The biggest threats to today’s markets

published 1 July 2014

140701-nasdaq — 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."

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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

"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.

What could derail today's markets?

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 easingdeployed.

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

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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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.