The biggest threats to today’s markets

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Dance while the music plays

Right now, I’m hearing and reading a lot of stuff that reminds me of 2007.

James Mackintosh sums it up in the FT this morning. “Finding bargains in the stock markets is getting harder and harder… everything is expensive,” he writes.

But he also concludes: “If Janet Yellen, Federal Reserve chair, keeps the taps on, perhaps the froth will remain for a while yet.”

In short, pundits and analysts are acknowledging that nothing looks particularly cheap. At the same time, they can’t see what might happen to rattle the markets.

So what could make everything come undone this time? And how are you meant to invest in this sort of market?

The best quote from the financial crisis

I’ve quoted it many times before, but the most perceptive words of the financial crisis of 2007-08 came from one Chuck Prince, former chief executive of US bank Citigroup.

“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”

Chuck almost certainly didn’t understand how insightful his words were at the time. Even if he did, it didn’t do him much good when the whole edifice toppled in on itself.

But his point summed up why bubbles carry on for so long. A common misconception about bubbles is that people don’t see them coming. So if lots of people are talking about something being a bubble, it can’t be.

This isn’t true. The real problem with bubbles is ‘career risk’. For most professional investors, the number one priority is keeping pace with the market. If a hot sector is going up, and making people money (on paper at least), you’d better make damn sure you’re invested in it. If you’re not, you’ll lose clients.

Chuck wasn’t talking about the stock market specifically. But he gets to the heart of the problem. If business is booming, then as a financial professional, you’ve got to be involved.

This is why these things take on such momentum and become so overvalued. It’s why economist Hyman Minsky also had the best model for understanding how crises happen: stability breeds instability. When people become too comfortable with one set of assumptions, they act as if they’re going to be the case forever – even if it’s clear that they are not.

So what could derail all this? Previous crashes have shared something in common – it’s when the assumptions that support the bubble can simply no longer be supported by the reality.

“Dotcom companies don’t need to make profits.” That daydream was shattered in 2000. “It’s impossible for US house prices to fall on a nationwide basis.” That one went up in smoke in 2007. “Financial innovation and Alan Greenspan have abolished risk.” That one followed rapidly in 2008.


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What could derail today’s markets?

The big assumption today is that “there’s no problem central banks can’t fix”.

What could undermine that assumption and change everyone’s view of the market?

One big ‘disaster’ scenario that a lot of people still worry about is a deflationary collapse. That’s the idea that we all end up like Japan, crushed under the weight of our own debt.

I have some sympathy with this view. But I don’t believe that’s the shape of the endgame. You see, deflation is the ultimate gift to an experimentally-minded central banker. Even if deflation became the single biggest threat, you’d see new iterations of quantitative easing deployed.

If you think central banks have gone as far as they can go with money-printing, you simply lack imagination. I’d have to see the Bank of England deposit a six-figure sum in everyone’s bank account overnight before I’d even think of declaring the ‘war on deflation’ unwinnable.

This is why I think inflation is by far the bigger threat. Once inflation picks up, that’s when the central bank stops being the investor’s best friend. Unless they time rate rises perfectly (which they won’t), then inflation is likely to get ahead of them, and force them to raise rates more rapidly than anyone currently expects.

With most investments currently priced for permanently very low interest rates, it’s hard to see how that can be good news for many assets right now.

The other big risk – the return of geopolitics

There’s one other big issue that central banks can’t do much about: geopolitics. As investors, we’ve become used to either ignoring geopolitical events, or treating them as a buying opportunity. After all, that’s what recent history has trained us to do.

But I’m not so sure that the geopolitical climate will be as benign in the coming decades, and we’re getting a sniff of that now. I’m not sure that I agree with the narrative of America’s decline.

But it’s clear that other countries are on the rise, and are jockeying for position on the global stage. We now have strongly nationalist governments in India, Russia, China and Japan. All major powers. All struggling with their own economic problems. All keen to carve out their own spheres of influence.

America – for a range of reasons, from military misadventure to financial crisis – is no longer in the position to contain or influence these countries through its sheer size, economic clout, or force of personality.

To me, all of this points to a much riskier world geopolitically – a genuine step change from what we’ve seen since the fall of the Berlin Wall. And this is something that central banks really have no power over.

(We’ll be covering this particular theme in more detail in a couple of weeks’ time in MoneyWeek magazine. If you’re not already a subscriber, get your first four issues free here).

So what do you do as an investor? My advice is similar to the usual. Avoid very overvalued markets (the US). Invest in more promising, cheaper markets (Japan, some European countries, Russia perhaps). And have gold as portfolio insurance.

But also make sure that you have some cash to hand. For all my concerns, I don’t think we’ll see a 2008-style crash again in the near future. But I can certainly see there being a lot more turbulence in the coming months. And if that happens, you want to have some money to hand to take advantage of any good buying opportunities that come up.

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2 Responses

  1. 01/07/2014, Chester wrote

    To assume central banks can overcome deflation is to believe that they control events, not vice versa. Their record on being ahead of any curve, at any time, is woeful. Remember the US Fed is a private institution (not a tentacle of Govt as in the UK). It may act to the advantage of it’s bank shareholders, but will not deliberately bankrupt those that control it. You are also assuming that CB’s control real interest rates – the bond market does, evidenced by steadily rising long rates, despite CB intervention

    2008 and it’s aftermath look more like the start of a deleveraging process – this thing is just getting started. Markets are driven by internal pressures more than external events. History shows they can rise in times of war, just as they can fall without “external shocks”. The next phase down will be triggered by leverage, complacency, and the fact that all bulls are all in – heavily. Once it starts to topple, it will gain real momentum as traders scramble to remain solvent, irrespective of misguided Govt / CB activity

  2. 01/07/2014, at wrote

    The BoE has clearly stated why it is printing money, and where this money has been going, namely insurance companies, investment banks, fund managers – in other words the £375 bl has gone straight into the hands of the financial sector and much of it into equities pushing shares up to ridiculous P/Es.

    http://www.bankofengland.co.uk/monetarypolicy/Pages/qe/default.aspx

    As long as the BoE keeps printing money and giving it to the financial sector, share prices will be held at artificially high levels. On the other side of the coin, share prices really ought to go up to simply catch up with inflation (the real high inflation that households face not the mickey mouse one reported by the government) not least attributable to the QE itself.

    What amazes me is that the £375 bl could have been spent to build hundreds if not thousands of brand new hospitals, nuclear power stations, improving schools and universities – no one in this country thinks of raising the living standards of the UK citizens and long term benefits.

    My final comment would be on the calculation of P/E. P/E should be calculated on bottom line profits, otherwise it excludes interest and write downs which are taken directly from the profits and can seriously change the picture. For example looking at Tesco’s accounts they have paid 1bn in interests and have written off 3bl in the past 3-4 years, all taken away from the “reported profit”. Calculating P/E excluding these monumental losses leads to a nonsense P/E rating. The real P/E rating of Tesco is 27 and Sainsbury’s is 10.

    If you use bottom line P/E calculations for the FTSE you will see a completely different picture emerging – a picture of utter danger.

    While you can use any figure for “profits” as you like, and you can thus arrive at any P/E number. But the prudent investors should be using the bottom line profits to calculate P/E, which is called “profits attributable to shareholder”. If you use this P/E calculation you will see the perilous state of some FTSE companies. For example Tesco at today’s “low” price, already trades on a P/E of 27. Its rival, Sainsburys trades on a modest P/E of 10, both using bottom line profits to calculate PE.

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