In financial euphoria episodes, investors become immune to the risks of capital destruction by blacking out to their normal risk aversion. Usually, these episodes come from extrapolating the recent past out many years into the future. What can we learn from other disciplines about blacking out? How did this happen with investors in the past and where are risks in the U.S. stock market blacked out today?
In his most recent book, “Talking With Strangers,” Malcolm Gladwell explains how intoxication from alcohol moves as blood alcohol levels rise. At somewhere around 0.14 to 0.15, intoxication moves to what can be described as a “blackout.” The person is active and functioning, but is not conscious of what they are doing. He discusses the terrible mistakes young people make in college from becoming overly intoxicated at these levels.
Over my 40 years of investing, there have been multiple episodes of investor blackouts. As the chart below shows, my first experience was in gold, oil and other inflation beneficiaries circa 1981:
Source: DoubleLine Funds, BofA Merrill Lynch Global Investment Strategy, Bloomberg. Data for the time period Jan. 1, 1977 to Dec. 31, 2018.
Inflation was running at 11% as 79 million baby boomers were forming households, buying houses, cars and having children. Too much money was chasing too few goods, and prices were overwhelmed. Investors moved nearly all their money into inflation hedges and short-term, interest-bearing securities and blacked out to the risk of doing so. Equity ownership among households dropped to 10% of total household assets and the energy sector of the S&P 500 Index reached 28% of the total market cap. Inflation investments were completely intoxicating, and investors were blacked out to the risk of extrapolating the recent trend. Gold and oil plummeted in price for the subsequent 18