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Expert Perspective

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Investment e.Perspective

Current Issue | April 27, 2017

Down the Rabbit Hole

By: Mark M. Green, CFA, Chief Investment Officer and Oxford Investment Fellow


"But I don't want to go among mad people," Alice remarked.
“Oh, but you can't help that," said the Cat. "We're all mad here. I'm mad. You're mad."
“How do you know I'm mad?" said Alice.
“You must be," said the Cat," or you wouldn't have come here."

--Lewis Carroll, Alice's Adventures in Wonderland


For some time now many analysts have warned of growing imbalances in the economy and financial markets resulting from policy measures designed to set things right in the wake of the financial crisis, the so-called unintended consequences of otherwise good intentions. One example of these imbalances is the chart below, showing the relative growth rates of US Household Net Worth and Gross Domestic Product (GDP).

Dr. Ben Hunt talks about this issue in his blog Epsilon Theory: "Is it possible for the growth of household wealth to outstrip the growth of our entire economy? In short bursts or to a limited extent, sure. But it can't diverge by a lot and for a long time. We can't be a lot richer than our economy can grow." At the risk of oversimplifying, Ben's point is that the world's central banks have created a price bubble for financial assets through a prolonged period of extraordinary monetary policy." It is an extension of the TINA concept (There Is No Alternative, which we have written about previously), whereby investors are pushed into risky assets like stocks in search of any meaningful return. He calls it the "Central Bankers' Bubble," and puts it on the same scale as the Housing Bubble and the Dot-com Bubble. It just hasn't burst yet. In addition, the concentration of financial assets in the relatively few hands of the "wealthy" exacerbates the disparity of income and wealth gains in a modestly growing economy, leading to further social, economic and political division.

A Mad Tea Party
It is important to recognize that asset price bubbles occur more frequently than many people think. Moreover, looking at who owns the assets, what those assets actually are and how much they have appreciated in the context of everything around them makes it easier to identify outlying trends. For example, the amount of leverage in the mortgage market (especially the creation of exotic derivatives) should have been a tip-off prior to the housing meltdown. The same goes for the sky-high valuations of technology IPOs in the late-1990s. Why didn't more people notice these imbalances at the time? Some did, but many investors were simply lost in the forest. The market as a whole seemed to focus more on what made those periods different from previous episodes, thus justifying the imbalances, rather than focusing on the similarities. That's human nature, or market nature if you will.

To be fair, it's hard to know from one week to the next whether the stock market is "accurately" priced at current valuations. If you believe that markets are rational and efficient over the long-term, it is easy to simply assume the current price and valuation must also be fair. After all, it's been trading there for what seems like a long time. ("You must be mad or you wouldn't be here.") Besides, to some extent, it really is different this time – if only because of how low interest rates are. We often hear well-articulated arguments that current equity valuations are perfectly justifiable, given historically low interest rates and the shape of the yield curve. In fact, we hear, they could even go higher! While the math of a discounted cash flow model is pretty simple, there is a point at which it breaks down: if you lower the discount rate to zero, the price of the asset goes to infinity, or at least well above any sense of intrinsic value. We're pretty close to that point already. Recency and Confirmation biases are powerful forces and are often difficult to resist.

The self-correcting nature of markets and economies over time tells you a lot about the potential impact of asset price bubbles as they develop. There is a feedback-loop between household net worth and the overall economy. The positive wealth effects of a rising housing or stock market help boost spending in other parts of the economy. And, of course, it goes the other way when the bubble bursts. We saw this in the recession of the early 2000s which followed the Dot-com Bubble, and again in the Great Recession that followed the Housing Bubble. If the scale of the Central Bankers' Bubble is to be believed, there is reason to be concerned about the impact of its bursting on the economy and financial markets.

As I wrote in September, there are three other cycles potentially turning simultaneously – political, monetary and economic. We now know who will be living in the White House on January 20, and we are beginning to get a better understanding of President-Elect Trump’s policy agenda. The Federal Reserve seems intent on raising short-term interest rates at their next meeting in December, and more rate hikes are likely in 2017. That leaves the economy. Recent data on employment, income, spending and investment have been encouraging, though corporate profitability remains weak. A well-crafted fiscal stimulus program – whether based on infrastructure spending, tax cuts or both – might help extend the economic expansion for some time and that is certainly one of the policy goals. As I mentioned in the post-election issue of the Investment e.Perspective, however, there is a combination of both inflationary and deflationary undercurrents in the policy goals that have been articulated so far, and stagflation remains a real possibility.

How the financial market cycle behaves in the midst of all this is the wild card. The post-election stock rally is so far based on hopes of change, the nature of which is still quite uncertain. It is essentially market adjustment to the new information surrounding the Trump victory, and it is doubtful that this recent momentum is sustainable without quick and meaningful follow through on policy. The rout in the global bond market has been longer-running but the post-election surge in long-term interest rates has clearly taken a toll on fixed income portfolios. We know that market cycles turn; we just don't always know when, why or by how much. As a result, we continue to recommend that portfolio allocations remain near their long-term targets, albeit with a modest underweight to US equities and a modest overweight to certain alternative strategies.

In another Investment e.Perspective article this month, Brendan O'Sullivan-Hale digs deeper into the election results and their implications for investment portfolios.

The above commentary represents the opinions of the author as of 12.06.16 and is subject to change at any time due to market or economic conditions or other factors.