Two events in 2013 stand out as pivotal. The balance sheet of the U.S. Federal Reserve was expanded 37 percent to surpass US$4 trillion. Secondly, the Bank of Japan, another serial monetary polluter of the world, expanded its balance sheet by 42 percent.
Effectively, this helped create enormous money flows and portfolio shifts in the overall financial system. This would not have been thought possible without destabilizing the broad global financial order. Yet it has occurred—and is continuing to occur—to the riotous jubilation of proverbial Wall Street.
Very few would have made the confident prediction 12 months ago that a new financial bubble would be again underway. This would be the third one in the span of only 15 years. Even given this recent experience with bubbles and busts, financial markets are again emboldened to believe that speculation and leverage can be done with impunity.
What may be forgotten, for instance, is that the world’s largest stock market (the U.S. S&P 500 Composite Index) fell in value by at least 50 percent following each of the two earlier bubbles (late 1990s and the 2005 to 2007 period).
Stock markets can soar for no apparent reason other than confidence and excess money. For example, stock market gains in 2013 were hardly driven by earnings growth but rather by valuation inflation. That said, such periods cause some of the most trying ordeals for investors and savers.
The bubbly markets, though expensive and unsustainable, become powerfully alluring. If that were not the case, one would not be human. Professional money managers are not exempt from these pressures either.
Though many influential economists deny that there are such things as “bubble environments,” at the same time they have been stumped and surprised by the past bust phases (most notably the global financial crisis).
Classical economists had quite a different view. They believed such dangerous conditions could be diagnosed in advance. We count five key symptoms:
1. A large expansion in debt, either driving an over-consumption or over-investment binge.
2. A heavy reliance on capital gains for income and reported profits.
3. A sharply higher participation level in an asset market (most importantly, of a kind that can be readily borrowed against, usually securities) either directly or indirectly.
4. Crucially, a misreading of underlying credit and inflation trends.
5. A “great new world” impulse, usually represented by a technological shift of some kind. (For example, the telephone and the automobile were impulses contributing to past booms.)
In our view, all the preceding conditions are observable at this time, possibly even exceeding the excesses of the 2006–2007 period.
But what is the “great new” impetus this time that is believed will change the world? In our view, it is represented by the new high veneration of central banks and the new science (technology) of macroeconomics.
Is there a new wonderful world beckoning that allows us to ignore all the cautionary lessons of past financial bubbles? While it remains true that central banks cannot produce real wealth, they can surely impact money flows and investor psychology for much longer than we may be inclined to believe.
Even “gold bugs” who had been adamant that central banks were likely to embark upon epic monetary malfeasance (in this, they were right) have hoisted the white flag, recognizing central bank power is formidable and have also misread inflationary conditions.
How and when will things play out in the near future? Frankly, we cannot predict the future with any precision. Suffice it to say that we are experiencing uncharted financial times. The world of money and financial assets remains both interesting and challenging.
As investors, we meet these challenges by adhering to our long-standing management style: Always maintain a longer-term perspective; keep a high sensitivity to risk; implement broad global diversification; and have a strong aversion to downside.
This has meant that the downdrafts experienced by our portfolios in the past have been muted during “inclement” financial markets.