A Risky Revival

By John Authers
Financial Times
September 25, 209

This should have been a week for traders in the stock market to feel good about life. US stocks have rallied by close to 60 per cent in barely six months since they hit bottom in March. The Federal Reserve meanwhile pronounced this week that “economic activity has picked up” – the most confident language the central bank has used for some time.

But Crispin Odey, one of London’s most respected hedge fund managers, was seeing things differently. He chose Wednesday, the day of the Fed’s pronouncement, to ruminate, both in a note to clients and in the Financial Times, that the rally was “entering a bubble phase”. The word “bubble” is highly emotive but Mr Odey could justify it. He argued that markets were being distorted by governments’ deliberate attempts to push down the price of money by buying bonds, a policy known as quantitative easing. “At some point the quantitative easing will have to come to an end,” he said, “but, until it does, this bull market is sponsored by [Her Majesty’s Government] and everyone should enjoy it.”

The remarks struck a chord. Stocks endured a sharp sell-off after his words . The fear that the unprecedented supply of cheap money from governments is creating another bubble has been circulating in Wall Street and the City of London for months.

To some, this seems alarmist. History is full of examples of strong rallies after big sell-offs – it is all part of the “physics” of markets. The all-time highs for developed market stocks, set in 2007, are not in sight. On conventional valuation measures, stocks are nowhere near as expensive as at the top of past investment bubbles. Also, the economic “free-fall” at the end of last year appears to have been halted. In addition, the Fed’s pronouncement signalled interest rates will remain low for a while – a sweet spot for risky assets such as stocks. A strong recovery for share prices since March, when there was a real fear of a second Great Depression, seems reasonable.

But the question of whether this is a real recovery or a bubble must still be asked, and there are worrying signs. The rally has been achieved with global economic growth barely above zero and unemployment still rising. The S&P 500 index of US stocks is already far above the forecasts nine out of 10 Wall Street strategists have in place for the end of the year, according to a Bloomberg survey. Concerns are prevalent that US consumers will not return to their old buying habits because of high unemployment and the debts they need to pay off.

There are also concerns that China, the other leading source of growth, has achieved that only by stoking lending – notably, Chinese stocks sold off sharply in August when authorities hinted at tightening lending.

The speed of the rally is itself cause for concern. Historically, big sell-offs have typically been followed by big bounces. But as measured by the S&P 500, the current rally is stronger after six months than any predecessor, including those that followed the lowest points of the market in 1932, 1974 and 1982.

Relationships between markets also imply unhealthy levels of speculation. Currency and stock markets had minimal correlations before the crisis took hold in 2007, while oil and stocks were usually inversely correlated. But oil and stocks have been rising in tandem this year, just as they fell together during the crisis, while the correlations between the dollar and stock markets remain remarkably close.

The implication of such correlations is alarming. Tim Lee, of Pi Economics in Connecticut, puts it this way: “[Since early 2007] 40 per cent of all movement in the S&P 500 can be predicted or explained from the movement of the yen and vice versa. If we assume, quite reasonably, that the yen and the S&P 500 should be fundamentally unrelated instruments, this implies a breakdown of efficient price discovery in the markets.”

So does this qualify as a bubble? The classic definition came from the economist Charles Kindleberger in his 1978 book Manias, Panics and Crashes. For him, a bubble is a phenomenon of mass psychology, and refers to the last stage of an investment mania, when assets are bought “not because of the rate of return on the investment but in anticipation that the asset or security can be sold to someone else at an even higher price”. The bubble bursts when there is no longer a “greater fool” ready to pay too much for the asset.

Thus, in a true bubble, stocks are wildly overvalued compared with their fundamental measures, such as their earnings or the value of the assets on their balance sheets. But conventional valuation measures of stocks suggest they are still far from a true bubble. US stocks are trading at a multiple of 18.7 times their average earnings for the past 10 years, according to the data kept by Professor Robert Shiller of Yale University. Historically, extremes in cyclical price/earnings ratios have accurately signalled long-term market peaks and troughs. The cyclical p/e stood at 27 immediately before the crisis in 2007, for example, and reached 43 at the peak of the internet boom. So it looks premature to say stocks are in a bubble.

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But an argument that this is an incipient bubble, carrying real risk that a mania will develop, is easier to sustain. First, according to Kindleberger, bubbles are driven by cheap credit. With US interest rates at zero, credit is very cheap. Second, many investors seem to be using bubble-like logic; they believe others will soon be prepared to buy even more.

There are true “bulls” who believe the global economy will recover strongly from here, bringing up corporate earnings in its wake. But others focus on the cash that has been on the sidelines, and on the pressures on fund managers who want to avoid the embarrassment of having stayed out of the market during the rally.

Mark Lapolla, of Sixth Man Research in California, who has called aggressively for investment in the market, says he “cannot emphasise strongly enough just how big a role simple game theory will play”. He argues it is large equity mutual fund managers who are driving the market. Most have done well this year, and are ahead of the benchmark stock market indices against which they are compared. “Therefore the incentive is to not lose ground rather than gain it,” he says, so they will stick closely to stocks in the main indices to protect their year-end bonuses.

Jeremy Grantham, co-founder of GMO, a large Boston-based fund manager, says: “Fund managers are simply not prepared to take the career risk of being wrong for a little while and losing business.” Thus they are herding into the index, though Mr Grantham – who advocated buying at the bottom in March – already considers stocks too expensive given the many risks in the world economy.

Another concern comes from more recent history. After the internet bubble in 2000, world stocks endured a bear market, falling 49 per cent before hitting a bottom shortly before the invasion of Iraq in March 2003. They then enjoyed a four-year rally in which the main stock indices doubled. It was rational, and successful, to be in the market from 2003 to 2007 but with hindsight it was a “fools’ rally”, triggered by cheap money, as Alan Greenspan’s Fed cut its target interest rate to 1 per cent. This fuelled a bubble in mortgages and housing.

The 2003 bounce came when stocks were not cheap – they traded at a multiple to cyclical earnings of about 21, according to Prof Shiller, when at the bottom of previous bear markets this multiple had fallen below 6. So it looks as though cheap money stopped markets taking all the medicine they needed. Similarly the current rally began with stocks trading at a multiple of 13 times the previous 10 years’ earnings. This was the cheapest in 21 years but still double the lows seen after previous great sell-offs, implying cheap money had once again saved prices before all speculative excess had been cleaned out of the system.

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The danger, in this scenario, is that lenders lose confidence in the creditworthiness of governments, which could cause rates to rise and spark a renewed sell-off. But that is not imminent.

Just as it made sense to stay in the market while the booming mortgage market kept credit unnaturally cheap, it may make sense to do so while state intervention keeps credit unnaturally cheap. And when bonds and cash pay so little, raising the risks of inflation in the future, the rational response is to buy assets that generate more reliable cash flows, such as stocks; or that act as a hedge against inflation, such as commodities. On this logic, investors may as well heed Mr Odey and “enjoy the bubble”.

They should do so now because, if this theory is right, the denouement will be painful. David Bowers of Absolute Strategy Research in London, who has been bullish for a while and advises staying in stocks, says: “It’s the last game of pass the parcel. When the tech bubble burst, balance sheet problems were passed to the household sector [through mortgages]. This time they are being passed to the public sector [through governments’ assumption of banks’ debts]. There’s nobody left to pass it to in the future.”