The four most dangerous words in investment are: “It’s different this time.”
That was one of Sir John Templeton’s many wise observations about markets. When people start reaching for reasons that a bull or bear market will go on forever, it’s time to position yourself for things to go into reverse.
I haven’t heard anyone say: “it’s different this time” about the current market. Templeton’s warning is too well-known for anyone to say anything so blatantly tempting fate.
But there’s a related three-word phrase that I’m starting to think should be added to the hall of infamy.
When you hear the words, “wall of money”, it’s time to start shuffling towards the exit door…
‘Wall of money’ is a classic capitulation phrase
In this morning’s FT, John Gapper looks at the sudden revival of the merger market. We’ve just seen two huge deals announced: computer company Dell being taken private for $24.4bn, and US cable company Liberty Global buying Virgin Media for $23.3bn.
One private equity executive comments: “A huge amount of liquidity has been sitting in cash or negative yield bonds out of fear. As that recedes, a wall of money is flowing into financial assets.”
This is similar to the ‘Great Rotation’ argument we’ve heard so much about recently. This is where a wall of money is going to flood from bonds to stocks as investors become more upbeat.
So what worries me about the ‘wall of money’ argument? What bothers me is that it’s a classic capitulation phrase. It gets broken out when markets are rising and no one can quite see a good reason for it. It’s a sign that the final doubters are giving up and have just thrown in their lot with the bulls.
The last time I remember hearing it bandied about so regularly was in 2007. What you have to remember about 2007 is that although stock markets were hitting new highs, it was becoming clear that all was not right with the world.
Mainstream economists, central bankers, and the politicians who were in charge at the time, like to pretend that the crash came out of the blue. This is probably the biggest lie of the financial crisis.
Plenty of people had the jitters back then. Few were as aggressively bearish as we were, but any halfway sensible City person you spoke to had a sense of foreboding.
Property markets around the world were even more obscenely overpriced than they are now. The oil price just kept rising. Central banks were gently raising interest rates. Ludicrously risky assets were selling at tiny yields. In the US, house prices had started to fall, and bond markets were starting to get stressed.
So there were lots of reasons to feel nervous. But equity markets just kept rising. So people clutched at straws to explain why – which is where the ‘wall of money’ came in.
Back then, the great wall of cash was being stored up in the sovereign wealth funds (remember them?) The SWFs were going to take over the world, and being government-run, the argument went, they wouldn’t care what price they paid.
Of course, in the end the Western banks went bust, and the SWFs spent that wall of money (mostly profitably, to be fair to them) bailing them out.
The point is, there’s always a ‘wall of money’ somewhere. As an Economist article – ironically enough, from 2007 – points out: “As for the wall-of-money argument, such theories have been heard before, notably in the late 1980s when Japan was investing heavily in American property and the odd movie-maker. Those purchases proved a bad deal for the Japanese and an inadequate support for asset prices.”
A ‘wall of money’ is already flooding in via the bond market
What people seem to miss is that there’s already a wall of money coming into the equity markets via the bond markets. Central banks are printing money and buying bonds from investors who currently hold them.
That’s a load of money that wouldn’t be in the market otherwise. And one way or another, that money is finding its way into other assets.
So the biggest threat is that the Federal Reserve or the rest of the world’s central banks decide to call a halt to quantitative easing (QE). That would leave the ‘Great Rotation’ high and dry as rising interest rates scuppered both bond prices and share prices.
Now, I will freely admit that I find it hard to see exactly what could make Fed chief Ben Bernanke decide to swear off QE. He sees money printing as the solution to all problems, after all.
But it’s not beyond the realms of possibility. For example, an interesting blog by Gavyn Davies at the FT notes that Professor Jeremy Stein, a new Fed governor, is clearly worried about credit bubbles.
He reckons that the significant amounts of high-yield debt (‘junk’ bonds) being issued “suggests that markets are over-reaching for yield”. He also thinks that the only solution to prevent this might be to raise interest rates. “Changes in rates may reach into corners of the market that supervision and regulation cannot.”
So how can you plan for something like this? The main thing is to stick with cheap assets – such as Japanese and European stocks – and to make sure your portfolio has exposure to a diverse range of currencies. You also want to own gold as insurance.
If you can’t resist having a punt, then by all means look for more speculative stocks. But have a price target, and be sure to protect any profits you make in case the market turns nasty.
In this week’s MoneyWeek magazine, our Roundtable experts look at various ways to protect your portfolio, and some more speculative stocks to profit from the ‘dash for trash’. Subscribers can read it now – if you aren’t already a subscriber, sign up now to get your first three issues free.
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