19 crash and recovery but will do even better if they start hedging their bets now instead of hoping for a greater fool to bail them out at the last minute before the next stock market crash.