When asked what we would learn from the financial crisis, Jeremy Grantham of fund management group GMO, responded:
“We will learn an enormous amount in a very short time, quite a bit in the medium term and absolutely nothing in the long term.”1
He was referring to the fact that in finance, a big crisis tends to instil a culture of conservatism among the regulators and investors that experienced it. They respond with more onerous regulations designed to promote cautious and less risky behaviour. It is not until a new generation of optimists come through a couple of decades later (and the old hawks retire) that the mistakes of the past are forgotten and the seeds sown for the next mega crisis. I remember reading this at the time during the turmoil of October 2008 and thinking it to be an apt observation consistent with economic history.
I find it both surprising and disturbing that today, a mere five years on from the crisis, we are already observing many of the same behaviours in the financial markets that we saw in the lead up to the 2008-9 financial crisis, suggesting that we may not have learnt very much at all, even in the short term! Here are three examples from the stock market:
– Highly valued initial public offerings (IPOs) are back. This is not just among the online / tech companies, even bricks and mortar retailers are coming back to the public markets at valuations we wouldn’t have thought possible a couple of years ago. As we have argued previously here, in many cases these floats are coming from private equity, keen to get out now while the door is open and at prices they would be unlikely to achieve on the private market2.
– Merger and acquisition (M&A) activity is on the rise. The recent news in the pharmaceutical sector shows that this may now be spreading to the large and mega cap areas of the market. Companies are often justifying these deals on the basis of “earnings accretion”. I suggested in “Earnings accretion is not value creation” that investors should be wary of these sorts of arguments. In the world of quantitative easing, where cash yields virtually nothing, there is a huge temptation for companies with cash to acquire other companies just to boost their earnings. But all sources of capital have a cost, and investors will only do well out of these deals in the long run if they yield a return on capital above this cost. The dynamic today is similar to the pre-2008 period but the cause is different. Back then it was the private equity / bank lending boom that meant vast amounts of cheap debt finance was available for M&A activity.
– Economic optimism is back, particularly in the developed markets. Compared to 2-3 years ago when there was a near universal negative sentiment towards the US, European and UK economies (that was firmly reflected in share price valuations), today we have the opposite. Although the fundamentals have certainly improved, it is hard to argue that we have solved our problems. The UK economy’s “recovery” has thus far been driven by the same arguably unsustainable factors as in the pre-2008 period, namely, house price growth and consumer spending funded out of debt rather than real earnings growth. It is possible that the UK economy may start to show sustainable productivity and real earnings growth, thereby justifying the current bout of optimism, but in my view much of this is already largely reflected in share price valuations.
And if we look outside the stock market a similar picture emerges. For example, in April Greece returned to the sovereign bond markets with a debt issue at under 5%, yet a mere two years ago the country partially defaulted on its debt, and it still has a debt / GDP ratio above 150%. The high yield market (formerly known as the “junk bond” market) is also showing signs of froth, with the return of “covenant-light” loans and historically low implied default rates among some of the riskiest tranches of debt.
Yet despite these obvious concerns, it is difficult to see what imminent catalyst there is to cause a big market correction or bear market. The banking system is less risky, having de-levered and is now subject to greater regulatory scrutiny. Inflation appears benign. Liquidity remains freely available. Stock market valuations are above average in most markets but they are not extreme. They could easily go higher at least in the short term. On the other hand, policymakers have largely used up most of their crisis-combatting ammunition with zero interest rate and quantitative easing policies, so if something were to unexpectedly go wrong, there is little they could do to combat it. In my view, the most credible near term negative catalyst would come from the emerging markets, most likely China where a significant slow-down in the credit fuelled housing and wider construction sectors would have negative consequences for the world economy. But this is far from certain to happen.
My conclusion is to be cautious, realistic and opportunistic. This means being sceptical of areas where optimism abounds and valuations already discount positive outcomes. The reality may well disappoint, as it frequently has done in recent history. But I recognise that conditions are such that the current favourable stock market environment may last for a while and as such where there are value opportunities based on sensible assumptions they should be taken. Finally, I am happy to hold a bit more cash than I normally would. While the most likely scenario (perhaps 50-60% probability?) is that stock market valuations continue to grind higher, the unprecedented nature of the current monetary and economic environment suggest to me that the downside should something unexpected go wrong is likely to be considerable (and probably a lot more than the upside should the bull market continue). If such downside scenarios were to materialise, the investment opportunity set for long-term absolute return minded investors would likely be much more appealing than what we see today. Cash has one great advantage in a portfolio – it always holds its value. This means it can be put to work quickly and opportunistically if and when circumstances change.
1. Source: GMO, October 2008
2. This is no recommendation to buy or sell any particular security