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Troubled by bubbles

23 February 2021 Old Mutual Wealth Investment Strategists Izak Odendaal and Dave Mohr

The local equity market hit a new record high last week. The FTSE/JSE All Share Index rose above 67 000 index points for the first time, a level that seemed far away not long ago. At least one headline in a prominent local financial website asked if this points to a bubble.

It does not. Equity markets generally rise over time and should be expected to regularly post new all-time highs. Local equities have struggled over the past five years, so this latest burst is very welcome and overdue. And since the JSE has largely been led higher by strong global equity markets and local mining companies benefiting from rising commodity prices (most recently platinum), it has little to do with the domestic economy.

However, there are legitimate concerns over the bubbles in other parts of the global financial system. Some corners seem more like casinos than markets. In fact, the absence of casinos and live sports appears to be behind some of this activity. Some people have turned to speculating as a way of defeating the boredom of lockdown, sharing the thrills and spills with peers on social media forums. All this is aided by free trading platforms such as Robinhood.

What is a bubble?
Financial bubbles happen when investments completely lose touch with reality and end up being driven higher by investors who are lured by price surges and believe they will sell for a certain profit. Bubbles are not necessarily caused by schemes and scams, but these are typically present. When they pop, it’s worse than just a bear market. There is often a permanent loss of capital. However, just because there is excess and overvaluation in some parts doesn’t mean the whole market is in a bubble.

There are many examples of financial bubbles, but the 17th century Dutch tulip mania is one of the first recorded and perhaps the best-known examples. It began with solid demand for tulip bulbs, especially exotic varieties, from the growing merchant class. Since tulips can take years to cultivate, prices increased. Higher prices attracted speculators, and eventually things got so out of hand that the cost of a single prized tulip bulb peaked at the equivalent of 10 years’ wages. Today, it seems absurd for a flower to cause such a speculative frenzy, but these things are sometimes obvious only with hindsight. At the time, speculators convinced themselves that tulip prices could only rise with near infinite demand and limited supply.

Although there is no single definition of what a bubble is, Charles Kindleberger’s 1978 classic “Manias, Panics, and Crashes” provides a useful starting point. He sets out five stages of a speculative mania, but also cautions that no two episodes are 100% alike.

The first stage is ‘displacement’, something new that comes along to shake things up. It could be anything from a new technology or financial innovation to a policy or political change. Or even a pandemic. This creates new opportunities in one or more sectors of the economy.

The next stage, the ‘boom’, happens when the sector starts experiencing real growth, and optimism rises. Rising asset prices fuel debt-financed investment and further growth.

The third stage is ‘euphoria’. At this point investors begin to lose touch with reality. The recent past is extrapolated into the future and “rational exuberance morphs into irrational exuberance”. Skyrocketing prices attract latecomers with FOMO (fear of missing out), as we call it today. Or, as Kindleberger put it: “There is nothing as disturbing to one’s well-being as to see a friend get rich”. The euphoria stage clearly has more to do with psychology than economics.

The fourth stage, ‘distress’, comes when a change in policy (such as higher interest rates) or some other event causes at least some investors to think twice. But since the bubble relies on forward momentum to keep going, much like a bicycle, any wobble can quickly become very destabilising.

This leads to the fifth stage, “panic”. There is a fire sale, often because debts need to be repaid. Prices plunge and those who bought near the top, particularly with debt, are wiped out.

Chart 1: Bitcoin’s surging price

Source: Refinitiv Datastream

Crypto-carried away
We can apply this framework to crypto-investments too, as there is lots of evidence of markets gone mad. (There is also no point in calling them currencies as they are rarely used for transactions or for pricing things.)

The poster child is Dogecoin, created as a jokey alternative to Bitcoin in 2013 yet worth almost $10 billion, but it is Bitcoin that continues to grab the most attention.

Initially some of the optimism around crypto seemed justified, and blockchain was a promising technology with potential real-world applications. However, these days people buy it because they see others buying. Price increases attract newcomers, leading to further price increases. The latest surge past $50 000 following Tesla’s $1.5 billion purchase has added to the chorus that crypto is going mainstream. But what this means, again, is buying because others bought and made a fortune.

Since there is no underlying cash flow, no one can say what the fundamental value of Bitcoin should be. It could be $0, it could be $100 000. It is worth simply what people are prepared to pay for it. However, what should give any investor immediate pause is that the price more than quadrupled in six months. Can a rational assessment of its value change so much in such a short space of time? And while it is not in itself a scam, there have been plenty of dodgy dealings associated with it, including the high-profile collapse of Stellenbosch’s MTI.

Pop!
The broader economic impact of bursting bubbles depends on the underlying cause of the bubble. As a general rule, residential property bubbles are the worst. They tend to be widespread (many people try to get in on the action) and are associated with increased household borrowing. When house prices slump, the outstanding mortgage debt doesn’t and household balance sheets end up in very bad shape. Even when interest rates fall, they do little to stimulate the economy because nobody wants to borrow, having burnt their fingers. Banks typically also end up with high levels of bad loans and are reluctant to lend even to creditworthy customers. It leads to a deep recession and tepid recovery, exactly what we saw after the 2008 financial crisis.

A stock market collapse, on the other hand, does not necessarily have much broader impact beyond the fact that shareholders are now poorer on paper. Most established companies are largely unaffected by moves in their share price.

However, in every bubble there are usually companies that rely on ever rising share prices to raise capital and sustain operations. If the equity bubble bursts, they don’t survive. Investors in the number of unprofitable start-up companies that have been listing recently therefore have cause for concern. The end of the dot.com bubble saw only a mild US recession, but many unprofitable and speculative tech companies disappeared for good. The big players also saw their share prices plunge but they are clearly still around today. For example, Microsoft’s share price tripled from 1998 to early 2000, and then fell 60%. It took until 2016 to recover its 2000 peak, but throughout this period the company was growing its sales and generating profits.

Some bubbles actually leave a positive economic impact, even if most investors lose their shirts. The canal and railway booms of the 18th and 19th century ultimately delivered poor financial returns but contributed to industrialisation in the UK, Europe and the US by dramatically lowering transport costs.

Tech wreck?
Back to the present. Is there a bubble in equities, particularly the high-flying technology shares? The last time the US equity market was this expensive was just after the peak of the dot.com bubble. The ratio of price to 12-month forward earnings of 22 times compares to a long-term average of 15. The big tech stocks account for a large part of this rating. One key difference between today and 2000 is that real interest rates are negative now, while they were 4% back then. There was an attractive alternative to equities, but not today. The picture could change were interest rates to rise sharply.

Chart 2: US 10-year real interest rates, %

Source: Refinitiv Datastream

To repeat, just because something is expensive doesn’t mean it is a bubble, and being overly optimistic is not the same as being deluded. A very simple test from hedge-fund notable Cliff Asnes is that an investment is in a bubble when it trades at a price “no reasonable future outcome can justify”.

Is there a reasonable future where the big technology companies grow into their elevated valuations? Yes, for instance if they leverage their platforms to move into adjacent markets, as Apple is doing by entering the car-making business.

These companies are already very profitable. Microsoft, Apple, Amazon and Alphabet (Google) together made a record $150 billion in profits last year. They are unique in the sense that they potentially benefit from increasing returns from scale. The bigger they are, the bigger they can get. Traditional companies have diminishing returns, since size brings complexity and inefficiencies.

A reasonable future outcome is not a certain outcome and there are also reasonable scenarios where these near-monopolies face regulatory headwinds or new competitors. It is always risky to bet on a single scenario materialising. Diversification remains important, more so when valuations are stretched.

Expected returns
Historically, investing when markets are expensive has resulted in subsequent periods of disappointing returns. Therefore, when one area of the market is extremely popular, it has historically paid off to look for other investments that are less popular or downright unpopular. There are areas of the US market that are reasonably priced, and of course there are attractive opportunities within the global equity universe outside the US. One can sensibly remain invested in the market while still avoiding the most extreme areas.

Counterfactual
What if we’re wrong and the US market is dangerously overvalued? The experience from the dotcom bubble is useful here. Firstly, adjusting for inflation, and reinvesting dividends, it took the S&P 500 13 years to return to its 2000 peak, but eventually it did. Over this period, bonds performed very well, and was a very handy diversifier, while emerging markets equities also had a good run. For investors with a long-term horizon it almost always makes sense to remain invested provided it is in diversified portfolios and broad indices. Thousands of individual companies go bankrupt, and there are examples of individual equity indices trending sideways for a few years, but you’d be hard-pressed to find examples of broad diversified portfolios losing money over the long term.

Chart 3: Forward price:earnings ratios

Source: Refinitiv Datastream

Secondly, when US equities started a long decline in 2000, the JSE was not immune, but it fell by a lot less since it was much cheaper to begin with. It also recovered much more strongly. The current gap between SA and US equity valuations looks very similar to the turn-of-the-millennium, when first the emerging market crisis of 1998 and then land invasions in Zimbabwe (2000) cast a long shadow over South Africa in the eyes of investors. That was all forgotten when the China-led commodity boom took off.

In summary, there are examples of irrational behaviour when it comes to individual securities, but the broad US stock market is not in a bubble. It does seem pricey, though, and therefore unlikely to deliver the stellar returns of the past decade. There are areas of value in the US market that active managers can exploit, and of course other global markets also trade at much lower valuations. If you add this to the fact that domestic equities are still attractively priced despite the recent rally, and that our government bond yields are still very high, the prospects for South African investors from a diversified portfolio are looking good.

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