Are we already in bubble territory?
AS the long hot summer is drenched by disaster floods in Houston, Bangladesh and India, whilst financial markets continue to hit record highs, we need to ask whether financial markets are simply over-valued or already in bubble territory?
The amazing fact is that almost all equity and bond markets are up, and with Fed chairman Janet Yellen only talking about financial stability, rather than signalling direction of interest rates, financial markets seem to be fearless, waiting for the return of traders from their summer recess to begin another bull run.
In broad terms, the MSCI advanced market index is up 10.9% since beginning of the year in dollar terms, the Emerging market MSCI index is up 24.7%, and world bond market index is up 7.4% to Aug 23.
According to Goldman Sachs, the current total real return for S&P 500 for the period 2009-17 is the second greatest post-war bull run after the 1990-2000 period. With one last quarter to go, the nominal financial asset returns this year already exceed the long-run average of a balanced portfolio of bond/ equity of 7% per year for the period 1926-2016.
Part of the global optimism, despite huge uncertainties geopolitically, lies in the fact that there is finally some consensus that the world is undergoing a more broadbased recovery after the 2007-2009 global financial crisis. With the dollar weakening somewhat and China maintaining stable growth, commodity prices are beginning to slowly move back upwards, with upticks in metals, and even more recently some increase in oil and gas prices, following the Harvey flooding of production facilities in Houston.
A lot of the optimism in the stock market has been in technology stocks, with the Nasdaq Composite Index up 16.6% in year so far. Corporate profits in the US and China are also recovering somewhat that seem to justify higher valuations, while Europe is also bottoming out and recovering. But it can also be argued that the recovery in corporate profits is also due to exceptionally low interest rates that cannot be sustained, if central banks begin to normalise their balance sheets.
Having been taught a lesson in the 2013 taper tantrum, the Fed is now much more cautious in its communications on monetary operations in giving the markets notice on how it will go about withdrawing its balance sheet expansion. With unemployment levels already low, it is a matter of time before the Fed begins to go back to “normal” interest rate levels, which will inevitably hit the financial markets.
Those people who think that financial crises tend to happen every decade in 1987, 1997 and 2007 perhaps forget that some of the worse effects are felt in the following year. For example, the Asian financial crisis reached its peak in 1998 with the speculative attack on the Hong Kong dollar (successfully repelled) and the European debt/Lehman crises went full blown in 2008/9, even though subprime problems surfaced in 2007.
Re-reading the hardy perennial book by Charles Kindleberger on “Mania, Panics and Crashes” (Macmillan 1996) reminded me of his definition of the historical phases of financial crashes. First, there is a period of “displacement”, which causes speculation, credit and monetary expansion. Second is a phase of over-trading, financial distress and perhaps the exposure of fraud, swindles and malfeasance. This leads to revulsion, mistrust of shady products and intermediaries, and then panic as everyone rushes to the crowded exits without parachutes.
A displacement is defined by Kindleberger as “an outside event that changes horizons, expectations, profit opportunities, behaviour”. In the South Sea Company bubble of 1720, the displacement was the growth in joint-stock companies in Britain after the turn of the 18th century. The company was one of the earliest public-private partnerships, given a monopoly on the South American trade (especially the lucrative slave trade), in order to finance British war efforts against the French, Dutch and Spanish. It engaged in a huge swap of the national debt for its equity, paying off politicians and investors alike with more issuance of equity.
In January 1720, its share price was £128, rising to £1,000 in August, not unlike the price behaviour of some tech stocks and bitcoin in 2017. South Sea share prices were propped up by allowing investors to buy shares on credit. Sounds familiar?
Inevitably, as the company could not pay its dividend and investors buying on credit had to force sell, the share prices collapsed back to £100 before the year was out.
The displacement in the 21st century is the tech boom, in which everyone thinks that there are fortunes to be made, but no one is totally sure which tech company will be the great winner. Bitcoin fits that displacement/speculative model. The whole purpose of bitcoin is to create private money, outside the purview of the state. It is an asset with no intrinsic value and not the liability of anyone. Hence, its value is totally dependent on finding the next buyer, or perhaps sucker.
Writing in 1856, the founding editor of the Economist magazine Walter Bagehot had this view about panics and manias, “but one thing is certain, that at particular times a great many stupid people have a great deal of stupid money. At intervals, from causes which are not to the present purposes, the money of these people – the blind capital, as we call it, of the country – is particularly large and craving; it seeks for someone to devour it, and there is a “plethora”; it finds someone, and there is “speculation”; it is devoured, and there is “panic”.
We are in this current state of a liquidity flood, founded on the current monetary logic that debt addiction, like drugs, can be cured by providing more debt at near negative interest rate costs. So we have too much money chasing speculative cyber-wealth.
The physicist Isaac Newton, who also lost a fortune in the South Sea bubble, claimed that “I can calculate the motion of heavenly bodies, but not the madness of people”.
I wish I shared Yellen’s optimism that the next financial crisis “will not be in our lifetimes.”
One thing is sure, the next bubble burst will shorten quite a lot of people’s lifetimes. You have been warned.