Are the markets going mad? That is a question many investors might have asked in recent weeks, as stocks in the UK, eurozone and US have soared – even as bond spreads decline.
* Gillian Tett, “Markets Insight: Phoney QE peace masks rising risk of instability”
The public discussion of bubble-like conditions in the financial markets is missing the forest for the trees. Gillian Tett and others focus on data patterns, index movements, and other market metrics while ignoring the larger question of what is driving this behavior. Her title implies that it’s all about QE (quantitative easing) by central banks. The financial repression induced by QE is quite influential in the markets, but a “bubble” is motivated by much more, which I outlined in my just-previous post. As the radio commentator, Paul Harvey, used to say, “there’s the rest of the story.”
A key driver of a bubble is “new era” thinking, the belief in a new paradigm, the conviction that the rules have changed permanently, in some fundamental way. As Sir John Templeton once said, “The four most dangerous words in investing are ‘This time it’s different.’” Those words prompted the title of the iconic book on financial crises by Carmen Reinhart and Kenneth Rogoff.
“New era” thinking has preceded every one of the major market busts in recent memory. Leading up to the Panic of 2008 was the belief that housing prices could only rise and that demand for housing was practically unlimited. Leading up to the bust of 2001 was the Internet boom and the belief that new information technology would radically and rapidly change all business models (that may happen, but not at the speed believed in 1998-99). Financial crises of the 1990s in Russia, East Asia, and Latin America were brewed in visions of long-term rapid economic growth and the ability of those regions to handle massive inflows of “hot money.” I could go on at some length, but you get the picture.
If we are in the onset of a new “bubble” today, where is the “new era” thinking, and on what is it predicated? Consider these possibilities:
· Shale gas, fracking, and permanently lower energy prices for the developed economies. I can find no one who thinks this isn’t a big deal. Some of the analyses I’ve seen suggest that the economic impact of shale gas will be huge. But in the media it is hard to separate the rigorous analysis from the buoyancy and bloviation of “new era” thinking .
· Austerity works. Government actually reduces its debts and deficits without triggering revolutions or social unrest among the long-term unemployed and under-employed. Economies grow. Bondholders rejoice, as will Tea Partiers and Libertarians. This “new era” vision could be a long shot, as Keynesians will be the first to argue. But some radio talk show hosts make it seem just around the corner.
· New technology redux. Last week, I heard Jeffrey Immelt, CEO of GE, extoll the rise of the Industrial Internet, in which machines talking to one another will dramatically improve manufacturing efficiency and profitability. For instance, he says that such improvements have reduced the labor content of GE’s jet engines to only 5% of the total cost per engine. In Immelt’s view, enhancements in new technology will drive manufacturing back to America. This may be good for corporate profits, but what about employment and consumer spending?
And if you hang around a university long enough, you’ll hear late-night student bull sessions spin out many more possibilities. The three “new era” visions I mentioned are plausible; over time, any one of them could turn out to be true. But they sure warrant critical reflection. As Yogi Berra said, “It’s tough to make predictions, especially about the future.”
Critical reflection on the “new era” sentiments is how analysts and pundits could usefully shed some light. In particular, four dimensions beg for attention:
· Profitability. Bigger is not better. Better is better. The realization of more economic activity is useless if it does not generate benefits in excess of the costs to produce those benefits. How profitable will be the “new era”?
· Timing. How soon will the net benefits of the “new era” arrive? How long will those benefits last?
· Growth. Will the net benefits change over time? With they grow? Will they decay? How fast?
· Investment. What’s the outlay necessary to realize this future?
These four factors are the underpinning for valuing just about any asset and should prompt a host of probing questions about any of the “new era” scenarios.
In my experience, it is good questions, rather than fervent opinions, that mark the successful investor. I don’t think that the popular conversation is asking enough questions about the fundamentals that might possibly underpin the current market conditions.
Whether we’re in the early stage of a bubble or not, investors are well-served by critical thinking about firms and market conditions. You’ll find plenty of it at the forthcoming University of Virginia Investing Conference, November 14-15, 2013 at Darden. The theme of the conference is “Finding Opportunity in an Unpredictable World.” We already have a line-up of impressive speakers and stimulating sessions. Mark your calendar.