Greater Fool Theory

Investors are not oblivious to valuations.  They just put less importance on valuations when markets are either 1) in a bubble 2) in a crash.  During a bubble, investors don't care that markets are overvalued because prices keep going up and they continue to make money.  During a crash, investors don't care that markets are undervalued because prices keep going down and they continue to lose money.  

Market conditions where investors ignore fundamentals are not stable.  I.e., those conditions do not last for long.  In bubbles, the greater fool theory is hard at work, as investors believe that someone else will buy their stocks at higher prices, sometime in the not too distant future regardless of valuations. 

The crowd is not stupid.  They can easily figure out that stock valuations are high.  Its out there in clear view.  In fact, many will admit that the market is overvalued.  But they believe that the market will stay overvalued and go up anyway.  That is what defines bubble psychology.

Fundamental value becomes less important.  Price momentum becomes more important.  A survey of individual investors done by the Yale School of Management shows the following results over the past 25 years.  

Proximity to Platonic Ideal of 100% Believe Overvalued, 100% Believe Market Up Next Year

The underlying belief that arises from bubbles is that investors think that prices will rise in the short term, regardless of what they think about the long term.  Investors have high conviction that prices will rise in the short term, but they also know that eventually the party ends, so they are not as positive about prices going up in the long term.  Short term positive, long term neutral to negative.  The stock market tends to do much better in the long term when investors are short term negative, and long term positive.  

It is this greater fool theory which makes investors' time horizons shorter.  It also causes investors to chase after high beta, volatile, and rising stocks.  MSTR is a perfect example of the type of stock that comes into favor near the peak of a bubble.  Boring, slow moving stocks are ignored.  When people see others making all this money in bitcoin and related stocks, big cap tech stocks just don't have the same appeal. 

In this bubble environment, put protection is an afterthought, and considered a waste of money.  Call volume rises and put volume falls.  In the options market, more and more evidence is building that investors are leaning very heavily towards calls over puts.  Individual stock put/call skew in S&P 500 stocks shows heavy bullish positioning.  

Conference Board survey of consumers shows record levels of optimism towards stocks, with 56.4% expecting stock prices to be higher in one year.  

No one knows when the party ends.  But when you see so many signs of highly bullish positioning, pervasive optimism, and an extended uptrend at historically very high valuations, usually there isn't much time left.  The long term risk/reward for long positions is quite poor.  On the other side, it presents an opportunity for great risk/reward for long term short positions.  These parabolic moves due to short squeezes, speculative fever, or just plain FOMO are hallmarks of a bubble market.  They always end with long term down trends.  Over the coming weeks, as we get closer to year end, I will look to put on some long term shorts in individual stocks which I can see go down 60-80% over the next 2 years.  

We got another move to an all time high in the low liquidity, low volume Black Friday session.  It looks overextended in the short term, so have put on a starter short position. Not looking for anything big here, something around a pullback of 3%.  The bonds have been acting strong lately as Treasuries catch a bid with European bonds trading higher over the past several days.  This will help limit any downside for stocks this month, along with positive year end seasonal forces, so wouldn't get aggressively short.  The time to look for bigger down moves will be early 2025, so keeping a lot of powder dry until then.