The Big Conversation
Episode 60: Good bubbles bad bubbles
This week we compare some of history’s largest bubbles. Investors are fixated on the unwinding of asset prices, but the longer-term impacts are not always negative. Is the recent price action in Gamestop a cause for concern or is this excessive activity still confined to a corner of the economy? If a bubble has infiltrated the credit market, their repercussions tend to be far worse than ones that merely impact asset prices. In the Chatter, we look at the conflicting growth signals that are being transmitted by the front and the back end of the US yield curve.
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Word searches for the phrase ‘equity bubble’ have soared in recent weeks during the retail rush into names such as Gamestop and AMC. The fear of a bubble has stalked the US equity market ever since the performance of the S&P disconnected from corporate earnings in 2015, since when the market has shrugged off a couple of 20% drawdowns to make a series of new highs. Perhaps our view of bubbles has become too one dimensional, focusing primarily on the short-term risks rather than the long-term trends which many of them represent. In this Big Conversation we ask if all bubbles are created equal?
Hi I’m Roger Hirst. The recent speculative furor surrounding companies such as GameStop has again raised broader questions about whether we’re now in yet another serious bubble. We’ve discussed this issue before, but it’s worth placing the GameStop story in the context of other financial bubbles. More to the point, does the existence of over-speculation necessarily point to the existence of a dangerous bubble and a corresponding market crash?
Bubbles and financial speculation have arisen wherever asset markets have existed. The objects of speculation challenge the imagination and have often resulted in serious financial calamity, whether they were Dutch tulips, silver, railways, the debt of new nations, or real estate. Occasionally the object of speculation has been one of those fundamental technologies –like railroads, electrification, automobiles, or the internet - for which financial speculators have mobilized capital on a scale far beyond what “rational” investors should provide. The Nasdaq of 2000 was once such example. The economist and market practitioner, William Janeway, has made the case that “the history of financial capitalism demonstrates the need to distinguish between bubbles along two different dimensions”. One dimension is defined by the object of specualtion. Only occasionally have speculators focused on fundamental changes in technology instead of simply asset prices such as gold mines or houses that don’t contribute to system-wide increases in productivity.” A second dimension distinguishes between bubbles that remain confined to the capital markets alone vs. those that impact the whole credit system, creating broader risks for the economy. And that's going to be a key distinction. For instance, we can contrast the outcomes of the dotcom and telecom bubble of 1999–2000 and the credit bubble of 2004–2008. Janeway notes that when the $6 trillion of nominal financial wealth of the dotcom era was liquidated, the economic consequences were within the bounds of postwar experience. It was a mild GDP recession, made worse by the exogenous shock of 9/11, but it left the technological foundations and business models of today’s tech economy. The great credit bubble of 2008, however, will be remembered precisely for its destructive economic consequences and not for any physical legacy, least of all the abandoned property developments scattered across the United States, Ireland, Spain and much of emerging Europe. So does the current environment fall into the benign or malign category, especially given a backdrop in which the Wilshire market cap to GDP ratio is now some 25% above the prior all-time dotcom peak, which occurred over 20 years ago. Maybe today’s U.S. market is underpinned by expectations of pure price appreciation and not by unrealistic expectations about corporate fundamentals? Bubbles driven purely by price expectation are rare, and we have to go back to the 1700’s to find just a handful of global examples. But the impact of the subsequent price decline for these events has been catastrophic. But bubbles – including history’s most extreme cases – are all about human psychology, which remains fairly constant through geography and history. The impacts, however, can be very, very different.
The Mississippi and South Sea bubbles of the 18th century were pure psychological phenomenon where prices were manipulated to maintain momentum. The implosion of both of those had long term economic and social implications. Speculation during the Canal and Railway Manias, on the other hand, were financial bubbles that seized the City of London before and after the Napoleonic Wars and helped transform Britain, establishing a base for the Industrial Revolution. Jeremy Grantham of GMO Partners, who defines a bubble as a two standard deviation rise from a mean, regards the run to the U.S. peaks in 1965 and 1968 also as bubbles. Looking at the chart, the 1965 and 68 bear markets are clear, but they didn’t represent a mania in the same way as Dutch Tulips of the 17th Century or the run up to the 1929 US stock market peak. Although the 1960’s were mostly driven by exaggerated expectations of fundamentals, they never reached the extremes of other historic manias, and crucially their decline had little impact on banking and credit. The US economy continued to grow robustly in the aftermath of the subsequent bear markets.
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Now looking at Brazil, in 1971 it had a stock market that went to 33 times trailing earnings. Here, the expectation of yet more unbroken annual 9% growth for the economy created a spiral of chasing prices for their own sake. It was very similar in character to the US in the 1920s, but with higher levels of expected growth. Today’s experience in the US equity market, outside of a few specific names, feels far removed from these all-encompassing experiences. Kuwait’s Souk Al-Manakh bubble of the 1980’s also highlights the difference between intense broad-based speculation and excesses within a very specific corner of an economy or asset market. In May of 1982, while US stocks were making their lows, and the bear market in US bonds was still completing its base, Kuwait was in the midst of a massive bull market in stocks in the aftermath of the OPEC price shocks. The wealth created in Kuwait by rising oil prices led to endless appreciation in local stocks and the royal family of Kuwait didn't fully grant corporate charters for companies that might have become listed entities so there was a shortage of stocks to trade. And this gave rise to an over-the-counter market in Kuwait City, where shares in companies domiciled elsewhere in the Gulf were traded. Housed in a converted air conditioned parking garage, the market was known as the Souk al Manakh. At its peak, the market capitalization of the Kuwait exchange and the Souk al Manakh combined, ranked third in the world, behind the US and Japan and ahead of the UK but most of the visible wealth was not reflected in these companies. Oil wealth, real estate and the extremely lucrative import franchises were closely held whilst virtually no assets underpinned the multi billion dollar entities that were now trading over the counter. The vast majority turned out to be shell companies. Margin for speculation had been financed by way of post-dated checks and when financiers began to call in these cheques in the summer of 1982, the market literally froze up and collapsed. The amount of worthless obligations totaled $93 billion (in 1982 US dollars), an amount equivalent to $90,000 US dollars for every person compared to a per capita income at that time of $14,000. In the end, all but one of Kuwait’s banks were technically insolvent according to the United Nations in 1989. The entire Gulf region went into recession. Again, this was an all-encompassing speculation that impacted all corners of the economy. Today’s excesses in the US do not. Japan’s bubble of the 1980’s still informs nearly all commentary on the economy even today. Economic historians usually date the beginning of Japan’s bubble economy to September 1985, when Japan and five other nations signed the Plaza Accord in New York. The Plaza agreement called for the depreciation of the dollar against other currencies including the yen, and was supposed to increase U.S. exports by making them cheaper. But it also caused Japanese asset prices, notably real estate, to explode in value. In the 10 years before the peak in 1989, Japanese stock and real-estate prices rose 500 percent. This compares with a 200 percent gain for U.S. house prices in the 10 years leading up to 2007 and a 70 percent rise in the S&P over the same period. The mania reached its peak in the last six months of 1989, with the biggest factor being manipulation. The market’s breadth got worse and worse, and organized price manipulation became ever more dominant. By December 1989, the benchmark Nikkei 225 stock average had reached nearly 39,000. But beginning in 1990, the stock market began a downward spiral that saw it lose more than $2 trillion by December 1990, effectively ending the bubble era. The banks had been freely lending to Japanese firms and individuals, who purchased real estate, which increased the paper value of land assets. This created a vicious cycle in which land was used as collateral to obtain further loans, which were then used to speculate on the stock market or to purchase more land. This was another case of a bubble reaching into all parts of the economy. We can contrast these last examples with US equity bubble of the late 1990’s. A long running bull market and the pace of technological change had fostered a speculation in new era tech stocks. Then, after the Fed cut rates due to the Asia crisis and the failure of the Hedge Fund Long Term Capital Management, plus liquidity injections ahead of Y2K, price alone took over as the major driver of the Nasdaq bubble. But much like the railway boom of the 19th century, the dotcom bubble left us with the internet infrastructure that now dominates the US economy. More importantly, the excesses never seeped into the credit system in the manner which characterized the financial crash of 2008. The credit bubble of 2008 left far fewer tangible benefits. We often mischaracterize the 2008 crisis simply as a housing bubble. If it had merely been the inflated values of housing, however, we would not have had the panic at the end of 2008. Credit excesses that had underpinned housing had begun to permeate throughout the entire banking network. The financial system seized up as a result of financial derivative debts that were piled on top of the housing debts and created synthetic exposures that were four to six times the total amount of the real economy’s sub-prime debts.
These derivative products were labeled weapons of mass destruction by Warren Buffett. Many of these credit instruments wound up being held by systemically important and fragile financial institutions like AIG, Citibank, UBS, Deutsche Bank and indeed virtually every single major financial institution in the world. in the world. The boom was also characterized by a massive increase in fraudulent activities. Predatory mortgage lending surged and households were provided mortgages that they would never be able to repay. When credit rating agencies finally analyzed the underlying assets of residential mortgage-backed securities, they found large instances of fraud. Compounding the problem were the “value at risk” or VAR models that should have reduced risk, but invariably allowed increased leverage when volatility was low, because the cross-asset nature of the risks was not well understood. As a consequence, realized credit losses were much higher than expected losses, because insufficient margins of safety had been kept. Creditors, including the banks, could not be paid. The end result was the most serious economic crisis since the 1930s. Now if we look at today’s market, we can see some instances of exuberance. Gamestop obviously comes to mind, but does the squeeze higher and collapse of a few single names reflect bubble market excess, or is it simply the corralling of new technologies and styles of trading that are yet to find an equilibrium? However compelling the story, is GameStop symptomatic of a bigger problem? It’s hard not to be struck by these comments by former Fed governor Frederick Mishkin. He says:
“I actually think that people overdo their focus on the stock market as driving things. In fact, Bubbles in the stock market, per se, when they burst are not really the problem for the economy. They can be dealt with. It’s when it involves the Credit markets. The thing that caused the problem in terms of the last global financial crisis……………was the fact that when that happened, it really affected the Credit markets and caused them to seize up. That’s not where we are right now.” And its pretty hard not to agree with that really. Leverage is clearly creeping into the corporate sector, especially by the leveraged buyout guys borrowing on the cheap to fund dividend recaps. US Corporate debt to GDP was at record levels even before the pandemic hit. But what distinguishes this entire episode, is that the central banks, have become the agents of speculation through their persistent attempts to backstop the credit system via QE and low rates to ensure that the system doesn’t collapse. So far, they have done a pretty good job in preventing any 2008-style meltdown, though by limiting the damage today they maybe storing up another round of issues for the future. Indeed, rather than focus on the equity market, it may be better to focus our attention on the actions of central banks, who have driven yields down across the curve and pushed many of them into negative territory. It is this move in yields that has helped push capital into buybacks and accelerated the shift towards passive funds whose constant inflows have helped underpin the equity market in the US regardless of the economic fundamentals. So far they have been able to rescue the equity market and have managed to stabilize the bond market during periods of economic dislocation. What is less clear is if they can manage to support an economy where the bigger risk is one of higher growth and higher yields. US yields are now edging higher – could it be that the bond market, rather than the equity market, is the place with the fragility of excess is felt first? And in the next section, we'll look at the dynamics of the U.S. curve, where the front and back end are outlining two quite contrasting outlooks on growth.
The US 2-year versus 10-year part of the yield curve continues to re-steepen and the difference between the yield on the 10 year note and the yield on the 2 year note now stands at over 100 basis points. If we look at the historical yield curve, this all looks very normal. We can see that, in advance of the COVID recession, the yield curve inverted, albeit briefly, and then started to re-steepen, just like it had on the previous three occasions. However, this obscures a very different dynamic that has been in play over the last 18 months compared to before and this is contributing to the confusion about the outlook for the US economy. On the previous occasions, the yield curve flattened because two-year yields were rising up to the level of the 10-year yield. This is called a bear flattening, because the 2-year note is selling off as a result of the US Federal Reserve tightening interest rates, which helps increase the yield at the front end of the curve. Invariably, the Fed would overtighten to such an extent that the economy comes under pressure and the Fed is once again forced to cut rates in order to stimulate growth. The flattening of the curve during the recent cycle was indeed initiated by a typical Fed tightening cycle that drove up yields that front end of the curve. The final hike by the Fed, however, was one hike too many and this led to a 20% collapse in the S&P at the end of 2018. By the middle of 2019, the Fed went into reverse. The yield curve however, continued to flatten in mid-2019 because yields at the long end fell at a faster pace than yields at the front end, so that they eventually converged and led to a brief inversion. People will often say that the yield curve predicts a recession, but this inversion in no way predicted the onset of COVID. The curve had inverted because of demand from global systematically important banks switching loans into bonds on their balance sheets in order to reduce their regulatory burden. If the yield curve had predicted the recession, it did so unknowingly. If we go back to the historical 2Y10Y curve and recession, here we can see the re-steepening that takes place before the onset of recession. The re-steepening usually results from the Fed trying to undo their handywork and cut interest rates. This drags down yields at the front end, causing a bull steepening of the curve because the 2-year note is now rallying. However, during the current re-steepening, it is the reverse that has been in play. It has been a rise in the yield of the 10-year – called a bear steepening, that has led the steepening of the curve. In fact, what we can see with this chart is that the 2-year yield has been retesting the lows – in this case the all-time lows - whilst the 10-Year yield has been rising. They are telling two very different stories.
The front end is reflecting skepticism about growth, or at least, the Fed’s willingness to react to growth, although if there was any real underlying growth, the bond market would be pushing yields higher. Instead, the front end is acting as if growth is about to take another hit lower. That’s hardly the expected outcome if there was true reflation in the air. The long end on the other hand has been pricing for inflation – from both the effect of higher commodity prices due to the weaker US dollar and from the expected fiscal and monetary boost that are constantly promised by policy makers. But, if we get inflation before growth, then growth is unlikely to take place. Higher commodity prices will boost the coffers of some commodity rich countries, but the commodity users will see higher input prices and margin contraction. In its simplest form, this is stagflation. The point here is that the reflation narrative continues to be mixed up with an inflation narrative. The two can take place at the same time, but when commodity prices are rising because the dollar is falling, rather than because there is massive demand from instance China, then the impact of the higher prices will quickly damage the prospects for real growth. It would therefore be no surprise if investors armed with cash handouts continue to target the equity market rather than the real economy. Until policy makers start aiming their fiscal stimulus at the real economy, the equity market will divert capital to those non-performing assets, making it increasingly difficult for policy makers to stimulate true economic growth.
Thanks for watching this week's episode, and we'll see you next week for more insights on the market.
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