In a recent TPI Podcast we talked at length about a potential Stockmarket Bubble and I also wrote a bit in a Weekend Charts Blog. Both times I think I promised to write a more detailed Blog specifically on the subject and in theory as I start writing, this Blog is intended to fulfil that commitment. You can find the Podcast here by the way:
First off I must make it very clear that I am not saying a Bubble is definitely going to happen; nobody can foresee the future (least of all me !!) and all we can realistically do is to assign probabilities to possible future outcomes. Using such an approach, I would guesstimate that perhaps a year or more ago, I would have said that a Bubble was a very low likelihood, perhaps something like 5 to 10%. The fact is that Stockmarket Bubbles are very rare and hence a low probability is appropriate, but with the various factors that I will get onto shortly, I would now say that the probability has risen to perhaps 15 to 20%.
Really the precise percentages are meaningless but I think it is fair to say that the probability of a Bubble has gone from quite remote to quite possible. What is important to grasp, is that however we attempt rather pointlessly to assign a number to it, the probability has increased and the higher that Stock Indexes grind up, the higher the probability gets.
What would a Bubble mean for us?
This is the really interesting and exciting part – so make sure you are wide awake and thinking. Go and get a coffee if you unable to focus.
Let’s forget the previous few paragraphs and glide seamlessly over to a fantasy world where we know a Bubble is going to come for certain. In such a case, we will be offered the opportunity of a lifetime, or at least of a generation, to make ridiculous amounts of money and by keeping calm, rational and with our wits about us, there is no reason why we cannot do this unless we are really stupid (and perhaps worse still, if we get too greedy).
And not just that, if we do get a Bubble, then we can ride the crazy run up by being Long on Stocks/Indexes and we can get out perhaps before the ultimate Peak or perhaps just after it has turned. Of course that is not easy and no doubt on the run up we will sell too early and on the way down we will sell too late; but it doesn’t matter – in such a bonkers run up and subsequent Crash, even if we are totally imperfect in our timing, we can still take out huge chunks of Profit by being disciplined and aware of what it taking place.
It all sounds very easy but of course it is not – and lots of people will lose barmy amounts of money. However, the advantage that many of the older amongst us has, is that we have in the majority of cases I suspect, lived through such an event not all that long ago, back in the Dotcom Boom in 1999/2000. Back then I had utterly no idea what I was doing with Stocks and Markets, and to be fair I probably don’t have much more of a clue even now. But the difference is that I have lived through the pain and later in this Blog I will outline the things to watch out for that clearly indicate the Top and there are several of these which we can exploit as long as we don’t get carried away in the euphoria and end up losing our minds and losing a mint.
What happened in the 1990s
As I keep stressing, it is impossible to know if we will get a Bubble and what kind of shape it might take on, however, I reckon the kind of run we had through the 1990s culminating in the Dotcom Peak is perhaps a good model. The Chart below should show the period from about 1985 to 2005 for the main US Index, the S&P500, and I took this Chart from the link below:
If you look at the bit between 1990 to 2000 you should be able to see the steady run up right through the decade and maybe we will see this sort of thing again. The 1920s followed a similar pattern from what I understand and of course we cannot know if the Peak would be 10 years away or just a few years away.
Why I see a Bubble as extremely possible
There are really loads of factors that are pointing this way and I will simply go through them in a series of sub-headings – so here goes:
QE and NIRP
This is the most crucial element and without this I doubt we would/could get a Bubble. This is something that is arguably unique in the history of the Global Financial System and it is very much an Economic experiment which the ‘Powers that be’ think they can control but it is highly likely that the usual unforeseen consequences that come along with Economic jiggery-pokery, will result in outcomes that are not what anyone expected.
QE is Quantitative Easing and this in essence means that the Central Bank of a Monetary Area creates Money out of thin air (it is like printing Money but in this case it is simply Computer Entries on a Central Bank’s Balance Sheet) and it then uses this Money to buy Government Bonds in the Public Bond Markets and the theory is that such activity will boost Economic Demand.
There are a couple of effects which follow from this such as swapping a Bond for some Money so that a Major Institutional Bank can lose something that is in effect ‘dead’ Money and it then has fresh Cash to buy another Asset. Because Bonds have such poor Yields, it is highly likely that the Bank buys Bonds with higher Yields which comes along with higher Risk (these could be Corporate Bonds rather than Government Bonds) or it buys Sovereign Debt (Bonds issued by a Government) that is riskier and therefore pays a higher Yield. For example, Bonds from Argentina pay much higher Yields than Bonds from Germany but of course you take lots of Default Risk when holding Argentinian Bonds.
In addition, the Bank could use the Money it got from selling Government Bonds back to the Central Bank, to buy Stocks (Equities) and these are again ‘higher up the Risk Curve’ but they offer much better Yields via Dividends and this effect is no doubt helping to fuel the Stockmarket Bull Run. This process of, in effect, forcing Banks to go up the Risk Curve means that there are loads of Buyers of Bonds and Stocks who perhaps don’t really want to be doing this and can see the inherent Risks, but in reality they have little option as they need the Yields to be able to run their Business Models efficiently (Life Insurance Companies and Major Banks are particularly in this camp). And as these Banks buy more and more High Risk Debt and Equities, this buying pressure has the side-effect of lowering Yields even more and of course it is also pushing up the Risk. Already I am sure you are starting to see the potential pitfalls here !!
But of course this lowering of Yields simply by creating ‘Magic Money’ has another useful side-effect for the Authorities and especially for Governments, because it lowers the Cost of Borrowing for the Governments and in recent times they are under immense Political Pressure to borrow more and to invest in Infrastructure in the Countries concerned etc. After the Credit Scrunch many Governments in Western Countries have run up immense piles of Debt and the cost in servicing that Debt by the Coupon Payments on the Bonds they have issued is immense. By getting the Central Bank to buy back Bonds with higher Yields and then issuing fresh Bonds with lower Yields (this is possible because the Yield at which a Bond gets newly issued is related to the Bond Yields available in the Bond Markets), this means a Government can lower its Debt Servicing Costs and this also enables it to borrow more.
As I am sure many Readers know, since 2009 the UK Government has been borrowing crazy amounts of Money despite the myth of ‘Austerity’ and these artificially low Interest Rates on their Debt has enabled much of this.
Things have got so utterly out of hand that in Japan the Central Bank has even been using QE to buy Equities in large Japanese Companies. To me this is astonishing and I simply can’t see how this will work out well.
NIRP is ‘Negative Interest Rate Policy’ and again the key effect here is to get Interest Rates down which benefits Governments in terms of their cost of borrowing but the theory is that it encourages Consumers and Businesses to borrow money to invest elsewhere to create Economic Activity. The theory is all well and good but in practice it doesn’t appear to work quite in the way that Central Banks would like and rather than the borrowed money getting invested into Projects such as expanding a Factory or developing new Products, it is far easier for Entities to take the money and to re-invest it in Financial Instruments such as Stocks. In fact, that is precisely what I have been doing myself with recent Car purchases – I have got both of them on Loans at crazy low rates and on very long terms (8 years believe it or not) which means that my Cash can stay in Stocks where I expect to get a far bigger return.
NIRP is where a Central Bank sets the Bank Base Rate (in essence this is the lowest ‘price’ of Money in an Economy) and then the Major Clearing Banks can borrow at this Rate and of course they then lend the money out to Consumers and Businesses at higher Rates and they make their Profit on what is known as the ‘Net Interest Margin’ presuming that the borrower pays back the loan and does not default. Of course this is how things should normally work but because Interest Rates have got so crazily low, it also means that Savers cannot get a decent Return on Cash they deposit at a Bank and yet again this has forced People to buy Equities (many ‘normal’ People will not buy Shares directly like I am sure the majority of WD Readers do, but they will invest via Unit Trusts etc.).
In fact, what I just described is not actually NIRP – the NIRP bit comes in when Interest Rates get so low that when you subtract the effect of Inflation, you get a Negative ‘Real’ Interest Rate. So for example, in more normal times when the Base Rate was perhaps 4%, you might have Inflation at 2% so the ‘Real’ Interest Rate would be 2%. However, when we have NIRP, the Real Rate has gone minus so for example, the Base Rate might be 1% but Inflation could be 3% so you then get a net effect of Negative 2% on the Real Interest Rate. When this happens, you are in effect getting paid to borrow money. That is truly crazy stuff but again it encourages Entities to borrow and to invest the money into Stocks and higher Risk Investments. Exactly the sort of things that can fuel a Bubble.
I think the potential for QE and NIRP to go really horribly wrong is utterly off the scale (turned up to 11) and there are so many side-effects that could combine to help pump up the Bubble. We also might have got to a situation where Local Economies have become so distorted by and dependent upon ‘Cheap Money’, that they won’t be able to survive if the tap was ever turned off and we recently had a good example of this where the Global Economy appeared to be starting a bit of a downturn and the reaction of Central Banks was to do more QE and to lower Interest Rates. It is like a Junkie who is now addicted and the Drugs cannot be taken away or the patient will collapse and die.
The evidence is even stronger when you consider that Central Banks and the US Federal Reserve (The Fed) tried to raise Interest Rates but didn’t manage to get very far before the trouble started. This shows a big dependency on Cheap Money perhaps and implies that every time there is even the merest sniff off a Downturn, we will see Central Banks come in with more QE and NIRP. The idea that this will work indefinitely seems rather dubious in my view and of course all these rounds of QE are highly likely to pump up the Bubble.
The theory is that QE and NIRP should be inflationary, but if anything it appears to be deflationary as it makes Savers very cautious and it distorts how Money lows within an Economy. This deflationary pressure will just encourage Central Banks to do more QE and other clever wheezes to try to stoke non-existent inflation.
The Hunt for Yield
I already hinted at this in the text above but it is worth covering it in its own heading because it is such an important factor. There are millions of people around the World who are desperate to own Assets that give off a Revenue Stream in the form of Coupon Payments (Bonds) or Interest Payments (Cash in the Bank) or Rental Payments (Property) or Dividends (Equities) etc. When you consider this kind of list (this is not exhaustive, there probably are some other ways of buying an Asset that gives a Revenue Stream), many of them such as Cash, give very little % Yield and this makes Assets that appear to pay a higher Yield much more attractive.
It is all relative. When Cash used to pay a chunky Interest Payment which might have been as much as 5%, then Stocks needed to pay a Dividend Yield up around 7% or 8% to justify the extra risk that taking on Equities can expose the Buyer to (the ‘Equity Risk Premium’). As the Yield on Cash has almost disappeared and as Bonds have seen their Yields become tiny, then Buyers are prepared to pay more for Stocks which drives down the Dividend Yield %.
However, even though we have seen this effect for most of the Bull Market since 2009, the Dividend Yields that are available on Stocks are still highly attractive when you consider what you can get on Bonds and Cash and the relative Risks. This is because even though Share Prices have risen immensely over the last 10 years or more, the Actual Amount paid out as a Dividend has risen for lots of Companies and this means that the Dividend Yield % is still very good.
For example, it is still possible to buy some Quality big FTSE100 Companies with Dividend Yields over 4% and many over 5% - although the latter are starting to get rarer I see. However, as QE and NIRP continue and Buyers are ‘forced up the Yield Curve’ then we could see a situation where Dividend Yields of perhaps 3% are still seen as relatively attractive because they are the ‘only game in town’ as everything else barely pays out anything.
As we see an increasing proportion of populations in Western Countries becoming of Retirement Age and living ever-longer lives, the demand for Quality Assets with decent Yield % will only increase – and this could help fuel a Bubble in Stocks as there is nowhere else to get a decent Yield. And of course it is not just Individual people buying such Assets, there are many many more who buy indirectly via Pension Providers and Fund Management Companies etc., and these kinds of organisations are also part of the ‘Hunt for Yield’.
Wall of Money looking for a home
This is very much related to the ‘Hunt for Yield’ which I covered above but in this case it is a concept Economists go on about whereby fast growing Emerging or Emerged Economies like China, Singapore, Middle East Oil Exporters and India etc. are generating huge Surpluses from selling Goods overseas to the West and all this Money needs to be invested somewhere so it is coming back to the West looking for Assets to buy. This is yet another factor fueling the demand for Stocks and stuff like London Property where it can get the benefits of a reasonable Rental Yield, the UK Legal System and thankfully it is not a War Zone (yet).
That’s it for Part 1, in the next Part I look at loads more factors and by the time you finish reading it all I suspect you will see why I am giving more weight to the idea that a proper ‘Full-on’ Bubble is really quite possible. I will also look at how we can identify when we are at the Peak and also how we can maximise our gains on the way up and how we can get out with as much Profit as possible.
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