We Have Markets That Aren’t Really Markets Anymore

For most investors, the biggest thing that happened in September of 2008 was the collapse of Lehman Brothers on the 15th. It was the ‘Big Bang’ of the Global Financial Crisis. In some ways, we’re still living with the consequences of that day.

Today we have quantitative easing. We have central banks playing a leading role in the support of higher and higher stock prices (and lower and lower bond yields). We have markets that aren’t really markets anymore.

By all objective measures of valuation (Tobin’s Q, Buffett’s market cap-to-GDP, Robert Shiller’s cyclically-adjusted price-to-earnings ratio), stocks are expensive. But it’s as if those measures of value don’t matter anymore. All that matters is liquidity. As long as it’s abundant, it has to go somewhere.

Maybe we’re living in an alternate reality. On 10 September 2008, the Large Hadron Collider went online underneath France and Switzerland. In some of the kookier corners of the internet, there’s a belief that when the world’s largest particle accelerator was switched on, it created a disturbance in the universe.

History forked, and we entered a new timeline in which everything took a new course. Or, if you prefer, a timeline in which everything is getting increasingly crazier. These certainly seem like the crazy years. And not just in financial markets.

Australia, for example, seems to be in the grip of a national psychosis regarding the coronavirus. The media, politicians, and public health officials are running the asylum. The national vocabulary is dominated by terms like ‘exposure site’, ‘contact tracing’, ‘variant of concern’, and other fear-inducing terms. From afar, it’s like watching a dystopian TV drama about how to turn a country into a police state.

When you’re allowed to go outside, you’re told you have to bring an ID and wear a mask. And of course, you mustn’t go more than 10 kilometers from your front door. And if you receive a text from a government authority to self-isolate, you must comply.

What’s the goal here? Eradication of a virus that will be with us forever anyway? Or is it sociopaths in power taking full advantage of the circumstances to make an unprecedented grab for more power and control? Hmm.

The only consoling thought is that history moves in cycles, sort of like financial markets. Take the fact that at the end of March, Americans had a 60% allocation to stocks, according to the Wall Street Journal (WSJ). The last time it was that high was at the peak of the dotcom bubble, where it reached 61.7%.

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Just when everyone was convinced stocks had to keep going up, they didn’t.

When expectations for future returns are high, the actual returns (going forward) tend to be low. The opposite is true. When expectations are low (because returns have been low), actual returns are high going forward. From WSJ:

When households’ stock allocations have risen to 54.6% or higher—as they did during the dot-com bubble and the years leading up to the 2007-09 recession—the average annualized return for the S&P 500 over the next 10 years has been 4.1%. In contrast, when stock allocations have hovered around 29% or lower, the average annualized return over the next 10 years for the benchmark index has been 16.3%.

You only get reduced allocations to stocks when something bad happens, like a recession or a crash. That’s the cycle. For something good to happen in the future, something bad has to happen in the present, or at least soon.

That’s probably not the most optimistic thing you’ll read today. But cheer up. For those of us with large allocations to cash, a crash can’t come soon enough. That’s when you can load up on quality businesses at a cheap price, unlike today, where you have poor businesses that are very expensive.

By all means, keep buying if liquidity is the only factor you’re considering. But liquidity moves in cycles too. It’s abundant and sloshes around everywhere, lifting all asset prices during a bull market. But beneath the surface, a torpedo punctures the hull and the boat sinks.

In financial markets, you never know where the torpedo is going to come from. If it’s not war or natural disaster, it’s usually a ‘credit event’ like Lehman Brothers. It can be a big, systemically important firm that finds itself on the losing end of a major bet. All its counterparties are then exposed, and you get the dreaded contagion.

Or it can be some hedge fund that nobody ever heard of (like Long-Term Capital Management in 1998). Using borrowed money, very smart people find themselves suddenly on the wrong end of a trade. The end which results in bankruptcy and the liquidation of the fund, and more chaos in the markets than anyone thought possible.

Maybe those things ARE impossible now that central banks are in charge all the time. Maybe rising stock prices have replaced job and wage growth as the number one priority for central planners to keep the population pacified. If stocks were to crash, imagine how many more people might be out in the street, looking for answers and asking for help.

We may get there yet. The French aristocracy had no idea what was coming in 1787. But when the timeline of history swerves in an unexpected way, watch out. It’s swerving now.


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Dan Denning,
Editor, The Rum Rebellion

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Dan Denning is the co-author of The Bonner-Denning Letter.

Dan was a founder of Port Phillip Publishing back in 2005, which quickly became the leading publisher of its kind for independent financial research and insights. In 2014 he left to head up Southbank Investment Research in the UK. Dan is also the author of the 2005 book, The Bull Hunter. Today, he’s based in his home state of Colorado. Each Monday in The Rum Rebellion you’ll get Dan’s unique contrarian thinking to provide insights you won’t find anywhere else.

Dan Denning’s belief in free markets, sound money, personal liberty, and small government have underpinned everything he’s done during his 23 years in the financial publishing industry.

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