- Steve Russell, a portfolio manager at Ruffer, is warning investors of big asset bubbles.
- Russell says SPACs echo the South Sea Bubble and explains how to position against bubbles.
- He breaks down what could burst those bubbles and what convinced him to buy bitcoin.
In 1720, inflated stock prices in obscure joint stock companies resulted in a market crash known as the South Sea Bubble.
Investors piled money into one company famously known as “a company for carrying out an undertaking of great advantage, but nobody knows what it is.”
When Steve Russell, who co-manages the £3.5 billion ($4.8 billion) total return fund for the UK investment firm, Ruffer, heard about special purpose acquisition companies he recalled that quote.
“It seems absolutely a perfect description of a SPAC, where you give them money for them to invest in something that they’re not going to tell you what it is in advance,” said Russell, who recently wrote a note comparing SPACs to the South Sea Bubble.
A SPAC is formed by a group of investors with a strong background in a business sector, they raise funds from other investors and use this cash to acquire a private company with the aim of taking it public. SPACs have been around for several years, but became more mainstream when top investors got involved in 2020.
SPACs are just one of the various speculative bubbles Russell sees in the market right now. The bubbles he has identified range from investors placing money in essentially profitless companies, such as electric vehicle maker Tesla, to bidding up the price of heavily shorted small-cap stocks, such as Gamestop.
What is driving the speculation? Investors with too much money, Russell said, who believes the discount rate, which is used to determine the present value of future cash flows, will remain at zero.
This speculation could have significant knock-on effects.
"These are all what I would describe as typical signs of excess and definitely things that make us take a cautious view on the overall market," Russell said. "What's difficult to really put across is the fact that this excess is pretty much contained into large, but specific, pockets of the market."
Though the overall index could fall, it doesn't necessarily mean everything will go down in value, Russell said.
Russell is still investing in traditional businesses, such as retail, energy and financial companies, while avoiding momentum stocks, the FAANGs, as well as any business where investors are being asked to pay high multiples for future profits.
What will burst the bubble?
A higher discount rate, which could come in the form of higher inflation, could burst these speculative bubbles, Russell said.
Consumer price growth might not suddenly materialize, Russell said. But there are already signs of increasing inflation in the pricing of oil, industrial metals, agricultural products and container shipping.
The growth stage of the recovery from the COVID-induced recession could push inflation up, Russell said. A shift in mobility and activity could also be a driver of bubbles bursting, as investors move their resources out of the financial markets in favor of spending those returns on holidays and entertainment.
If there is an upturn in inflation, central banks can't use monetary policy to fight it, Russell said.
The firm believes interest rates will remain close to, or at, zero for the foreseeable future, as this is the only way for governments to afford the current levels of debt.
Generally inflation and interest rates have been roughly the same thing, Russell said. But if interest rates are at zero then what is the right discount rate - interest rates, which are artificial, or inflation, the actual value of future money? he said.
"We think eventually, the market will realize, and price in, the fact that it's the inflation rate," Russell said. "Therefore, instead of being able to discount things on effectively a zero interest rate, you have to discount them on 2/3/4/5+ % discount rates, which would make current valuations for a lot of companies extremely unattractive."
Inflation would just need to move above the target rates of Western central banks to puncture equity valuations, Russell said. The Federal Reserve, for example, has said it is willing to tolerate inflation rising above its 2% target rate and won't rush to raise US borrowing rates.
In this scenario, investors could leverage US and UK inflation-linked bonds and gold to position against inflation, Russell said. Those assets also currently make up 40% of his firm's total return fund portfolio.
Where does bitcoin fit?
Russell is also looking at bitcoin as a hedge against inflation and recently placed a 2.5% allocation to the asset in the portfolio.
Bitcoin appears speculative, with a 146% price increase since the start of December. However, it wasn't the price surge that caught Russell's attention. Instead, he believes fiat currencies are likely to lose value and he has an interest in safe havens that protect against that.
"We monitored bitcoin solely from the view that it could become an alternative to gold as a safe haven away from currency," Russell said.
Bitcoin has similar characteristics to gold - it's not attached to an interest rate and supply is not controlled by governments, or central banks.
As more corporate and mainstream investors took an interest in bitcoin, such as BlackRock, Russell felt there was a very real risk that bitcoin could become a digital alternative to gold.
"I very much taken the view that, what we didn't want to have to do, was turn around to our investors and say, 'we're selling some gold to buy bitcoin, because it's an alternative to gold and we're paying $100,000 for bitcoin because we've waited to see what happened'," Russell said.
Russell bought bitcoin around the $15,000 mark, financed by selling some of the fund's gold exposure. He admits he could be completely wrong on bitcoin, but said he has already recouped that initial investment.
When bitcoin's price doubled, the allocation in the portfolio increased. So he sold half to return the allocation back to 2.5%.
Institutional interest also convinced Russell to invest. It's becoming increasingly unlikely that the US government will make bitcoin illegal or wish it away, he said, wider adoption is putting pressure on the Fed and the Securities and Exchange Commission to approve its broader use.
"We saw an increasing likelihood that China would look to develop its own version," Russell said. "And we could see that the US would look to support bitcoin because it's, broadly speaking, viewed as a US entity, and they could effectively have some control over it."
"The sharp moves that we're seeing upwards are very nice, but they sort of blur the point that actually," Russell said. "It's meant to be a safe haven for currency devaluations, rather than something that you can make fast profits in."