Developed world equity and bond markets (and currencies) look like they are in bubble territory, the US stock market in particular. This is in large part due to the distortionary impact of monetary emissions on a vast scale – so-called “quantitative easing” – and the widespread belief that this will go on for an undefined period to support markets as necessary. We are now at the point where pundits are not debating whether there is or is not fair value in US stocks, but rather when to exit, given the risk of losing out on more gains and the perceived lack of alternative investment destinations.
Yet the Federal Reserve has started to increase interest rates. Fed. Governor Bill Dudley has made it clear in a recent BIS speech that the US central bank is now targeting financial conditions (i.e. will likely raise rates until banks pass on tighter credit conditions). And the Fed. has announced plans to not replace all the maturing bonds on its balance sheet – initially $10 billion a month rising to $50 billion such that $90 billion should be withdrawn from the market this year and $510 billion in 2018.
The Trump Administration is claiming annual GDP growth will be 3% by 2021. Yet there has been little progress on fiscal stimulus and the IMF is predicting US growth of 1.8% in 2020 – a big difference.
The still widespread assumption that any increase in US interest rates will suck in more money from overseas is increasingly tenuous. The context is that enough investors now realise that the return on such capital is highly dependent not on yield but further capital appreciation. A simple mechanical relationship between US interest rates and inflows was always a convenient fiction. Instead we should assess investors’ perception of the expectations and behaviours of others. One is reminded of Keynes’s beauty contest:
“It is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.”
(Keynes, General Theory of Employment, Interest and Money, 1936).
In the search for alternative homes for capital, only rather limited consideration is given to opportunities outside the developed world. Yet there is the absolute need that savings from the excluded majority of the global economy continue to flow to the developed world. This willing sacrifice is typically either seen as sustainable, or its necessity to keep the US dollar afloat is entirely over-looked. Yet there are plenty of reasons to question its sustainability, most especially should further speculative gains in US assets be in doubt. How does one deflate a bubble gradually? Not easily is the obvious answer, and the bigger the bubble the harder the task.
US Stocks in a bigger bubble than 2000 or 2007: S&P500, and S&P500 adjusted for CPI inflation.
Purist believers in the Efficient Markets Hypothesis argue that all asset price moves are the result of new information – why let facts get in the way of a beautiful theory after all. On planet Earth, however, bubbles are unsustainable deviations from some objective measure of asset value – typically some estimate of replacement cost (such as Tobin’s Q) or discounted future income. Bubbles are caused by factors such as the credit cycle, monetary conditions, and market momentum. But as bubbles are essentially moves away from what one might consider reasonable valuation, some irrationality (in a broad sense) is also necessary. This includes, amongst other things, our collective greed, belief that existing trends will continue, appeals to why things are different this time and an over-estimation of our information advantages and of our ability to exit ahead of the herd.
Investor Base Structure Matters
Although economic models typically consider market participants as uniform in their preferences and behaviour, the structure of the investor base is important to financial market dynamics. Investors can be grouped according to their liabilities and objectives but they may also have different beliefs about how markets operate – different models and world views. Indeed, some of the most important dynamics come not when new information arrives per se but when a homogenous group of investors suddenly change their world view and hence their assessment of asset values. Homogeneity of an investor base, a misperception of risk which may shortly change, and leverage somewhere which affects behaviour, are three warning signals a bubble is about to burst.
Investor bases can start heterogeneous and get more and more homogenous as groups of investors realise something is amiss over time, and exit. Those remaining may for a long time just buy more as they seek to exploit what they consider to be temporary arbitrage opportunities caused by the exit of others. But there eventually comes a point when the bulk of those still invested see the light – be it that the “risk free” has risk, that growth and income expectations are suddenly realised as seriously over-estimated, that an assumption of no default or devaluation is false, or that some other event outside their previous model becomes an obvious risk or reality.
Keep Dancing
So part of the problem of why bubbles keep building long past credible valuation levels is that market participants are perceiving risk incorrectly. But it is also partly that they often don’t want to exit until long after they first realise a market is in bubble territory.
“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”
Charles ‘Chuck’ Prince, CEO Citigroup, July 2007
The motives for continuing to dance can outweigh the fear of getting caught in a credit crunch for several reasons – and this can be true for an individual, for institutional investors and also for financial intermediaries (like Chuck Prince’s Citigroup), although each may ascribe different weights to their reasons. Different investors, in addition, have different reasons for bubble chasing. Simplistically, one could say that financial intermediaries may be making too much money to stop, institutional investors are incentivised to herd, and individuals may not understand the risks. We shall discuss those differences in the next instalment…
Dr Jerome Booth in London.