If you have ever taken children to an illusion museum you will know about infinity mirrors. Look into one and the lights around the edge appear to head to infinity. It gives you a sense that the path to the future is both clearly defined and well lit. This is what stockmarkets feel like in periods of intensely loose monetary policy.
When money is constantly cheap and available everything seems straightforward. Markets go up whatever happens, leaving investors free to tell any story they like about why. It is easy to believe that tech companies with profits in the low millions are worth many billions. Or, as one fund manager told me last month, that traditional equity valuation methods are no longer the point – all we need to think about before we invest these days is how the company in question can respond to digitalisation.
Nothing else matters. You can believe it is perfectly possible for a company to have no obvious end to its cash-burning stage, but that its valuation will keep rising. Perhaps it is worth financing three separate dockless e-scooter brands on the streets of Madrid, for example? (Last week I spotted Voi, Wind and Lime scooters scattered around the pavements.)
You can believe that the Phillips Curve (which describes the relationship between employment levels and inflation) is genuinely dead: that labour will never regain the power to really make a difference to real wages. Or that, even if it did, workers are becoming such a tiny part of the corporate cost base that it simply doesn’t matter to profit margins. And you can believe that global companies will never be subject to the tax or regulatory whims of sovereign governments; that this time everything is different.
It has all been a central-bank induced illusion
It is all an illusion, of course. Turn the power off at the museum and the bright lights of a comprehensible kind of infinity disappear. Turn off the liquidity taps at the world’s central banks and so does the ability of the market to believe seven impossible things before breakfast.
That is why nearly all equity markets have had a horrible month. Almost all indexes are down – by as much as 14% over the last four weeks, and 24% on the year. The only major markets in positive territory over a year are those in the US and Russia.
The surprising thing here is not so much that markets have tanked, but that – given that they are supposed to be discounting mechanisms, taking in and reacting rationally to all available information – it didn’t happen sooner.
US monetary tightening has not exactly been kept under wraps. The dual approach of cutting its asset holdings while raising rates has been well advertised. The Chinese government’s intention to deleverage has been no secret either. Nor has the tapering of quantitative easing in Japan or the intention of the European Central Bank (ECB) to pull back from it completely. The ECB’s asset purchases fell from €60bn a month in 2017 to €30bn in January 2018. Its president, Mario Draghi, expects them to halve again in this quarter, with a view to ending them completely by the end of year.
All this tapering and hiking might or might not be a good idea – not everyone would necessarily want to tighten monetary policy in Europe at a time when the German economy is looking iffy and Italy is attempting to assert its fiscal sovereignty.
Investors once again have to focus on cash and valuations
Whatever you think of it, there is no doubt that the liquidity lights, if not already off, have been dimming for some time. Suddenly what matters is not how much money is being printed, or when and where, but where we find ourselves in reality. In the case of stockmarkets, that means politics starts to matter again – but, in the main, it means investors have to start focusing properly on cash and valuations.
October shouldn’t be seen as the end of the bull market (look at the annualised performance numbers for most markets and you will see that it ended some time ago). But this month can be recognised as the point at which the market shifts from being driven by liquidity to being driven by fundamentals. For those badly positioned going into such a change (less thoughtful growth investors, perhaps) this is nasty. For the rest of us it is good news, twice over.
First, some of the things fund managers believed a few months ago could well be true in part. US corporate profits look fine. Around 40% of S&P 500 companies have reported in this earnings season and some 80% of them have managed to produce a positive surprise; digitalisation may well be about to transform productivity in developed economies; and there is as much scope as ever for conventional industries to be wiped out by canny disrupters. (I still firmly believe, however, that Madrid needs between zero and one provider of e-scooters, instead of between one and three.)
Second, stockmarkets outside the US really are not that expensive any more and pockets of them are beginning to look like they offer some value. That should please long-term investors.
It should also be absolutely thrilling to the active investment industry. This sort of shadowy environment is exactly the kind in which they can have another go at proving their special stockpicking skills are worth paying for.