After my post on Wednesday, I’ve had some questions come back – which I’m quite pleased about, because it allows me to draw together a couple of things that I’ve been thinking about this week.
In Monday’s post (The Great Divestment), I said that the stock market appears to be going crazy, because:
- Prices go up because people are optimistic and greedy.
- Prices go up because people are anxious and afraid (yes, Robert Shiller – I’m a-talkin’ to you).
Then on Wednesday (Investor Diaries: Week 30):
- The world today is very different to the world five years ago.
- Five years ago, the Fed was just beginning QE round 2.
- As of this October, we’re…well…5 years on – and the tapering is only finishing this month.
- Meaning that there is so much more money sloshing around in the global market place.
- Obviously there has been a steady increase in the stock market indices (where else was the money to go?).
- But does that mean “exuberance”?
- I think far from it.
Finally, here’s a graph of the S&P 500 and the JSE All Share over the last five years:
So my thinking is, over the last five years:
- The USA has leapt on and off the fiscal cliff repeatedly.
- The Eurozone has been a dire mess.
- China has slowed down and there has been constant warning of a shadow-banking crisis à la 2008.
- Russia annexed the Crimea.
- The Middle East has been the Middle East.
- The Arab Spring came and went and came back again and it’s all looking a bit dicey.
- Japan and China threatened war with each other over some islands.
- The Islamic Caliphate.
- The Rise of Bitcoin as an alternative to the existing financial system.
- Israel and Palestine.
- Libya and her oil imploded.
- North Korea regularly threatened nuclear warfare with just about everyone.
- Iceland’s volcano downed almost all air travel in Europe for weeks.
- And the current outbreak of Ebola has been ravaging West Africa since December 2013 (yes – that’s when it broke out – we’re talking about 10 months of epidemic).
And despite much calamitous reason for the markets to be anxious, we have witnessed the greatest equity rally in history:
The question is: does that sound like a “bubble”?
Well, to answer that, I’m going to call on Robert Shiller (mentioned above in Monday’s off-hand comment). Mr Shiller, who won the Nobel last year for his work on asset prices, is sort of the market authority on bubbles. I wrote about him last year in Bitcoin: Bubble Bubble but no Toil or Trouble (a post that I’m still rather proud of), and he defines asset-pricing bubbles thus:
…a psycho-economic phenomenon. It’s like a mental illness. It is marked by excessive enthusiasm, participation of the news media and feelings of regret among people who weren’t in the bubble.
The last five years have been a long dreary series of economic disappointments and compounding global crises.
If anything, we should have seen the opposite of an equity rally.
Only we didn’t.
Very deliberately: the world was pumped with liquidity.
This wasn’t an equity rally driven by enthusiasm – it was an equity rally driven by an overabundance of money. That is: asset price inflation – where “inflation” is the monetary phenomenon, rather than a function of animal spirits/whatever.
And yes – agreed, this has led to some seeming market dysfunction (high average PE ratios, etc).
The Return To Equilibrium?
Two potential paths to correction:
- Asset prices deflate.
- Earnings inflate.
On the Asset Prices front – how realistic is deflation? It was driven by money supply. So in order for a full correction to take place, my guess is that you’d need excess liquidity to be drained out of the markets by the Central Banks.
But the Central Banks don’t really do that kind of thing. Bad for growth, etc.
So we may have to wait for consumer price inflation before we get any type of correction of earnings relative to asset prices.
Only, Central Banks don’t really like that kind of thing either.
The Third Option
As we move into a world with lower growth and more inequality – we might just have accelerated ourselves into a new equilibrium – one where capital earns lower returns.
That is: higher asset prices (from investments by the wealthy) and lower earnings (from the diminishing middle class) might combine to make higher PE ratios the norm.
After all – why should anything return to historic averages, when the circumstances that gave rise to those averages have so drastically changed?
It’s just a thought.