No bubble evident

We are continuously subject to spurious arguments that there is a bubble developing or, more typically, a bubble has already developed in the equities markets. Much of this analysis[1], some of it throwaway, is from individuals who have never been significantly invested in the markets and merely serves to scare off would-be investors as the markets continue to rise.

The reality of market bubbles is that it is almost impossible to identify them as they are forming – for the simple reason that the rises in the markets can always be rationalised at the time that they are occurring and such rationalisation is not obviously irrational. For example, the Dow Jones and the FTSE 100 are both close to record highs, but the pricing of them can be justified on a relative basis: their dividend yields are significantly better than can be achieved from government bonds or the return on cash, and they have growth prospects (neither the US nor the UK economies are facing recession) which are positive. Of course, the bears would argue that the prices are, on some measures, over-extended. But that, in itself, is not a justification for categorising them as being in bubbles.

To see whether there is a significant bubble risk, we need to look at other indicators. The classic one is that there is strong positive sentiment amongst investors which is sucking new investors/capital into the market. In such a scenario, investors are effectively leap-frogging each other and forcing up prices. The bubble falters when the capital committed reaches a maximum and there is no additional capital available to continue the price-rise process.

But that is not what has been happening in the markets in recent years. Instead, many discretionary investors have actually been withdrawing capital from the market. In many instances, this has left stocks at such low prices (in DCF or absolute terms) that private equity has taken them out of public ownership, and we have seen public markets stagnating or even shrinking in terms of the number of companies.

The withdrawal from equities has been most evident by private investors since the 2008/9 recession – typically at the ‘amateur’ end of the market – who have suffered the double-whammy of missing the recovery in stocks (after their losses in 2008/9) and exceptionally low returns from the savings accounts in which they subsequently placed their capital. But even institutions have been participating in the withdrawal. In their case, however, the equity withdrawal has been typically more moderate and rational with the capital being switched to government bonds, which have continued – until recently – to produce some exceptional returns. One might think that the professional investors are just a little smarter than the private investors, but the main reason for the shift into bonds has been more typically the irrational but mathematically-correct requirements of Solvency II, which has been slowly sowing the seeds of a future disaster in the bond market.

The Financial Times[2] reports that UK insurers, pension funds, and trusts have withdrawn GBP31bn from equities and bonds in the 12 months to the end of September. Clearly the nervousness is now spreading from equities to bonds. And, before anybody mentions Brexit as a cause, the largest withdrawals from UK stocks (GBP34bn) were almost exactly matched by the withdrawals in overseas stocks (GBP33.5bn), even though exposure to the latter was smaller.

Reconciling such withdrawals with new record highs in market prices obviously involves some interpretation of the numbers. The most obvious one is that risk-averse investors are withdrawing while risk-takers are increasing their exposure. To some extent that is a normal process that facilitates buying and selling, but I believe that we have seen it to the extent as in 2016. There clearly is a strong polarisation of perspectives. One consequence of this is that the rich (who can afford to take greater risks) are becoming richer from these markets, while the man in the street (as represented by the retail investors and institutions) is becoming poorer.

If so, this is not a bubble. Rather, with a narrowing investor base, it is an anti-bubble and a concentration of wealth. The bubble will only start to inflate when the risk-averse return to equity investment – and that could take some time. Even if prices suffer a set-back, that is more likely to evoke a feeling of relief of no loss of capital by the cash-holders, rather than a sense of an opportunity arising.

[1] I appreciate that there are also some serious work done by analysts who reach some negative conclusions; this comment is not aimed at them

[2] ‘UK investors pull more than ￡31bn from equities and bonds’, FTfm, 9 January 201717

Copyright VARE Consulting 2017