This article is part of Morningstar's "Perspectives" series, written by third-party contributors. Here, Jeremy Batstone-Carr of stockbrokers Charles Stanley explains how and why bubbles form.
When thinking about bubbles it’s always handy to see what those ye olde dust-covered financial textbooks from way back when have to say on the matter. In fact the exercise has proved pretty rewarding. Bubbles in financial assets, it is said, represent extreme asset price inflation and overvaluation. There are a number of ways in which bubbles can be ignited but one obvious trigger lies in the extent to which easy money results in exaggerated price performance. The ground is prepared by favourable fundamentals which spread optimism and encourage animal spirits to leverage up in order to bring to the boil. The cauldron bubbles away until, eventually it boils dry and a crash occurs as everybody attempts to exit at the same time.
While much is made of market crash periods through history we have always been much more interested in the conditions serving to precipitate the inflation of the bubble. The crash is merely a very aggressive period of mean reversion. So what do we see before us? Easy money? Check. Big price gains across developed equity markets? Again, check. Leverage? In some sectors such as the banks absolutely check and in others we sense that leverage is indeed rising. Overvaluation against fundamentals? Well here the text books come in handy. The formal definition of a high asset price relates either to high expected future cash flows and / or a low discount rate or as JP Morgan likes to call it, a low internal rate of return. An overvaluation must, according to the text books, mean that either future cash flow expectations are too optimistic or that those cash flows are being discounted at too low a discount rate.
Considerable debate currently centres on whether the Western, and indeed global, economy is gaining sufficient traction to achieve the much-desired “escape velocity” and whether the much-desired trough in corporate earnings, having been marched further into the future, persistently so since mid-2011, might be reached any time soon? We believe that we place little faith in crude measures of economic health such as real GDP, especially given the scope for that data to be gerrymandered by goal-seeking politicians and economic authorities. Thus we believe that concerns regarding the true health of the global economy, riven as it is by deep structural fissures, are entirely legitimate.
Furthermore, we believe that asset price over-valuation comes both from exaggerated expectations for future cash flows and from an ultra-low discount rate. It is hard to argue with JP Morgan’s view that the most important market participants in setting that discount rate are central banks. Central bankers set the return on cash, therefore they set the benchmark for returns on everything else. Although ultra-easy money and unconventional monetary policy is being pursued by most developed economy central banks the most important of those, by far, given the extent to which US dollar-denominated assets make up around 50% of the global security universe, is the Federal Reserve.
Of course developed Western stock markets are not the only assets in bubble territory. The sovereign bond market has been in a bubble for decades, to the extent that investors are, rightly, wondering whether future returns can be anything other than very pedestrian at best and likely negative at worst. This absence of obvious alternative is widely regarded as helping support persistent fund flows into the stock market as investors hope that another year of positive returns might be on the cards for 2014.
Back testing to through the post-WW2 period reveals that internal rates of return on equities and bonds are indeed greatly affected by the Federal Reserve but, when measured against history, do not appear to be excessively low. However, this setting can only be sustained if the Fed continues to hold the return on cash near zero. This is, of course, the subject of a seemingly endless and at times heated debate. As an aside we note that risk premiums on both bonds and equities are still at fairly elevated levels, appropriate in our view given still elevated uncertainty ahead. The bottom line is, perhaps inevitably, that risk assets are in a bubble and are display strong indications of over-valuation thanks in large part to the Fed’s prolonged zero interest rate policy.
