While financial markets continue to hit record highs, we need to ask whether they are simply overvalued or already in bubble territory.
Almost all equity and bond markets are up. And with US Federal Reserve chair Janet Yellen only talking about financial stability, rather than signalling the direction of interest rates, financial markets seem to be fearless, waiting for traders to return from their summer holidays to begin another bull run. Broadly, the MSCI advanced market index is up 10.9 per cent since the beginning of the year in dollar terms, the emerging market MSCI index is up 24.7 per cent, and the world bond market index is up 7.4 per cent. According to Goldman Sachs, the total real return for the S&P 500 for 2009-17 is the second greatest post-war bull run after 1990-2000.
Nominal financial asset returns this year have already exceeded the long-term average of a balanced portfolio of bond/equity of 7 per cent per year for the 1926-2016 period.
Part of the global optimism, despite geopolitical uncertainties, lies in the fact that there is finally some consensus that the world is undergoing a more broad-based recovery after the 2007-2009 global financial crisis. With the US dollar weakening somewhat and China maintaining stable growth, commodity prices are slowly moving back up.
A lot of the optimism in the stock market has been in technology stocks, with the NASDAQ Composite Index up 16.6 per cent so far this year. Corporate profits in the US and China are also recovering somewhat, which seems to justify higher valuations, while Europe is bottoming out and recovering. But it can also be argued that the recovery in corporate profits is due to exceptionally low interest rates, that cannot be sustained if central banks begin to normalize 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 lowered, it is only a matter of time before the Fed returns to “normal” interest rate levels, which will inevitably hit the markets.
Those 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 that went full-blown in 2008/9, even though subprime problems surfaced in 2007.
Re-reading Charles Kindleberger’s Mania, Panics and Crashes reminded me of his definition of the historical phases of financial crashes. First, there is a period of “displacement”, causing speculation, credit and monetary expansion. Second is a phase of overtrading, financial distress, and perhaps the exposure of fraud 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, behavior”. In the South Sea Company bubble of 1720, the displacement was the growth in joint-stock companies in Britain. The company was one of the earliest public-private partnerships, given a monopoly on the South American trade (especially the lucrative slave trade), 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 behavior of some tech stocks and bitcoin this year. South Sea share prices were propped up by allowing investors to buy shares on credit. Sound familiar? Inevitably, as the company could not pay its dividend and investors buying on credit had to sell, the share price collapsed back to £100 before the year was out.
The displacement in the 21st century is the tech boom. Everyone thinks there are fortunes to be made, but none is 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 it isn’t the liability of anyone. So its value is totally dependent on finding the next gullible buyer.
We are in a liquidity flood, founded on the current monetary logic that debt addiction, like that to drugs, can be cured by providing more debt at near-negative interest rate costs. So we have too much money chasing speculative cyber-wealth.
Physicist Isaac Newton, who lost a fortune in the South Sea bubble, said, “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”.
This article first appeared in the South China Morning Post on September 1, 2017. The views expressed in the reports featured are the author’s own and do not necessarily reflect Asia Global Institute’s editorial policy.