The author is editor in chief of MoneyWeek
For those who have been confused by the market this year, I have a suggestion. Invest in the Practical Financial Market History course run by the Edinburgh Business School (you can do it online – you do not have to come to cold Scotland). One of the modules focuses on the history of extreme market valuations – what causes them and what causes them to collapse.
The first thing to note is that, although we like to talk about bubbles, periods of extreme valuation in the stock market do not really occur very frequently. Of the 29 business cycles in the U.S. since 1881, only a few have ended in one, according to Professor Russell Napier. But although each had its own peculiarities, the basic driving force was very much the same: the ability of investors to absolutely believe in something that always seems impossible. Namely that, thanks to some “wonders” of technology, corporate profits will remain indefinitely high (and probably rise) and that interest rates will also remain indefinitely low.
In most cycles, investors do not think so. They assume cyclical normality – that rapid economic growth will lead to capacity constraints and then to inflation and rate hikes, something that will slow both economic growth and hurt corporate profits – that will lower valuations. We like to think of stocks as all sorts of things: at the moment, for example, too many investors are thinking of them primarily as virtue signal vehicles (witnessing the now collapsing bubble in renewable energy stocks).
But in the long run, equities are not really about feelings or showing pony: it is about the net present value of all future income streams that are discounted at whatever the discount rate is at that time. That’s it. So discount rate up, value down (usually when inflation reaches about 4 percent).
A proper bubble can then only develop if investors do not accept cyclical normality, but rather succeed in convincing themselves (against all historical experience) that it is possible for a high-profit, low-inflation environment to be permanent. It always ends badly. Think of 1901, 1921, 1929, 1966, 2000, 2007, briefly 2020 and possibly now.
The only question is how fast it ends badly. The most important thing here, Napier says in his lectures, is what part of the comparison got investors wrong. If it is the belief that interest rates will never rise, you tend to get a long drawn out bear market (from 1966, when it would have been difficult to imagine inflation of the late 1970s). If it is more the belief that corporate earnings will remain high forever, it tends to be shorter and sharper (2020 was a mini-classic of this genre of collapse).
So here we are. Inflation has been minimal for years. US corporate profits are very high and rising for years: they hit another record high in the third quarter of 2021. And of course, U.S. stock market valuations reached bubble levels some time ago: by the end of last year, the cyclically-adjusted price-to-earnings ratio was hitting about 40, more than double its long-term average. Investors again believe in too many impossible things before breakfast – something they may be starting to realize.
So here’s the question: what little do we have most wrong this time. Is it the discount rate or corporate profits? The discount rate feels like the obvious one, although rising interest rates naturally also hit corporate margins.
Cheap labor and globalization have long ago made inflation no more than a distant nightmare for older investors and a mystery to younger ones. So most fell for the nonsense of central banks last year that the rapidly rising inflation they saw was transient. And even those who thought it could last longer than, say, Easter still believed that central banks would withstand the rise in rates, regardless.
The fact that high growth (US gross domestic product grew by 6.9 percent in the last quarter of 2021) could actually hit capacity constraints and create inflation rates starting at sevens, therefore, seems to be a terrible shock – just like the indications that central banks may actually do something about it.
The Federal Reserve, under pressure from inflation itself and possibly also from opinion polls indicating that the said inflation is not helping President Joe Biden, is now changing course (no longer “perishable”). There is even, says Aegon Asset Management, “a reasonable probability of seven interest rate hikes this year, one at each meeting”. Illusion-exploding stuff.
It also leaves investors with little choice: as long as the Fed keeps this line, they should certainly not buy declines, but sell rallies – at least when it comes to their most expensive assets (we can argue about whether Peloton, like Peloton, ‘ a drop of 80 per cent in six months, is still expensive or not). In inflationary times, value today starts to look like it is worth more than possible value tomorrow (a bird in the hand is worth much more than an electric flying car in the woods).
With that in mind, it’s worth noting that the FTSE 100, with its reasonably priced revenue-generating shares, outperforms the S&P 500 – so much so that it’s on track to close by the end of a period of 12 months to perform better. this month. This is something it has not done for a full year since May 2017. But this is a switch for which I suspect most Practical History of Financial Markets students were ready.