This conversation was conducted on the third week of January 2022 by Emma Nilsson – Zinqular’s head of media and communications.
In this discussion; Zinqular Group’s Co – Chief Investment Officers, Barry S. Graham & Michael Yaw Appiah provided their perspectives on the state of play of private markets after COVID, higher-order market bubble and the impetus for portfolio changes and re-allocation. This is an abridged transcript of that discussion.
Emma: The last time we spoke was just before the pandemic. A lot has changed since then, can you give us the state of play on alternatives?
Barry: The past two years has been turbulent for private and public markets, as it was for much of the world. This primarily due to the pandemic and other events spurred the continuing volatility of markets from 1Q20 to 4Q21. This period led to the “COVID market correction ”, private markets have since experienced their own version of a K-shaped recovery: a vigorous rebound in private equity; a tailwind for private credit, natural resources, real assets, logistics and infrastructure.
Our industry continues to perform well, outpacing other private markets asset classes and most measures of comparable public market performance. The strength and speed of the rebound suggest resilience and continued momentum as investors increasingly look to us for higher potential returns in a sustained low-yield environment. The most in- depth data we have continues to affirm that, by nearly any measure, private equity outperforms public market equivalents (with net global returns of over 14 percent).
Alternative investments purchase multiples (alongside price-to-earnings multiples in the public markets) have kept climbing and are now higher than pre-GFC levels. In parallel, dry powder reached another new high, while debt grew cheaper and leverage increased—factors providing upward support for alternative investment deal activity. Few transactions were completed in the depths of the (brief) slide in the private markets, reminding many in the industry that “waiting for a buying opportunity” may entail a lot more waiting than buying.
Michael: Despite the economy rebound, volatility in the markets have continued unabated to the surprise of bulls and many market players. This also raises the question: To what extent are the lessons of previous downturns relevant? We looked briefly at few aspects of how the industry confronted the last economic downturn for hints on what may drive value in the COVID and post-COVID era. Looking at the data, we think operating groups appear to matter; and “buying low” is great, if you can. Alternative investment firms with portfolio value-creation teams outperformed in the last crisis. The data also confirmed that PE firms with specialist teams focused on driving value creation in portfolio-company operations are also did well; their investment returns and their fundraising have been impressive.
Our data also shows that PE investors appear to have a stronger risk appetite than they did a decade ago. During the global financial crisis (GFC) in 2008, many limited partners (LPs) pulled back from private asset classes and ended up missing out on much of the recovery. This time, most LPs seem to have learned from history, as investor appetite for private alternative investments appears relatively undiminished following the turbulence of the past 18-24 months. You have to remember that fund raising in the entire industry was up over 20% YoY to reach about $1.2T for the past two years.
Barry: Real estate was hit hard by the pandemic, we rotated to higher risk-return strategies relative to their pre-COVID preferences, which perhaps reflects our anticipating buying opportunities in a stressed or distressed environment. Fundraising in opportunistic and value-add strategies grew sharply, while open-end core and core-plus funds experienced net outflows. Our concerns about rising inflation may prove to be a tailwind for the asset class, given its inflation-hedging properties.
Office and retail saw the most pronounced changes—some of which seem likely to endure—which caused us and owners to rethink valuation and value creation strategies alike.
The success of the unplanned transition to a remote workplace surprised employers and initiated a review of both their footprints and their in-office experiences.
A rapid shift to omnichannel shopping impaired retail real estate valuations, particularly for shopping malls. The industrial sector proved less vulnerable, benefiting from a surge in demand for direct-to-consumer fulfillment.
Michael: Private debt was a relative bright spot in 2020/1. Fundraising growth continued in private debt, the only private asset class to grow fundraising every year since 2011, including through the pandemic. This cyclical resilience is partially driven by the diversity of private debt sub-strategies including distressed and special situations strategies. Over the longer term, growth has been driven by a dramatic expansion in direct lending strategies, which have accounted for over 70 percent of fundraising growth in the last decade.
At the same time, more private markets investors are now tracking environmental, social, and governance (ESG) metrics in earnest. Some—a small but growing minority—have begun to use these “nonfinancial” indicators in their investment decision making. Its early to say whether this trend ultimately proves a good for investment value, but one thing is becoming clear: our data suggests that the individual companies that improve on ESG factors also tend to be the ones that improve most on total return to shareholders.
Barry: Within infrastructure—which we think is more than rail-lines, power-lines, roads and bridges. In 2021, infrastructure and natural resources set a record for fundraising, AUM, and deal volume; indeed, global AUM broke the $1T mark for the first time. The mandate for infrastructure have evolved in over the past decade. Capital is increasingly flowing into subsectors that support the energy transition and digitization, such as alternative energy, clean-tech solutions focused on improving environmental sustainability, and infrastructure technology (i.e., Infratech). Investors are also looking beyond physical assets at operating companies and technologies to generate value.
Emma: Can we briefly discuss market bubble as experts think the public market is in a bubble territory? What are the dangers of assets allocation in major bubbles?
Barry: For the past 12 years, the long bull run of public market has ultimately ripped into a fully-blown epic bubble. The past 18 months have seen shocking extreme overvaluation, volatile price rises, manic issuance, and illogical speculative investor conduct, meant that this event will be marked as one of profound bubbles of financial market history, similar to the Dutch tulip bubble (1634/6), South Sea bubble (1720), 1929, 2000, and 2008 bubbles.
Great fortunes are made and lost in these bubbles. Generally, realigning a portfolio to escape the worst suffering of a major bubble breaking is very challenging – to say the least. The illogical investor conduct and individual human psychology will work toward sucking more investors in this bubble event.
This bubble is in the early stages of bursting or will burst in due time, no matter how hard the Fed tries to support it, with consequent damaging effects on the economy and on portfolios. Beware that this event, could sure be the most momentous event to most investors investing lives.
Usually, over 70% of the time, major asset classes are sensibly valued relative to others. The appropriate response is to make reasonable stakes on those assets that measure as being cheaper with the believe that these estimates will be accurate. Being sensible at evaluating assets the valuation-based allocator can expect to outlast these stages in one piece with some “little returns”. “Little returns” as the opportunities are quite small and that asset allocation at this stage may not be very important. During these periods, it helpful for the asset manager to add value in the portfolio construction based on parameters such as , from the effective selection of countries, sectors, industries, and individual securities as well as major asset classes.
Michael: The main issue with asset allocation, is in overexuberant periods where asset prices are detached from fair value. It is not terrible in bear markets since key bear markets tend to be brief and ruthless. The first reaction of clients is generally to be startled into “deep freeze”; within this stage the investment manager has time to reconstruct the portfolio in order to retain clients and business. The difficulty is in major bull markets that continue for many years. An endless, low velocity-burning bull markets can last several years above fair value and even up to five years. These occurrences can easily outlive the tolerance level of most clients and market players. Usually toward the end of a bull market, restless and disgruntle is followed by worry and bitterness particularly when price rises are extremely rapid. In short, there is nothing more annoying than seeing your fellow competitors get wealthy.
So, what should clients do? How can they differentiate between unfavorable extreme market behavior and a manager confused of the times and who has lost his bearing? Normally, a win of 2 out of 2 events or 3 out of 3 is not as persuasive enough as a larger sample pool would be because the long cycles of the market are few and far between. To make matters worse; earlier major market bubble burst has long faded. New financial legislations will have been enacted and market players will have changed. In summary the market can remain illogically longer than the investor can stay solvent.
In our humble opinion, we are in a major bubble event in the U.S. public market, of the kind we usually have over decades of each other and last occurred in the late 1990s. Our view is, it is occurring now and it will surely end terribly, although nothing is certain. Our take on success for a bear market call is to exit the market at the right period. We think that it is just a matter of time when an investor is thrilled to have exit the market. This means, the investor will have saved money by the exit, and also have reduced risk or volatility on the whole journey. This “success” does not take into account the exact timing; in fact, the forecast of bust of a bubble is not about price. Previous bubble markets have been extremely overvalued, as is this one. Overvaluation is required but not enough condition for their blow up and therefore, predicting the quarter, month or week is unrealistic.
Emma: Share with us some examples of how market indices and assets values have risen beyond realistic due to the bubble? What are the characteristics of late-stage bubbles?
Barry: A few instances come to mind. For example, some bear asset managers got entirely out of Japan in Q4 1987, when it was over 40% of the EAFE index and sold them in excess of 41x earnings, against a previous all-time high of 25x. It was logical to exit at that time, but for next three years they shockingly underperformed unbearably as the Japanese market rose to 65x earnings in path to over 61% of the index. But with discipline they exited completely for three years of the top and at long last made great returns on the whole journey.
The narrative in Q4 1997, as S&P 500 exceeded its previous 1929 peak of 22x earnings, some portfolio managers quickly sold down their discretionary U.S. equity positions then noticed in astonishment when the market rose to 37x on earnings. Half of their asset allocation book of business disappeared but in the succeeding nosedive they gained much more than their initial losses.
We know these are old narratives but they are directly applicable and suitable. This current market event we believe has the same narrative. The most concrete measure of the late stages of the great bubbles of history has been really crazy and irrational investor behavior, particularly on the part of retail investors. In the first decade of this bull market, which is the longest in history was the absence of such ferocious speculation. For the past two years 1Q20 to beginning of 1Q2022 we saw it in unbelievable record aggregates.
For instance, Tesla market Cap., now (Jan./Feb.2022) over $700 B, amounts to over $1.4 M per car sold each year versus $9200 per car for GM, other established competitors. Similarities to 1929 is clear. Most of these similarities could perhaps be thrown out as isolated instances, but we believe, they are not because the broad measure looks even terrible.
The overall stock market capitalization to GDP exceeded its 2000 record highs. By the end of 4Q20, there were 479 IPOs that includes an astonishing 244+ SPACs – more new listings than the 404 IPOs in 2000.
There are 148+ non-micro-cap companies (i.e., with Market Cap. of over $250 M) that have more than tripled in the year, which is over 3 times as many as any year in the previous decade. The volume of small retail trades, of less than 10 contracts, of call options on U.S. equities has increased 8x compared to 2019, and 2019 was already well above long-run average.
Michael: I will also like to add that, Nobel laureate and long-time bear Bob Shiller – who accurately and boldly predicted the 2000 and 2007 bubbles – is hedging his portfolio, explained that his famous CAPE model indicator (conveys those stocks are overpriced similar to the 2000 bubble highs) reveals unimpressive overvaluation when compared to bonds. Bonds, on the other hand, are even more spectacularly costly by historical records than stocks.
It is precisely what usually happens at late-stage bubble; an accelerating, nearly vertical stage of unpredictable and unknown time frame – usually short. Even if it is short, this stage at the end of a bubble shockingly hurts and full of reputational risk for bear managers.
The bizarre aspect of this bull market is how different it is from every previous great bubble. Past bubbles have mix of accommodative monetary policies with economic conditions that are considered at the time, as almost excellent, where excellence is universalized indefinitely into the future. The status of economic perfection of past bubble was certainly temporary, but if it could have lasted, then the market would have rationally sold at a big multiple of book.
The current “sick” economy is totally different; inflation spiking to 30 years high in the United States; massive supply chain challenges; huge commodity price spikes; the economy perhaps facing a double-dip slowdown and potential recession (due to the possibility of Ukraine-Russia war) – the environment is surely facing a very high degree of uncertainty. Even so the market is much higher today than it was 1Q21 when the economy was quite OK and unemployment was at a record low. Currently, the P/E ratio of the market is in the top quintile since record began. This is a good measure of speculative intensity than any SPAC or meme stocks.
Emma: Were Fed policies partly or fully the trigger for this bubble?
Barry: A lot have been written in the media about linkages between Fed policies and this current bubble. I do not want to repeat them. Now more than in any past bubbles, investors are depending on ultra-easy monetary policies extrapolated in perpetuity. This is in principle similar to presuming peak economic performance indefinitely: it can be used to substantiate much lower yields on all assets and thereby matching higher asset prices. And so, neither perfect economic settings nor ideal financial conditions can last forever, and that was friction. Bubbles burst suddenly with broad recognition that the current one will probably not end:
- Since in 1929 the economy had climbed into “an indefinite high plateau”;
- Since 2000 Greenspan’s Fed in 2000 forecasted enduring better productivity and assuring its faithfulness (i.e., moral hazard) to the public equity market;
- Since 2006 Bernanke Fed trusted that “U.S. house prices merely reflect a strong U.S. economy” as it upheld the moral hazard theory: if you win – you’re on your own, but if you lose you can count on Fed support. Yellen and Powell Fed maintained this approach.
The Fed leaderships for the past 22 years, declared asset prices they assisted to inflate successively helped the economy through the wealth effect. The “effect” is material and the Fed leaderships over that same period praised themselves for the successful market “home runs” that unavoidably led to the 2000 TMT equity blow up and the housing bust of 2008. What we least expected was; each bust accompanied rise in shocking levels of poverty; an anti-wealth effect, exacerbating an already assured weakness in the economy.
Michael: I will add that, in the final episode of this moral hazard, market players have come to depend on asymmetric market risk – i.e., the high prices will hold due to indefinite low interest rates. Even until 1Q21 the school of thought was low rates can prevent a decline in asset prices, indefinitely! Certainly, it was a delusion in 2000 and it is a delusion right now. Eventually, moral hazard did not halt the TMT bubble decline, with the NASDAQ plunging over 80%. Yes, 80%! Neither did it stop 2008 where U.S. housing prices declined all the way back and below trend. The guaranteed:
- 1st, a shocking loss of over $8T of perceived value in housing;
- 2nd, a follow up weakness in the economy that was deep; and
- 3rd, a huge increase of risk premia and a wide deterioration of global asset prices.
All assurances meant nothing in the end, except the Fed did not reconfigure the market architecture and prepare the economy for the next financial crisis. Eventually the current bubble will blow up.
Emma: When do you think the bubble will burst? What could trigger this? What signs should stakeholders look for?
Barry: In financial markets nothing perfectly recurs particularly not for investment bubbles. There are differences of illogical ebullience; in what we term “invisible architectural” similarities. Currently, we suspect this market can surge upwards for a couple of weeks/ months/ even quarters – it happened between Q2 1999 and Q2 2000. In other words, it may break at any time, having fulfilled all requirements, but could continuously surge upwards for few more months.
Currently, the key demanding issue confronting the world economy has to be solved. Market stakeholders will breathe a sigh of relief and immediately realize that the economy is still getting back to normal (albeit rough one), stimulus has been cut back with the end of the pandemic (and possible variants) in sight, absurd valuations, supply chain challenges and high inflation. Let not forget that timing the bubble bursting has a media record of disappointments and frustration.
Indeed, with benefit of hindsight, it is difficult to identify the nail that blows up the bubble. The key reason is that the great bull markets do not usually break when presented with a major unexpected negative. Events such as the 1987 portfolio insurance debacle, inclines to provide sharp down legs and swift recoveries or rallies. In broader layout of things distinctive and technical – do not lead to the tide and flow of the great bubbles.
Michael: Typically, great bull markets “turns south” when market conditions are remarkably positive, just subtly less positive than prior days. And that is why they are always missed.
Regardless, the market fulfills most requirement for a major bubble. The most spectacular attributes are the zeal and exuberance of bulls, the broadness of public equities and the market, and the rising antipathy toward bears. In 1929, to be a bear was to risk verbal harassment, physical attack and ensure character assassination. Next, in 1999 bear asset managers endured clients reacting as if they were willfully and maliciously denying them of gains. Strangely in 2008, some bear asset managers were lucky to escape hostility. However, from 1Q21 to the beginning of 1Q22 the hostile tone has been rapidly ratcheting up. The paradox for bears though is that it’s precisely what they like to hear. It’s a definitive forerunner of the eventual break; together with public equities surging, not for their fundamentals, but simply rising for rising sake with “no particular reason”.
Another more quantifiable attribute of a late-stage bull, from the Dutch Tulip bubble (1636), British South Sea bubble (1720), Wall Street bubble (1929), Japan bubble (1989), TMT bubble (1999), the US housing bubble (2008) and the current bubble is marked by a quick speed in the final leg, which in recent instances has been over 60% in the last 21 – 36 months to the peak, a rate well over 3 times the normal rate of bull market rise.
Barry: At Zinqular Public Markets Unit, we view bubbles as opportunity as well as a risk. During bubbles fortunes are made and lost swiftly and investment advisors have a unique opportunity to proof their worth. These opportunities to be useful come loaded with risk.
So why is it difficult for institutional advisors to de-risk even during the last stage to great bubble?
The mixture of lack of clarity of timing and swift regret on the part of clients means that the business risk of combating the bubble is high price for large commercial investment firms. They do not favor the bearish advice even if the P/E is beyond illogical realms (e.g., P/E 60x Japan case). Therefore, do not hold your breath for the Barclays, Goldmans and Morgan Stanleys to become bearish. Never! They view it as terrible non-commercial gamble. Profitable and risk-reducing for the clients, yes, but commercially impractical for advisors. For them it is simple and clear policy – constantly be bullish. It is good for business and intellectually easy. It is alluring to most investors who much like favor positive outlook to realistic valuation. In the end, you will as an enduring bull have overpowering company. This explains why there is always bullish advice in a bubble and always will. Zinqular see the bubble as it is and call it last stage accordingly.
Emma: There is school of thought we are entering into super-bubbles environment? Are we there yet?
Michael: It is difficult in a bubble for bear reasoning to be accepted. It is so true for the kind of bubble that financial markets currently find itself. At Zinqular, we believe we are currently in the midst of a super-bubble.
It is incredible that broad number of public equities (Small-cap, Mid-cap and large-cap stocks) in the market had a spectacular and meteoric rise in stock prices in some cases 10 to 20 times within 6 months (in the 2020 to Q4 2021 window). In early 2022 most of these stocks came crushing down in a panic fire sale and the sale is still ongoing as we do this discussion?
These events make some market participants sympathize with the view that bearish warnings in bubbles comes from “golden ager” who “simply never understand”. We think speculators in the current bubble will not listen to bear advisors; but giving this advice is our duty and quite so the right thing to do.
Barry: In 2020, it appeared the market might have a “text-book” bubble that comes with usual economic pain but within the same year, the bubble upgraded to the class of super-bubble, we believe one of only three in past 100 years of US financial history, and the potential misery has increased disproportionately. Even more reckless for market players; the equity bubble, which last year (2020) was already connected to extreme low interest rates and high bond prices, has now (2021/2) been coupled to the developing bubble in commodities and a bubble in housing.
There are many factors for super-bubbles – one being the current over-accommodative policies of Fed and other financial regulators. As bubbles develop, they provide market players an absurd exaggerated view of their real wealth, which motivates them to spend extravagantly. Suddenly, as bubble deflate and mark down asset values – they crush their rosy aspirations and speeds up negative economic forces on the way down. It is simply terrible economic strategy to enable bubbles much less support them.
Incredibly, there seems to be no discussion that higher-priced assets are simply worse than lower-priced ones. When assets for e.g., wind energy plant or Copper/Nickel mining plants or commercial forests, doubles in price so that yields fall from 8% to 4%; the investor may feel wealthier. However, their wealth amplifies much slower at bubble valuations, and therefore their income also drops. Shocking! Young people waiting to acquire their first house or first portfolio, might find it is too costly to even begin.
On the other hand, there is the huge rise in economic inequality that goes with higher asset prices, which many segment of the population simply do not own, (i.e., the middle-class society or the median family or below). Shockingly, this group in the society have been “ignored and forgotten” and is certainly angry and annoyed by this. This intend affect the economy negatively.
Emma: What are some of features of higher-order bubble event?
Michael: Each and every second order sigma equity bubble in developed countries have corrected back to normal. Before they did, a few upgraded to become super-bubbles of higher order sigma: for instance, 1929 Wall Street bubble, 2000 TMT bubble, 2006 housing bubble and 1989 Japanese bubble. All these super-bubbles snapped back to trend with much larger and extended pain (and suffering) than norm.
We think today (2022) in the United States, we are in the fourth super-bubble within 100 years window. Past equity super-bubbles had a succession of distinct attributes that are rare and uniquely grouped to these events. Each and every instance has a shared characteristic that have already taken place in this current cycle.
The pre-final attribute of these super-bubbles was an acceleration in the rate of price rise 2 to 5 times the normal speed of the full bull market. In this cycle, the acceleration occurred in Q2 2020 and ended in Q1 2021, during which the NASDAQ rose to 60% (computed from Q4 2019) and a shocking 109% from the COVID low.
Barry: The final attribute of the great super-bubbles has been a prolonged narrowing of the market and un-usual worst performance of speculative stocks, many of which drops as the blue-chip market rises. Similar event played out in 1929, in 2000, 2007 and it is happening now (2021/2). We believe the reason for this phenomenon would be that expert advisors that know the market is dangerously over-priced yet think for commercial reasons they must keep “playing” at least to “level off” the steep with safer stocks. This explains the reason at the end of great bubbles it appears as if the assertive “marine sharks” attacks the most speculative and risky first and work their way up, sometimes quite slowly, to the blue-chip stocks.
The most significant attribute and difficult to define quality of a late-stage bubble is in the over-exuberance characteristic of illogical investor conduct. In the last 30 months there is surely no doubt that the market has seen illogical investor behavior – astonishingly more even than in 2000 – specifically in meme stocks, in EV-related stocks, in SPACs, in Cryptos, NFTs, and remote working tools stocks.
Michael: When the registry of phases that super-bubble runs through to completion and then the spectacular blow-up begins at any moment (day, week, month, quarter, half-a-year, etc.).
The super-risky levels and what is new this time, and only similar to Japan in the 1980s, is the unbelievable danger of jamming several bubbles together. Today (2022) with about four major asset classes bubbling concurrently for the first time in the history of modern financial markets. When “doom and gloom” comes back to markets, the economy will be confronted with the largest potential depreciation of of perceived wealth in America’s history.
Emma: What are higher-order bubble event? How different are they from first order bubble event?
Barry: An investment bubble (or first-order market bubble) is a mathematical method of detecting financial bubbles or crashes based on a data fitting with an exponential function. In higher-order bubbles, we use a higher-order statistical measure of multiple extremes – a higher-order sigma deviation from multiple trends.
An example; for a random distributed series, like the sum of throws of a fair coin, a 2-sigma event should occur once every 40 trials in each direction. This measure is random but seems quite realistic.
In reality, though, humans are not efficient (in prudent use of resources) but are often quite irrational and can be enraptured so that 2-sigma outliers occur more often than random – not every 40 years, but every 31 years. Data reviewed across all asset classes over modern financial history and found a total of more than 330 2-sigma moves.In advanced public markets, all instances of a 2-sigma equity bubble in the last 100 years have eventually fully deflated with the price moving all the way back to the trend that existed prior to the formation of bubble.
However, market extremes do not halt at second-order sigma (2-sigma). We define a super-bubble as a third-order sigma (3-sigma) event. That would occur in a world of tosses fair coins about once in every 100 events, but in real life appears to occur two or three times more frequently than that. Humans do illogical things.
Michael: Even if the bubble hits second-order sigma, third-order sigma, or higher, it still plunges way back to trend, resulting in asset value losses of colossal magnitude.
Two important things are valid:
- the higher asset prices go, the lower the expected future return. Which do you prefer; glutting on your cake now or enjoy it piece by piece into the distant future, but you can’t have it both ways;
- the higher asset prices go means the deeper, longer and greater the pain there is to endure to get back to trend – in the current case to a trend value of about 2450 on the S&P 500, adjusted for the passage of time, from whatever high point the market might reach (now 4482 (data as at 20 January 2022)).
It was the same narrative in the three great bubbles of the United States, i.e.,1929 and 2000 (equity bubbles), and 2006 (housing bubble). It was a similar story in the Japanese stock and real estate markets bubble of the late 1980s. It not surprising to us; that all of these bubbles fell way back to trend.
Emma: What are the dangers of concurrent multiple asset bubbles? How does it cascade to various areas in the economy and the overall society?
Michael: Specifically, it was very clear in the Japanese event, that while it is perilous to have a bubble in equities – the loss of value usually reverberates through all wealth strata. The effect can notoriously get out of control, which was a partly an issue in 1929 and the follow up slump – it is very dangerous to have a housing bubble, but even unbelievably dangerous to have multiple bubbles together (i.e., equities + housing + commodities, etc.).
In Japan, the economic repercussion of its double bubble is unquestionably still felt.
Current data for the U.S. shows for the first time we have simultaneous bubbles across all major asset classes.
Firstly, we think the U.S. is part of the broadest and most extreme global real estate bubble in history. Currently, the U.S. housing market is at the highest multiple of family income ever, after an increase record of over 20% in 2021, even much higher than the 2006 awful housing bubble. Even though the U.S. housing market sales is at a higher multiple of family income, it is much lower than many other countries, particularly China and other OECD countries. In China, real estate has been a key and distinctive part of the enlarged boom and consequently causes an equally distinct risk to the economy and the rest of the world when real estate market falls.
Secondly, we have the most high-spirited, buoyant, euphoric, even crazy investor conduct in the history of the U.S. equity market. The U.S. market has the most sizeable buy-in ever notion that stocks only rise, which is surely the real lifeblood of a bubble. On the other hand, while other developed economies lead in housing prices, they fall behind the U.S. in equity prices.
Thirdly, to make matters worse, the U.S. and its peers has the highest-priced bond markets and the lowest rates, that go with them, that markets have ever witnessed in history.
Barry: Finally, broadly commodities (including oil and key metals) are way overpriced and above trend. Furthermore, data from United Nation’s Food & Agriculture Organization (UN FAO) index of global food prices is around its all-time high. These expensive prices are relevant as they push inflation and stress real incomes. The fusion of rising commodity prices and a deflating multiple asset price bubble will ultimately lead to the fall of the economy and is all but guaranteed to cause major economic pain.
If financial regulators and governments do not address the impeding negative “economic explosion” – there will be an enormous multiple shock ever seen in history – leading to historic write-down of perceived wealth.
This loss we think will exceed the 2007 U.S. housing value $10T or over 7 to 8 months of GDP should house prices declined even slightly below trend. Similarly, the bond market which is currently overpriced at the risky corporate end, and least to say, the stock market is absurdly overvalued.
Despite that recent pain, all of the economic signals and financial dangers that are forming from multiple major bubbles, it does not seem that the Fed and its peers around the world consider them dangerous. Shockingly, the warning signs does not appear to be detected (even in the least).
Emma: After all the 3 great bubbles that has happened, what has central bankers learnt? What has been their action, inaction and response?
Barry: The U.S. has experienced three great asset bubbles since 1997, far more than usual. This was a direct result of the post-Volcker regime of dovish Fed bosses. The question is why did the Fed not only have allowed these events but encouraged and facilitated them.
It is remarkable with all the resources the regulators have; they still do not have an effective early bubble detection system (if any); and have still not detected asset bubbles since 1990’s. The Feds in these eras acted seriously incompetent either by cheerleading in the bubble formation (Greenspan era) or were blind believers in market efficiency to ignore the possibility of occurrence of bubbles (Bernanke & successors).
In the mid 2000’s, when faced with an obvious third-order sigma situation in the U.S. housing market, Bernanke maintained that “the U.S. housing market merely reflects a strong U.S. economy…”. The message he intended to send was “… it never will decline because there is no bubble and never can be…” At that time, based on statistical data, the history of U.S. house prices had never bubbled before; as it’s so diversified collectively. In advance to that, the sustained excess stimulation of the Greenspan and Bernanke era created an ideal occasion to ultimately bust in most regions, markets and countries.
The “once in history” and evidently non-existent housing bubble pulled way back to its trend that had existed prior; and went well below trend. The 3-sigma event came to past and became a text book representation bubble of all time (see Exhibit 3), causing huge economic destruction to the U.S. and global economies, largely due to absence of regulation around the new mortgage-related instruments. Now, the Fed again, we believe, is aiding and abetting the creation of a great bubble. This time around the pain will be aggravated by the housing bust, linked to mortgage mayhem, and the subsequent down-turn in the U.S. stock market – only terribly overpriced albeit not a bubble – plus the total loss of “perceived wealth” hastening a depression and requiring a historic bailout and massive stimulus.
Michael: Generally, the Fed at the helm of a giant-sized economy, had misguidedly rally the economy through a wild atmosphere, ignoring the risks of superstorms so radical that the captain deserved to be disciplined but instead, after the “airplane crashed”, was honored for doing a “good” job of helping “vulnerable people” into parachutes. “Vulnerable people” represent the wall street banks and other financial players.
The question is – what has the Fed and other central bankers learned? Not that much! With the explicit dangers of an equity bubble revealed in 2000 – 2002, the even greater dangers of a housing bubble in 2006 – 2010, and the extra risk of two asset bubbles together in Japan in the late 1980s and in the U.S. in 2007.
Shockingly, the only “knowledge” gained from the 2009 devastation by that the central bankers and other financial stakeholders is that they didn’t solve it with bigger stimulus or “firepower”. They should have taken safeguards to prevent the crisis in the first place seems to be a “knowledge” not learned, and sadly not even taught. Therefore, they rely more parachutes rather than superstorms avoidance. They forgive and forget incompetence and fail to punish even serious misconduct. In Iceland (300k population), they jailed 26 bankers; the U.S. (with over 310M population) jailed zero.
Emma: How does blow up of market bubbles affects socio-economic inequality? What should be done to address these social issues?
Barry: It is plain for all to see, that the negative impact of these three bubbles over 25 years, has been the enduring miserable social and economic inequalities; to engage in the upside of an asset bubble you need to possess some assets and the impoverished section of the population have no wealth.
In contrast, the top quintile in the United States owns over 90% of all assets. Since 1997, there has been a rapid rise in inequality, that has made U.S. the most unequal of wealthy countries and, strikingly, with the least level of economic mobility, even worse than that of the “rigid” Great Britain. The rise in inequality is directly offset from widest consumption metrics because, on the margin, wealthy people getting wealthier will expend almost nothing of the increment where the poorest quintile expend all of it.
Michael: Therefore, with world record stimulus from the housing bust era, followed up by staggering massive Covid stimulus for Covid (some of it needed). Everything has its repercussion and the reaction this time may have some out-of-control inflation- boasted by most dangerous breadth of asset overpricing in financial history. Eventually, when doom and gloom become rules again, asset prices will slowly reset and decline.
In our humble view, in the United States alone; we think total wealth on the scale of $32T will be wiped off, if overpriced valuations across multiple asset classes falls by a modest 50% back to past norms. The negative wealth and income impact is aggravated by inflationary pressures from demand/supply imbalance, energy, food, and logistics bottleneck; means there will be terrible times ahead.
Emma: What your recommendation for clients in this market? How do you create value and reduce risk in equity higher-order bubble?
Barry: Controlling risk connected to bubbles (or super-bubbles) has been difficult and is one of the sizable challenges in the investment management.We at Zinqular (specifically our public equities business) commit to attempt to get the broad calls correct. Highly risky market realms, almost to this one we are facing currently, historically have managed to add good weighty value to investors’ portfolios.
We think the winning proposition in this higher-order bubble environment is to reduce equity, focus on non-U.S. value and alternative strategies; modest fixed income, no treasuries, and only specialized credit.
Michael: The epicenter of the bubble – both at home and abroad – is concentrated in growth stocks. As such, we are long a global portfolio of value stocks and short a global portfolio of growth stocks. We also have worked with a client to build a pure U.S. growth short portfolio, with a focus on the most expensive names in the growth universe. We believe this particular type of portfolio is an excellent hedge to the significant gains many have experienced via investments in technology-focused private equity and venture capital.
Barry: Outside of long/short strategies, we have reduced our equity risk considerably and emphasized non-U.S. stocks, which we believe are considerably cheaper than their U.S. counterparts. We have concentrated our exposure to non-U.S. value stocks globally, including those in emerging markets and Japan. To us, these stocks look very cheap relative to the U.S. and in the case of emerging markets, China and Japan value, particularly Chinese & Japanese small value, they are attractive in absolute terms as well. Japan also benefits from secular tailwinds related to shareholder-friendly reforms and improved profitability and return on shareholder equity.
Resource equities, which are largely a segment of value, also look cheap relative to the rest of the world.
Emma: Thank you. I really appreciate you spending the time with me today.
Barry: We are glad to do this.
Michael: It is our pleasure.