It’s either sadness or euphoria
The Chief Executive of Morgan Stanley, James Gorman, commented in a recent interview that he believed the chance of another financial crisis in our lifetime was “as close to zero as I could imagine”. We couldn’t disagree more strongly. The thought process which concludes that a period of apparent calm, driven by extreme policy measures can bestow an increased likelihood of future financial stability is, in our minds, not only flawed, but deeply concerning when expressed by the CEO of a large financial institution. Unfortunately, the gyrations in the stock market which occur over time would suggest that the James Gorman thought process is part of human nature for the majority. Complacency grows with periods of calm and the fear of missing out gradually overwhelms the fear of losing money. As Billy Joel so aptly put it in Summer, Highland Falls, “it’s either sadness or euphoria”; we seem unwilling to spend much time in between.
From our perspective, an understanding of why the current economic and market environment should not instil calm requires a few historic observations. Economic stability has rarely been associated with rapidly escalating income disparity. Using a simple measure such as the proportion of US wealth controlled by the top decile of the population, we can observe the path of income disparity in an economy such as the US over the past century. It reveals a number of periods of note. In the decade prior to the Great Depression, income disparity rose rapidly. Depression and wartime unwound this disparity and laid the foundations for an extended period of post war boom time, during which income disparity remained remarkably stable. Since the 1980’s income disparity has been rising rapidly, reaching a level now that exceeds the 1929 peak. This rise was punctuated by significant falls at the time of the tech bubble collapse (2000/01) and more recently, the global financial crisis. In each instance, the correction (i.e. the natural forces of capitalism to unwind disparity) was averted through massive monetary intervention which artificially supported bad debts and averted wealth destruction for those that had it.
The path of income disparity over time correlates almost exactly with credit growth, supporting the intuitive conclusion that rapid credit growth is the primary driver of disparity and resultant instability (the more the younger generation are willing to borrow, the more the assets of those that acquired them previously are inflated). Rather than encouraging long term stability through slow and controlled credit growth, central bankers and governments around the world have created a highly unstable system through a misguided focus on manipulated and partial measures of inflation such as CPI. Although this may be reality, we are not expecting Ben Bernanke, Glenn Stevens or any other central bank governor to collapse into paroxysms of grief, lamenting years of erroneous policies, vowing to mend their ways. What we should expect, are ongoing efforts to exacerbate an already unbalanced system (through trying to stimulate further credit growth), making it increasingly more vulnerable, and elevating the propensity for future crises. We are also sceptical that efforts to perpetually prop up bad debts (assets and businesses that don’t generate sufficient cashflow to justify their value) through a combination of subsidies, interest rate manipulation and government regulation can overwhelm the forces of capitalism in the long-term.
October saw another episode in the continuing circus of manipulation with the US debt ceiling debate. Although the sea of liquidity and continuing herding of investors into riskier assets through distorted bond pricing overwhelmed the debt ceiling fiasco and pushed markets ever higher, it should at least serve as a reminder that despite James Gorman’s exhortation, propping up an unsustainable system does not become incrementally easier. The path in Australia is similar, and in any case is inextricably linked to the rest of the world through globalised financial and trade markets. No matter how intently Glenn Stevens tries to talk down the value of the Australian dollar, as a pawn in the global economy, our economic future will never remain wholly within our control.
Much of the rationale for needing to understand the global picture rests with our belief that one cannot claim to be a “bottom-up” stock picker without an understanding of the influence of these factors on industry and business specific revenue and costs drivers. Ignorance is not bliss. The abovementioned trends in credit growth income disparity and manipulation are a large factor in driving profits, revenues and share prices. Whether it is the banking sector, its huge volume and profit growth and almost non-existent bad debts, Crown and the explosive growth of gambling in Macau or Challenger’s booming annuity business, the aforementioned policies are providing much of the tailwind. I’m no Nostradamus, but a few percent higher interest rates and collapsing credit growth in the economies driving these businesses might change the picture a little.
Nevertheless, with euphoria now dominating sadness, property prices rising and markets having a good head of steam, momentum remained the order of the day this month. Bank earnings released to date have been characterised by ongoing solid margins and an almost total absence of bad debts, propelling further gains for stocks with already exceptional performance over the past year or so. ANZ, Bank of Queensland and Challenger were amongst the best of the financials, whilst Perpetual and Platinum Asset Management were indicative of increasing enthusiasm on market momentum. REA and Seek continued the rampage on anything technology related, with stocks like Tabcorp and Aristocrat Leisure benefiting from increasing excitement around the potential of their online businesses. I might be getting old, but it seems to me like we’ve been here before.
Successful investment in an environment of increasing froth and bubble necessarily involves succumbing to the Dennis Denuto principles. Rather than focus on fundamentals and valuation, “the vibe of the thing” will become increasingly more important. Many of the businesses currently being offered to eager buyers are likely to be the equivalent of Darryl Kerrigan’s jousting sticks; quite difficult to accurately price, of questionable utility, but almost certainly worth far less than the asking price. Rather than taking Darryl’s advice and “tell him he’s dreaming”, most IPO’s (initial public offering is probably not a wholly accurate acronym as many are recycled public offerings, but RPO doesn’t quite have the same ring to it) are turning into frenzied auctions. Stockbrokers managing the IPO process are relishing their position, with lemming fund managers again busily trying to ingratiate themselves with intermediaries as investment performance is bestowed from on high, rather than extracted through mundane exercises such as trying to value cash earnings. Predictably, there is no shortage of private equity and insider sellers emerging as the frenzy heightens. When the ducks are quacking! Good to see policymakers not worried about market levels or house prices and unprepared to take any action to short circuit ongoing wealth transfer.
Although this inevitable phase of the market cycle can be frustrating for those of us preferring to buy sensibly priced businesses with reasonable prospects of being around for a while, the positive angle is that those investors determined to pick up pennies in front of steamrollers will invariably discard that which we find attractive in their race to pick up the trash. As increasing amounts of investors’ money crowds into artificially supported financials, intermediaries and anything with a technology or even partially feasible “growth” story, we are finding far more appeal in the more traditional “real” businesses. Whilst not intentionally adopting antediluvian tendencies, we find it far more logical that better future returns and lower risk are likely to be found in areas that have not been the beneficiaries of the unsustainable policies referred to earlier. As always, the danger is that speculation and fervour prevail for far longer than expected. As Mr Buffett put it, investors “hate to miss a single minute of what is one helluva party”. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: they are dancing in a room in which the clocks have no hands”.
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