Will the everything bubble pop this year?

By Roger Montgomery, Montgomery Investment Management

As a new year begins, market predictions are coming in thick and fast. Significantly, in recent days, the views of some of the giants in the industry are echoing those we hold and have shared with our readers. If we are right, then investors will need to be rather more nimble than usual this year.

You may remember Alan Greenspan, the 13th US Federal Reserve Chairman between 1987 and 2006. Having presided over the US central bank for an unprecedented five terms, and coining the term 'irrational exuberance' during the dot.com bubble, he is - now at 91 - an undeniable legend of modern finance.

For our purposes, however, it is worth noting that he has joined other value investors, including Howard Marks, in noting investors are 'at it again'.

In a recent interview with Bloomberg, Greenspan observed, "There are two bubbles: We have a stock market bubble, and we have a bond market bubble."

It's worth paying attention when the person who originally observed irrational exuberance notes it again. And instances of irrational exuberance are growing in frequency.

Late last year, as recently as 21 December, the Hicksville, New York-based Long Island Iced Tea company announced a "Corporate focus shift towards opportunities strategic to blockchain technologies". The company rebranded itself as Long Blockchain Corp. The loss-making company's shares rallied from just under US$3 to over US$15 during the day of the announcement. Then, on 5 January this year, the company agreed to buy 1,000 Bitcoin mining machines. Share price declines since then have triggered the possibility of a class action.

Long Blockchain Corp. isn't the only company betting on the new distributed ledger technology. More recently, on 9 January, Kodak jumped on the buzzword, launching its own cryptocurrency, KodakCoins - tokens for use in the blockchain-powered KodakOne photography rights management platform. Upon the announcement, Kodak's share price surged and has risen as much as 270 per cent since.

These recent name changes are reminiscent of the adoption of names ending with '.com' during the tech boom of 1999 and early 2000. Whether unwitting or otherwise, investors mistakenly believed that new technology, which can change the world, would render all companies involved profitable. It is a common mistake to believe all companies involved in a new technology will make it. They cannot.

During previous bubbles extreme examples of inexplicable behaviour were evident. 'Cash boxes' - companies conducting no business activity of any description - added '.com' to their names causing share prices to surge. In my book Value.able, I wrote about the company NetBanx.com Corp. that disclosed, after changing its name from Professional Recovery Systems, they were "not currently engaged in any substantial business activity of any description and [have] no plans to engage in any such activity in the foreseeable future…" Despite this lack of activity of any kind, the shares surged from US$0.50 cents to near US$9.00.

It's happening again, and in the UK last month a similar event unfolded. A cash box - or 'special acquisition company' - AIQ Ltd, raised GBP3.6 million by issuing 50.0 million shares at 8.00 pence each on the London Stock Exchange, giving it a market capitalisation of GBP4.0 million.

Just two days later, AIQ was trading at 125.00 pence, or more than 15 times its listing price.

And Australia is not immune. The ASX-listed Getswift, with revenue of just $600,000 last year is currently valued by the market at nearly $600 million.

History reveals that prior to any bubble bursting, there is a tendency to completely unbridled enthusiasm for investing in stocks. Newspapers are full of stories of small or younger investors making millions. Given modern 'investors' have much more opportunity to make millions in bitcoin, which also seems to be attracting the media; and given the Bank of International Settlements is already reporting historic record levels of margin lending by retail investors on US stocks, perhaps we don't require this qualification. Time will tell of course.

Bubbles have been growing everywhere thanks to cheap money. Indeed, some have referred to the current broad enthusiasm as the 'everything bubble'. And there can be no doubt that a synchronised asset boom has been created by synchronised central bank quantitative easing. Early investors who've made money in shares, bonds and property don't want to put their profits into cash. Earning just 2.5 per cent or less, cash has become a liability. And so instead, profits are being recycled into more obscure non-income producing 'assets'. Unsurprisingly, record prices have been smashed in everything from art and wine to collectible number plates, coins, notes, cars and motorbikes.

Curiously, many asset classes, with a higher risk of capital loss than cash, are generating net yields that are lower than cash. In other words, cash is offering a superior risk-adjusted return than some popular alternatives.

The question to ask is not whether this will end - it most certainly will. The question is whether it will end in 2018 or 2019.

To help address that questions it's worth remembering that high prices themselves aren't usually enough to trigger a rout. The market for stocks is expensive. The CAPE ratio created by Nobel Laureate Robert Shiller is at a level only seen once before since the mid to late 1800s, and that was prior to the Tech Bust. On the CAPE measure, prices are even higher than prior to the Great Crash.

For a rout to take hold, there typically needs to be a reappraisal of the major inputs that go into an asset valuation. Those two major inputs are growth, and the cost of capital. If anything causes investors to reappraise their expectations for growth or their expectations for interest rates, then high prices suddenly become unpalatable.

What we aren't seeing however is the steep acceleration in share prices that are typical of a bubble that subsequently bursts. Perhaps that is yet to come. Perhaps it is sufficient that we are seeing it in a multiple of other asset classes. Remember, the GFC rout was triggered by a collapse of the US housing bubble. It dragged stocks down with it, globally.

At present the expectations for the input to valuations are supportive of high asset prices. Global synchronised economic growth - the IMF upgraded its forecast for the world to grow at 3.9 per cent - is a positive because it contributes to corporate earnings growth. Trump's tax cuts will also provide a handy boost to profits too. These factors, if they persist, and while interest rates remain relatively low, could cause the stock market to rally sharply. Of course a sharp rally soon would mean a sharper correction later.

But not all believe that growth will continue. Capital Economics believe that further ahead, "there will be a US-led slowdown in 2019 which, along with higher US interest rates, may cause a slump in equity prices."

On the interest rate front, rates remain low and many are watching the US Federal Reserve for indications about when and by how much they will raise rates. Investors however should carefully watch the other interest rates. US Ten Year government bonds are already backing up. In mid 2016 they were trading at 1.36 per cent. Earlier this week the hit ADD 2.88 per cent. In other words, rates have already doubled.

If and when growth slows, and if and when rates start to negatively impact on sentiment towards that growth, current high equity valuations will be reversed, because financial instability fears will take centre stage. It is plausible that some shock to current sentiment will occur in 2019 because a hit to growth from either China's unconstrained credit binge or an 'event' surrounding the historic record amount of junk bond debt due to be refinanced could occur in that year.

 

Roger Montgomery
Roger is the Founder and Chief Investment Officer of Montgomery Investment Management. Roger brings more than two decades of investment and financial market experience, knowledge and relationships to bear in his role as Chief Investment Officer. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

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