Monday 27 November 2017

All set for the biggest equity bubble in history?

Back in February, I wrote about how my biggest fear in markets was not a melt down, but rather a melt up - a risk I felt investors continued to underestimate. The post - which is one of my best to date (if I may say so), can be found here. Nothing that has occurred in the nine months that have elapsed since that post has assuaged those fears, and indeed, we have seen global markets rally some 15-20% since that point in time, with Bitcoin and other speculative asset classes vastly exceeding that. Events seem to be unfolding in exactly the manner I had most feared.

Trying to definitively predict the future course of markets is of course a fool's errand - markets and economies are complex, adaptive systems that are path dependent in nature, and therefore are inherently unable to be predicted with deterministic precision. Consequently, the below analysis is not a prediction. However, it is, in my submission, a distinct possibility that - barring an unlikely radical change in the current pattern of central bank behaviour or inflation shock - that we could witness one of the biggest equity and asset pricing bubbles of all time before this cycle is over.

Systemic liquidity matters more than the 'fundamentals'

When many pundits talk about the outlook for equity markets, they often make the mistake of approaching the issue from a similar vantage-point to how one might look at the outlook for an individual stock. They look at the various fundamentals, including the outlook for the economy; earnings growth; valuations; and various geopolitical and other risk factors, and then draw a conclusion about how the market 'should' be behaving in light of these various factors. Often, bemusement results when the market action deviates from what a rational assessment of the fundamentals seems to suggest ought to happen. Rational explanations for the market action are sometimes conjured up to explain the mystery, such as 'perhaps investors are optimistic that Trump's policies will boost economic activity', and the like. At other times, investors are simply declared to be irrational.

The problem with this approach is that it overlooks the following fundamental reality: that to a very large extent, active asset managers cannot and do not set the aggregate absolute level of equity market pricing; instead, they can only determine the pricing of individual stocks relative to one another. While it is true that active managers have some flexibility to increase or decrease cash weightings, in practice this flexibility is limited, as managers have their hands tied by both (1) explicit mandate restrictions (i.e. many fund managers' offering documents stipulate maximum and minimum cash weightings); and (2) implicit business/career risk, as substantial benchmark performance deviation could result from any decision to hold a large level of cash - particularly late cycle when markets are prone to rapid blow-off gains. Consequently, for the most part active managers need to remain approximately fully invested at all times.

Furthermore, active managers also cannot control the level of aggregate inflows or outflows into their funds, and historically, such flows have tended to be highly pro-cyclical. What this means in practice is that fund managers are forced to buy at the top and sell at the bottom, regardless of either the absolute level of prices or their own preferences, because that is what their fund inflows/redemptions require them to do. All a fund manager can really decide to do is buy more of some stocks and less of others. This impacts relative prices, but it does not effect the overall absolute level of prices.

Consequently, market moves are therefore to a large extent driven by exogenous system-wide liquidity factors, rather than active managers' dispassionate assessment about the appropriate level of aggregate stock prices in view of the outlook for aggregate earnings, and a very significant influencer of liquidity conditions (although by no means the only influencer) is central bank behaviour. While this is far from a novel insight, and has been long recognised by market participants, it is my view that investors are underestimating the extent to which continuing central bank intervention, in combination with various other concurrent factors I discuss below, could end up driving equity prices to utterly absurd levels - perhaps the highest the world has ever seen. This would not be unbecoming of what has been the largest experimental central bank intervention the world has ever seen. Indeed, given the unprecedented degree of central bank stimulus we have seen and continue to see, it is arguable that we should be surprised if this is not the ultimate outcome.

How central banks may engineer the biggest bubble of all time 

One of my preferred ways to understand the effect of a complex phenomenon is to consider what the effect would be if taken to the extreme (provided it is a phenomenon where what is true in the extreme is also true when scaled down). Consider the hypothetically extreme situation where tomorrow, the world's central banks purchase not merely some, but all of the government and corporate bonds outstanding, with newly printed currency (sadly, this is less far fetched than one might care to acknowledge - the Bank of Japan, for instance, already owns half of all outstanding JGBs). What would the likely impact subsequently be on non-bond asset prices, including most obviously, stocks?

The holders of those previously interest-bearing bonds - predominately wealthy individuals and institutions - would now, instead of owning cash-generating assets, be holding large cash bank balances yielding zero rates of interest, or something very close to it (if not negative). If you're already very wealthy, some return is enough. Sure, you'd rather more than less, but some is enough to not deplete your capital. But no returns will eventually deplete your capital (after drawing down living/lifestyle costs), and is to be avoided at all costs.

Now, if these ex-bond-holders were to simply rush out and spend the funds newly-deposited in their bank accounts by central bankers on consumer goods and services - perhaps a new fleet of Ferraris or private jets - it would both stimulate the economy and, quite likely, be inflationary (if the 'demand-shock' this sudden burst of activity was not able to be accommodated by sufficient supply-side slack in the economy). This is exactly what many, if not most, conventional economists - including central bankers - models implicitly expect to occur. This is why they have been surprised - indeed frustrated in the case of central bankers - that inflation and more rapid growth has not emerged in the wake of their stimulus, which has caused them to double down and print even more money to buy even more bonds (a preferable alternative, it seems, to admitting their models are flawed). Even Warren Buffett - a great investor but a subpar macro-economist - does not understand this, and has expressed befuddlement about the absence of inflation in response to central bank printing.

The reason why all these players are wrong is not hard to discern if one actually thinks about it for a while and how real people are likely to behave in the real world, instead of how theoretical people are likely to behave in a contrived theoretical world.* In reality, such a profligate wastage of this newly-liquified stockpile of savings on an epic consumption binge is most unlikely, and the reason is obvious: wealth today is highly concentrated, and the wealthy generally do not consume their wealth - they instead invest their wealth and live off a fraction of the investment income (even the middle class who is saving for retirement is unlikely to suddenly spend all their savings because now they have 0%-cash deposits instead of a bond portfolio yielding 4% - if anything they are likely to need to save more; this is exactly what has occurred in Japan, to the perpetual confusion of economists, whose formal models deem this outcome impossible (I'm not making this up!).

Consequently, the much more realistic response of the wealthy, were they to suddenly have all their interest-bearing bonds replaced with zero-interest bank deposits, would not be to rush out and consume, but instead to rush out and look for alternative investment options capable of absorbing some of their excess cash and generating any sort of return. Equities are one option. Sure, equity markets may currently be priced to deliver 5-6% instead of the historical 8-10%, but 5-6% is much better than zero! And sure, gross rental yields on property might only be 3% - way below the historical average of say 7% - but 3% beats the hell out of 0% (and that 3% yield is a real, inflation-protected yield too, unlike bank deposits which offer no such guaranty; there is also no guaranty deposit rates will not fall perpetually negative in the future as well). 'Alternatives' such as venture capital and private equity would also represent other possibilities, as even might cryptocurrencies such as Bitcoin. Literally anything would do, provided it offers the prospect of some returns.**

Upward pressure on all remaining asset prices would therefore be an inevitability. Furthermore, for every buyer of an existing asset, there must be a corresponding seller, so in the aggregate, all the cash sitting in investors' bank accounts would be incapable of being absorbed. Consequently, what would instead happen is that investors would endlessly compete with each other to part with their cash to purchase income generating assets, and in the process drive asset prices into the stratosphere. This process could be expected to continue until an equilibrium was eventually reached where a sufficient number of investors were willing to hold significant bank deposits earning zero (or negative) returns, rather than hold income generating assets. That point might not be reached until yields on competing investments compressed to extraordinary low levels - perhaps as little as 1-1.5%.

Now, no one is suggesting central banks are imminently about to purchase all outstanding bonds. But what is true in the extreme is also true at lesser degrees, and what we have at the moment is a world where global central banks - despite the global economy growing quite nicely - continuing to happily print and purchase in excess of US$150bn in financial assets every single month, continuing a policy that ought to be - at most - a temporary crisis-era measure, with a complete and utter disregard for the longer term financial stability consequences of their actions. Every month, central banks are essentially confiscating income-earning assets from the private sector, and forcing private sector investors to compete with each other for the more limited supply of remaining assets.***

In addition, central bank buying has already gone beyond the government bond market. The Japanese central bank now reportedly owns not only 50% of all outstanding Japanese government bonds, but also 15% of the Japanese equity market as well. And it continues to enthusiastically buy more every day. The Swiss central bank has also been an aggressive purchaser of equities. The above behaviour has already been going on for some time, and has already had a visible impact on asset pricing.

So long as this central bank behaviour continues, there will be a strong systemic tendency for asset prices to rise, irrespective of the fundamentals, such as geopolitical risks; Trump's latest Twitter musings; the North Korean threat; Brexit; Catalonia's independence referendum; the level of valuations; or the outlook for the economy, or any other such headline. This is the issue that many commentators arguing that markets 'should' be going down tend to completely miss.

But wait, there's more...

However, as if the above wasn't already enough, the world also happens to have recently begun to experience - for the first time since 2005-07 - a synchronized economic expansion, that has recently driven a sharp upward inflection in global earnings growth (albeit that this pickup in global growth still has an unhealthy degree of reliance on the continuing growth of the black-box, leveraged-to-the-hilt Chinese economy).

Furthermore, equity valuations are - despite all the stimulus that has already happened to date - while generally higher than long term averages, still exceptionally cheap relative to bonds and other available investment alternatives, reflecting the long shadow the GFC cast on investor risk appetite over the past decade. Only now does widespread confidence appear to be returning and a willingness to invest in riskier assets over (putatively) lower-risk fixed income/bonds. The rise of ETFs and robo-advisors also appears to be contributing to this reallocation - ETFs - particularly US-index-linked - have delivered strong returns over the past decade (since March 2009), and more and more valuation-agnostic money continues to pour into these index products - driven by favourable recent return-vs-volatility characteristics. Money is also disproportionately flowing into the same large-cap stocks, with a particular affinity for technology stocks starting to become notably apparent.

Private Equity (PE) in particular also looks set to radically amplify the bubble, as growing desperation for returns coupled with increasing risk appetite causes investors to chase past returns. With PE's able to boast historical returns of some 20% (not stated prominently is that these were heavily leveraged products during a secular bull market), coupled with limited apparent volatility, this 'asset class' superficially stands out as a highly attractive proposition in today's return-free world. Money is therefore likely to continue to flood into these high-fee vehicles, which will take those inflows and leverage them up 5x to buy public market equities, and any other businesses they can get their hands on. This will amplify the force of such PE inflows considerably, helping to push equity market valuations higher. This, in turn, will help the PE industry to continue to report strong returns with low volatility, and in the process drive yet further inflows, in typical bubble fashion.

Indeed, PE's putatively 'low volatility' is another highly-marketable yet fundamentally-flawed selling point. Most investors hate volatility, because it forces them to confront the reality of the inherent degree of uncertainty and risk of loss associated with any investment undertaking. Through the clever alchemy of 'mark-to-model' return accounting, PE is able to create the comforting illusion for its fund investors that a 5x leveraged equity fund is less volatile than a standard unleveraged equity ETF. Nevertheless, this illusion is likely to persist and remain self-perpetuating until the cycle turns, and if liquidity conditions remain loose, a full-blown PE-bubble of epic proportions appears not only possible, but quite likely. This bubble is likely to contribute to further equity market strength, as very large amounts of PE dollars compete for a relatively scarce degree of reasonably-priced deal flow. M&A activity still appears fairly low (still lower than 2006-07 levels) compared to where it could well peak out at this cycle - another sign that much more irrational exuberance may lie ahead.

What could stop the above pattern?

I wish to emphasise again that the above is absolutely not a prediction. Wise investors think probabilistically, and consider multiple potential future outcomes. Investors who confidently declare they can predict the future of markets, or who call definitively for crashes/crises etc, may make charismatic talking-heads on TV shows, but they generally make lousy investors.

Nor is the above something I would like to see happen - to the contrary, as I argued in my February piece - a world in which equity markets and all other viable investment alternatives are systematically and materially overvalued would be a complete disaster for investors - particularly those that want to build a business managing other people's money in an ethical fashion (I will give all the money I manage back to my investors if I can no longer find attractive investments). The above is one possible scenario, but there are many reasons why it may not occur.

The first thing to acknowledge is that the above general pattern does not preclude the possibility of short term market panics/drawdowns. The trend towards increasingly activist and (in my view) irresponsible central banking activity is one that has now been in place - to varying degrees - since the early-mid 1990s under Greenspan - albeit that the degree of recklessness has radically escalated in the post financial crisis years.

During this period, central banks have contributed meaningfully to the existence of and/or amplification of speculative booms and busts, including at least one major banking crises, by responding to each downturn with successively more aggressive monetary policy that has, in each instance, precipitated an even large boom and an even larger eventual bust in subsequent years. The late 1980s/early 1990s US commercial real estate bust gave way to the 1990s tech bubble and bust, which gave way to the US housing bubble and bust, which has since given rise to the latest iteration of market excess. Another serious bear market could occur at any time, which could then go on to precipitate and even bigger central bank response and an even bigger bubble in the next cycle, until the current cycle of central banking madness is eventually brought under control.

In addition, more pointedly, central bank behaviour and/or policy mandates could well change. There are several possible triggers for this - eventually, central banks are likely to so thoroughly discredit themselves that reform will be unavoidable, but this could take a very long time. A more likely medium-term catalyst for change could be via the political system (both direct, as it pertains to central banker appointments and mandates, and indirectly via the impact of politics on inflation).

One of the unintended consequences of central banks' incompetent and reckless management of the financial system has been that it has amplified growing wealth inequalities, which have in recent decades been allowed to rise to dangerous levels. It has done this by juicing up asset prices that have mostly benefitted the rich, while in the process boosting the incomes of high-income professionals that manage, advise, and distribute investment products (Wall Streeter bankers; asset managers/private equity players; lawyers; real estate agents; mortgage brokers; property developers, etc).

The property market in particular has been a growing source of popular angst, as more and more middle class families have had to witness their dreams of home ownership continue to fade as house prices have spiralled upwards and become increasingly unaffordable. Those that have managed to barely climb onto the 'housing ladder' have in many cases only done so by signing up for several decades of mortgage servitude (along, I might add, with the perpetual risk of financial ruin should interest rates rise, or were they to suffer an unexpected period of unemployment).

In addition, the growing social and economic divide that has emerged between the top 1% and the rest of society, and the sense of injustice engendered by watching wealthy landlords get rich tax free, while the middle class toils away paying high taxes and struggling to make ends meet, could well fuel a growing sense of resentment. Left unchecked, a political backlash and major swing to the hard left is likely to be an inevitable eventual outcome, and to the extent central banks have played a significant role in these unfortunate outcomes (they have), the eventual backlash may also extent to central bankers and their policies as well. This could result in a change in bankers' mandates, and/or a reigning in of the unchecked power these democratically unaccountable institutions have wielded.

We are arguably already beginning to see the initial signs of this. Although Trump is a Republican - not a party typically know for its socialist credentials - the underlying zeitgeist of growing middle class malaise he correctly read and capitalised on (and which his political opponents were out of touch with) likely contributed to his victory, with his protectionist, anti-globalisation, 'America first' rhetoric - all policies that are far from being traditionally right wing. A vote for Trump was a vote against the existing establishment and order of things - a vote for change, which only happens when the seeds of discontent have long ago been planted and have started to blossom. In practice, it is quite likely Trump will fail to execute on many of his promised policies and leave his supporters disillusioned, and this could well pave the way in the next election for a hard-left Bernie Sanders type figure to emerge and fill the void. Something similar can likely be said about the dynamics of Brexit.

Meanwhile, New Zealand has recently elected a Labour Government, while unceremoniously throwing out the National party after nine years in office. This is likely in no small part due to growing dissatisfaction on the part of middle New Zealand with spiralling house prices - an issue on which the prior National government not only showed poor leadership, but demonstrated a dangerous degree of complacency, and which ultimately cost it the election.

A swing left may also eventually result in much higher rates of inflation, driven by some combination of increased protectionism; rising labour unionism and other pro-labour policies; and more radical wealth redistribution efforts (which have the impact of reducing aggregate savings and boosting aggregate demand, as the poor and middle class have a high propensity to spend, whereas the wealthy have a high propensity to save). Rising inflation will force central bankers into tightening monetary policy even if they do not wish to do so, although it is likely that their reading of the changing political winds will have already induced them to do so (central bankers, let's not forget, have politicked their way into office, rather than via distinguishing themselves as practical economists; most of them have little to no real world experience of markets and investing).

However, a politically-driven radical change in central bank policy still appears some distance away at the present time. In the meantime, despite the world experiencing a global economic upswing, global central banks continue to purchase in excess of US$150bn a month of financial assets (stocks as well as bonds), notwithstanding the Fed's recent move to a cautious tightening bias (the Fed is now running off US$10bn of its balance sheet a month). The Fed will also likely resume asset purchases at a moment's notice at the first sign of financial market turbulence as well (the 'Greenspan put' has evolved into the 'Yellen put', and will soon - no doubt - become the 'Powell put').

In the meantime, investors and asset managers - particularly those that are value rather than momentum oriented - could well be set for a very challenging time ahead in continuing to find a sufficient number of safe places to invest their money that offer the prospects of reasonable returns. For the moment, I am still personally able to find a sufficient number of attractively-priced individual securities, by sifting around in neglected corners of the global markets, including Russia, Greece, and the energy, commodity, retail, and auto industries, as well as selected financials and media companies - all out of favour sectors/regions.  However, the opportunity set grows thinner every day, and the bullish outlook for markets is a cause of continuing anxiety.


*Many conventional macroeconomic models are right in theory but only because they have said something akin to 'let's assume the world is flat, and then develop a theory of physics'. If the world is flat, they are theoretically correct. The error comes when the economists try to apply theories based on a flat-earth assumption to the real, spherical world. 

**For the record, I have not changed my view on Bitcoin. I still think it goes to zero. But as I stated quite clearly in my cryptocurrency post, it might go a lot higher before it does - indeed Bitcoin looks set to become one of the biggest speculative manias the world has ever seen - a modern day Tulip mania.

***It is seldom described this way, but in many respects central bank asset purchases represent a covert form of nationalisation of private property. The prior stream of income related to the purchased assets ceases to accrue to private holders, and instead begins to accrue to the government, and the said nationalisation of income is achieved via the use of newly printed currency. It is arguable that not only ought this policy be subject to constitutional or parliamentary oversight or prohibition, but also that this policy ought not be stimulatory to the real economy at all, as all it ultimately succeeds in doing is depriving the private sector of income.