When Michael Burry shorted housing in 2005, he did so with a specific catalyst in mind. Teaser rates were set to expire in 2007. Without them, borrowers would pay the long-term—higher—interest rate, and their payments would soar. It was a brilliant trade, but Burry’s firm almost didn’t survive long enough to profit from it. What should have been a victory was marred by bitter fighting with investors and, for Burry, a loneliness that had always clouded his life and, in this case, ground his exuberance to dust. The problem Burry faced was the problem everyone who’s ever shorted a bubble faces: you’re scared to miss an opportunity, so you get in too early, and then you suffer.
Shorting the biotech bubble is one of our highest conviction ideas. How do we know the bubble is going to burst? Because it already is. We don’t need to wait for markets to catch on, as Burry did. The S&P biotech ETF is already down 22% YTD. When people talk about shorting, they usually talk about what they’re shorting. But this ignores the dimension of short-selling that really counts. It isn’t what you short, it’s when you short it. And the time to short a bubble is on the way down, not the way up.
Biotech is poised to do what the tech bubble did in 2000: fall 40%, then 40% the next year, and yet another 40% after that. This is how you respond to a Federal Reserve that has inflated markets and taken all future returns away from you. You respond to Ben Bernanke and Janet Yellen by—and I’m quoting Fight Club here—“selling their own fat asses back to them.”
The state of the world today
The U.S. market is at one of the most expensive times in its history:
Source: Robert Shiller.
Only the tech bubble and the bubble involved in the 1929 crash are bigger than the present one. Unlike those other bubbles, however, this bubble isn’t limited to stocks. It includes bonds and real estate. I recently had drinks with a friend who’s a junior portfolio manager at one of the top debt shops in the U.S., and I asked him what they were doing.
Me: “What do you mean?”
Him: “We’re doing nothing.”
Me: “Yeah, but you have to do something.”
Him: “No, we’re literally doing nothing.”
The bubble is so large that in the value-minded investor, it induces a state of fatigue previously only seen in the very poor and the very rich: “learned helplessness.” But we think there’s some hysterical misery hiding in this pile of ordinary unhappiness.
The price/book of the most expensive 10% of the U.S. stock market:
Source: Ken French data library.
The total market may be mile-high, but growth stocks have punched a hole in the ozone. They’re not just enjoying some of the highest valuations in the last 150 years. They’re almost back to something none of us thought we’d ever see again in our lifetime: tech bubble valuations.
But let’s slice the market even thinner. Let’s look at companies that not only trade at a rich price/book but that also have the worst profitability in the market (i.e. aggressive growth stocks).
Source: Ken French data library.
These companies aren’t close to the tech bubble. They’ve been in it for two solid years. And this is no un-investable segment of the market. The average firm size is $1.3 billion, and this sample includes over 300 firms. The tech bubble has risen from the grave, and few people have noticed the extent of it because it sits hiding in small- and mid-caps.
We didn’t stop here, though. We divided this segment of the market yet again. We don’t like Price/book as a stock selection metric. We prefer EV/sales. When we look at the largest 50% of the market and look for the worst-ranked stocks in terms of EV/sales, 76% of them are biotech firms. Biotech is the worst bubble of them all, so egregious even the Fed can’t stop it from crashing. It’s like the movie Inception, where going into a dream within a dream layers distortion upon distortion until you’re leveraging time-space itself.
Source: McKinsey, Federal Reserve, Artemis Capital.
Stocks, like bonds, like any capital asset, follow an iron law: the higher the price, the lower the yield. Sky-high valuations mean we take Mozart risks for Miley Cyrus returns. Seth Klarman has said that investing is complicated, and the way to simplify it down is to focus on risk, not on what you’re getting paid to take it. The fact is the risk we’ve all habituated to is huge. We have three-times-a-century valuations sitting on top of an economy that’s even more levered than it was before the Great Depression.
The tech bubble part II
Our only comp for biotech at its current valuation is the tech bubble of 2000. (If there were ever a phrase that should never be applied to something you care about, it’s that.)
Growth stocks, which are defined in the graph above as the 100 securities with the highest EV/sales, roared along in the second half of the nineties. Then in 1999, they soared even higher, shooting up 200%, where they attained almost the exact same valuation they have today. Quickly afterward, they fell 67%. It would seem that you missed out on the short opportunity here (though you also missed out on huge losses on your short book in the run-up). But this was the time to put the position on. I don’t know if you’ve ever seen a drunk fall down and then somehow fall down again while still on the ground. But growth stocks did the same thing, losing another 40% in 2001 and then another 50% in 2002.
The wonderful part about a bubble this intense is that its demise isn’t dependent on broader economics, like, say, a recession or a market crash. We don’t need to bet on the failure of the Fed or on a repeat of 2008 for this to work.
Like the tech bubble, the biotech bubble could crash over several years. As a result, we think shorting biotech is the most compelling hedge out there against a broader correction in U.S. equities. A nice feature of these stocks is that they tend to be extremely high-beta. And they’re high beta at a time when beta is losing steam. Even going just 30% short a broad basket of biotech securities could net out the lion’s share of a portfolio’s market risk. Moreover it could do so without forcing you to take concentrated positions or go 100% short, both of which themselves involve risks that can be worse than simply not hedging in the first place.
Some names we’ve been shorting:
We use loose stop-losses for each position, but a tighter stop-loss at the portfolio level. If tripped, we simply take all short positions off for a set amount of time. We don’t view shorting as the inverse of going long, and we’re unwilling to withstand much pain on the short side. Our motto on hedging: always err on doing too little, too late.
At its present valuation, the U.S. stock market is at risk for another lost decade. The problem is there are very few compelling opportunities outside the U.S., particularly for institutional strategies. You can’t run, but you can hedge. We think for the foreseeable future, de-risking is the name of the game, and shorting biotech offers the best way to do it.
Disclaimer: Nothing the author writes should be construed as investment advice or a recommendation to buy or sell specific securities. Please do your own research. While everything the author writes is factually correct to the best of the author’s knowledge, a lot of this is guesswork and is far more subjective and far more prone of error than it may seem. You are encouraged to notify the author of any mistakes or oversights in the comments section, but the author assumes no liability whatsoever for the accuracy of the information herein. Moreover the author undertakes no duty to update the information contained in this write-up. Do not rely on the information set forth in this write-up as the basis upon which to make an investment decision.
I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.
Continued loss of hope (now that the high-watermark for biotech has already been reached).