By chance last week I found myself rereading a favourite passage from a classic stock market text, The Money Game, in which the author, Wall Street veteran George Goodman, recalls the time back in the 1960s that his trader hero, known only as The Great Winfield, hired three “kids out of college” to do some trading in the mad bull market days of those far off days. The strength of my kids, so the trader explains, is “that they are too young to remember anything bad and they are making so much money they feel invincible”, while older investors are too haunted by the memories of past phases of euphoria that ended badly to join in the game of chasing richly priced stocks ever higher.
The “kids” see nothing wrong in paying 100 times earnings for a computer leasing company, or anything that sounds whizzy and high tech and is growing fast, even if it means leveraging the position with cheap borrowed money. In bull markets there are always “theme stocks” that attract flows of hot money on the back of a plausible growth story. One of the kids in the story then – a detail I had forgotten – pipes up with one such idea he is busy chasing.
“Sir” said Sheldon the Kid “The Western United States is sitting on a pool of oil five times as big as all the known reserves in the world – shale oil. Technology is coming along fast. When it comes, Equity Oil can earn even hundred and fifty dollars a share. It’s selling at twenty four dollars. The first commercial underground nuclear test is coming up. The possibilities are so big no one can comprehend them!”
Talk about nothing new under the sun – remember that this was the late 1960s when oil was selling for less than $5 a barrel, cars were still as wide and as guzzly as a bus and Opec was a distant mote in investors’ consciousness. What’s more, the point as far as Goodman was concerned was, even then, that the young kid’s enthusiasm for shale oil was not even the first time that this dream of energy independence was being touted round Wall Street. Something similar had happened in the 1950s too. “The flow of the seasons! Life begins again! It’s marvellous!” exclaims The Great Winfield, warming to his theme that he himself no longer has the nerve to do this kind of faith-fuelled trading himself.
Now of course, there are plenty of differences between today’s financial markets and those of the go-go years of the 1960s, let alone the uncannily reminiscent TMT bubble years of 1998 to 2000. With oil at more than $100 a barrel, and fracking technology well-established, it does appear that the shale oil revolution – so often just around the corner – may finally be coming to fruition in the States. Today’s equity market participants display none of the mindless euphoria of those earlier bull market episodes. The memories of what transpired in the great financial crisis five years ago are still too fresh.
And yet the echoes in market behaviour and attitudes from the period leading up to the crisis cannot be entirely ignored. The source of momentum may be different, but the psychology is converging. Five years of easy monetary policy in developed markets have successfully kept asset prices higher than they would otherwise have been, but have done little to restore past levels of economic growth. The US stock market has added $32 trillion in market value since March 2009, while the economy has grown by just $1 trillion. As last week’s Deutsche Bank study of long term asset class returns records, even with the China engine included average global nominal GDP growth over the past five years is the lowest recorded since the 1930s.
The massive amounts of liquidity provided by the Federal Reserve and other central banks have helped to bolster bank balance sheets, but little of the monetary stimulus has so far found its way into the real economy. More importantly, with only a modest increase in nominal GDP, it has proved impossible to make serious inroads into the mountains of unrepayable debt that were accumulated in the run up to (or added in the resolution of) the global financial crisis.
Indeed, in one way the problem may be getting worse. William White, former chief economist at the Bank for International Settlements, was one of the few to warn about the dangers of the build up of debt before the crisis. He is now sounding the alarm again at the way that history appears to be in danger of repeating itself. As investors scour the world for yield, the price of risk has been tumbling. Credit spreads are back down to the level they reached in 2007, while high risk leveraged loans now account for 45% of the total syndicated debt market, according to the latest quarterly report from the Bank for International Settlements. Covenant standards are again slipping.
In the equity markets, the cyclical bull market which began in 2009 is well established – indeed long in the tooth by the standard of more normal past historical cycles. Nobody could describe market sentiment as euphoric, which is one reason why it is perfectly plausible that the equity market surge we have this year can be sustained for some time yet. The Federal Reserve’s decision last week not to taper looks likely to keep equity momentum going. But the number of late cycle bull market signals is multiplying: look at the levels of margin debt, the rise in valuations and the rise in M&A activity –more IPOs already this year than in the whole of 2012 and 2013 on course to be the best dealmaking year since 2007. Biotech stocks are this year’s hottest property.
The equity market behaviour is taking place despite the fact, as Deutsche Bank points out in its asset class study, that if you believe in mean reversion, expected ten-year returns for both the S&P 500 and a bog standard 60-40 equity-bond portfolio are now the lowest in recorded history, save for the bubble years of 1998, 1999 and 2000. Other than by comparing it to the even worse prospective returns from bonds, it is hard to see how this deliberately induced bull market in equities can continue to justify itself. To enjoy these markets to the full, without anxiety, you need to be young and free from the scars of long experience.