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If not now, when?
“During the gold rush, it’s a good time to be in the pick and shovel business” ― Anonymous
With vaccination programmes and huge stimulus packages in progress, in the developed world at least, the path to recovery from Covid is a driver for market optimism, and, while the definition of normal may need to be revised, some semblance of ‘normality’ is starting to return.
But from an investment perspective, March 2020’s hiccup aside, you could be forgiven for thinking the markets were immune: the price of bitcoin raced past $29,000 in 2020 and touched $64,829 in April 2021; while the S&P 500 finished 2020 up 16.3%.
Over the past decade, investors would have received about 19% annualised returns investing in the Nasdaq’s index of large cap US tech stocks. This dwarfs the MSCI World’s 10% annualised return and 3% annualised return for global investment grade bonds over the same period. With stocks like Tesla up 743% in 2020 and the Nasdaq up 43.2%, why would anyone choose to diversify?
Put simply, parties end and bubbles burst. Eventually. If my PhD research, which was focused on speculative bubbles, has taught me anything, it is that bubbles never end the way people expect them to.
Speculative bubbles are defined when prices persistently deviate from any rational expectation of future cash flows and people buy with only the expectation of selling at a higher price in the future. Also called economic or asset bubbles, these usually form during periods of easy monetary policy and technological advancements making future cash flows very difficult to estimate and the discount rate too small.
These bubbles usually burst when cheap money ends. We’ve seen this time and time again: the tulip mania of 1636; the Mississippi bubble—when France switched to paper money; the South Sea Bubble in 1720; the 1840’s railway mania; the encilhamento in Brazil in the 1880s; Florida’s land boom in the 1920s; and Wall Street’s bubble (where it was difficult to value airplanes, department stores, steel, telephone, oil and the radio to name just a few) and the subsequent crash of 1929.
More recently, we have had the ‘tronics’ boom of the early 1960s; the biotech bubble between 1991-1992; and Japan’s asset bubble that started deflating in 1990 eventually bottoming out years later and resulting in more than just a ‘lost decade’. Today, FAANGS+ appear unstoppable, and while this time it may be different, in December 1989, Japanese stocks appeared invincible too.
Let’s not forget the cryptocurrency market’s 80% plunge in 2018. This was worse than the dotcom bubble in 2000, suggesting altcoins were already potentially bubbling three years’ ago with naysayers heralding their demise.
Could bitcoin’s recent 50% plummet; and the 29% correction in the Renaissance Capital IPO index between 12 February and 13 May, be harbingers of a bursting bubble? And if not now, when?
Japan’s bubble was driven by several factors including an uncontrolled money supply. The effects of our current period of ‘easy money’—which originated with Alan Greenspan’s monetary policy in response to the crash of 1987 and is known as the ‘Greenspan put’—have been compounded by successive ‘Fed puts’ and now exacerbated by pandemic-related government support and lockdown-related fall in revenues.
The pandemic has seen global government debt grow by $20 trillion since the third quarter of 2019 to the end of 2020 when it reached $277 trillion, equivalent to 365% of global GDP. And this debt, and deficits, will continue to grow. In the US alone, debt is predicted to hit 202% of GDP by 2051.
Markets are optimistic right now, but there are some major future headwinds that investors should prepare for. Eventually, large deficits need to be reigned in and the debt burden needs to be repaid. Inflation and growth are two ways to get out of debt.
Investors who believe that the debt burden can be simply diluted this way, as it was the case in the 1950s to 1970s, however, should also remember that for the majority of the 1950s and 1960s, corporate tax rates were above 40% (and even 50%). And the top income tax rate then was above 70%. Compare this to 21% and 40%, respectively, now.
The political climate is pro taxation at both the personal income-tax and company level, but the latter will affect profitability and valuations. It is likely that ‘pandemic ‘winners’ will be targeted by tax authorities and worth noting that Amazon reported only $162 million of US federal tax liability for 2019 after reporting more than $13 billion in profits; a tax rate of 1.25%.
At the same time, it is hard to imagine that the historically low interest rate ‘party’— rates at their lowest since 1350—is coming to an end any time soon. There are too many vested interests: reduction of interest burdens on governments; boosting the housing markets; and helping high yield corporate bonds.
Low rates, however, are not always a good thing. At the end of 2019, the 10-year treasury stood at 1.8%, and, today, the ultimate defensive asset yields 1.6% with limited upside if rates go back to the lows of 0.6%. More importantly, fixed income securities offer a slow bleed if inflation returns.
But despite dramatically reduced market liquidity (and increased volatility), low interest rates along with monetary expansion have supported all assets since the global financial crisis. This helps to throw future corporate profits into the long grass and supports growth equity stocks by incentivising investors to ‘buy growth at any price’ and thereby inflating the bubble by driving valuations in both public and private markets even higher.
As with every other period in history that saw easy monetary policy and new technological advancements, we are seeing animal spirits take hold of financial markets and at current valuations, the indicators are giving us warning signals and signs of excess.
In 2001, Warren Buffett famously described the stock market capitalisation-to-GDP ratio as “the best single measure of where valuations stand at any given moment” and now the ‘Buffett indicator’ is in excess of 200%.
At the same time, the Nasdaq Composite index futures broke the 50-day simple moving average three times in the first week of May; and the Shiller P/E ratio is over 35 right now, its highest level since the dot-com bust in 2000. Its average has been 16.78 over the past 148 years and it was 32.56 on the eve of the 1929 stock market crash.
With low interest rates equities are cheap when compared to bonds but what happens when interest rates rise, or stimulus is unwound? If history has taught us anything, it is that one common end to most bubbles is monetary and fiscal tightening.
But calling this period an ‘everything bubble’, a term that dates back to 2014 and describes the appreciation of everything, is both unhelpful and, inaccurate. For this reason, we prefer to look at the market in terms of pockets of speculative bubbles.
Take the solar powered industry; which is part of the green mini bubble, and electric vehicles hoping to jump on the coat tails of the new market created by Tesla. Let’s not forget that in 2017, Tesla was a month away from bankruptcy and today it has a market capitalisation of $600 billion.
But not all valuations live up to expectation as witnessed by the recent correction of Nio, XPeng and Li Auto, three Chinese electric-vehicle groups now worth $110 billion, a fall from $150 billion.
This artificially low interest rate environment, along with plentiful money supply, means the 60/40 portfolio is significantly challenged, as the Germans and Japanese have witnessed for a while, and US investors discovered recently.
The hunt for yield has manifested a quest for new asset classes, fuelling the cryptocurrency and special purpose acquisition company (SPACs) bubbles. SPACs, which are vulnerable to interest rates and market volatility and driving private market valuations higher, have already raised $87.9 billion in the US in the first three months of 2021.
Cryptocurrencies (and gold) are part of the non-sovereign currency alternative bubble created by the fear of an eventual collapse of fiat currencies which, according to Carmen Reinhart and Kenneth Rogoff’s book This Time is Different: Eight Centuries of Financial Folly, is an inevitability.
Blockchain offers significant advantages but it is questionable whether the valuation of $44.5 billion for a ‘joke’ altcoin based on the Shiba Inu Doge meme is justified. Moreover, with 10,000 new Dogecoins mined every minute, according to Coinbase, there is no maximum supply.
The sheer size of central bank quantitative easing assets accumulated by central banks over more than 10 years means that there is no prior data on this scenario, so models cannot accurately predict what will happen.
The US Federal Reserve alone has ‘printed’ more than $2 trillion since the global economic crisis in 2008, while Covid-triggered QE programmes by the world's four major central banks total $7.8 trillion.
China is one of the few countries with a rational monetary policy and its central bank balance sheet is 6% of GDP, compared to 16.3% for the Bank of England or 16.8% for the Federal Reserve. Additionally, China has dealt with the pandemic and is now focusing on the domestic economy. Could Chinese government bonds the new risk-free asset?
Cheap money has led investors to chase the next unicorn, piling into technology start-ups that are typically high margin, high-growth businesses that reinvest profits back into the business. To achieve scale, they are less concerned with earnings and more with growing rapidly.
Goldman Sachs’ Non-Profitable Technology Index, which includes Pinterest, Peloton and CrowdStrike Holdings, is up more than 400% since the March 2020 lows to mid-February 2021.
IPOs are also part of this quest. With companies such as Snowflake, DoorDash and Airbnb, 2020 has been the busiest IPO market since the dot com bubble. Retail traders, which opened more than eight million accounts in 2020, have pushed the average IPO first-day return to 40%, compared to 17% the average return since the 1960s.
The speed of market cycles, reduced market liquidity and increased retail speculation leads to abnormal market moves, which means process-driven active management has once again taken centre stage.
Investors looking for a 7.5% return in 1995 only needed to hold investment grade bonds. By 2005, portfolios had to include US large caps, international equities and alternative investments to achieve the same return, but at the cost of higher risk.
In 2015, bond alternatives had to be weighted at 25% and in the current environment investors should diversify to non-US equities, given the low valuations and low expected returns.
Bottom line is that higher valuations imply lower expected returns going forward. This means investors need to implement more complex portfolios diversified across: asset classes; between value and growth; longer term themes; geography; and tax jurisdictions.
Cash generative businesses such property is one way forward, or as those that made fortunes selling supplies to miners during the gold rush can attest; buy the commodities over the final product.
Take rhodium, used to meet tougher clean-air legislation for cars. It has been trading above $20,000 since February 2020 and almost reached $30,000 as the market heads for its third year of supply deficit. Or cobalt, which has seen prices rise 40% in 2021.
It is also an essential commodity for the electric vehicle sector, as is neodymium, which is also used for wind power. For solar power, silver and tellurium are in demand.
Continued fiscal and monetary support will keep rates low and the US dollar is likely to weaken as the economy ‘normalises’. The post lockdown euphoria and pent-up demand may lead to a profitable 2021, but the headwinds we have outlined will not go away. A return to normal life may actually mean a return to normal valuations.
Speculative bubbles are like knowing it’s time to leave the party, but everyone says ‘have one more drink’. It’s better to leave before things get out of hand, than be left cleaning up the mess.
Photo: © Niki Natarajan 2018
Artist: Christian Guemy
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