Along with every extreme episode of financial market speculation is a “story,” whether it’s one of technological change, financial innovation, demographic shift, or central bank support. Each story serves the same purpose, which is to encourage and even promise investors that risk is not really risk. As a result, typical levels of cyclical overvaluation aren’t enough to deter further speculation. At the peak of every speculative bubble, there are always those who have persistently embraced the story that gave the bubble its impetus in the first place. As a result, the recent past always belongs to them, if only temporarily. Still, the future inevitably belongs to somebody else. By the completion of the market cycle, no less than half (and often all) of the preceding speculative advance is typically wiped out.
In 2009, during the depths of the last crisis that followed such speculation, economists Carmen Reinhart and Kenneth Rogoff detailed the perennial claim that feeds these episodes in their book, This Time is Different:
“Our immersion in the details of crises that have arisen over the past eight centuries and in data on them has led us to conclude that the most commonly repeated and most expensive investment advice ever given in the boom just before a financial crisis stems from the perception that ‘this time is different.’ That advice, that the old rules of valuation no longer apply, is usually followed up with vigor. Financial professionals and, all too often, government leaders explain that we are doing things better than before, we are smarter, and we have learned from past mistakes. Each time, society convinces itself that the current boom, unlike the many booms that preceded catastrophic collapses in the past, is built on sound fundamentals, structural reforms, technological innovation, and good policy.”
“The essence of the this-time-is-different syndrome is simple. It is rooted in the firmly held belief that financial crises are something that happen to other people in other countries at other times; crises do not happen, here and now to us... If there is one common theme to the vast range of crises we consider, it is that, excessive debt accumulation, whether it be by the government, banks, corporations, or consumers, often poses greater systemic risks than it seems during a boom.”
My view on “this time” is clear. I remain convinced that the U.S. financial markets, particularly equities and low-grade debt, are in a late-stage top formation of the third speculative bubble in 15 years. On the basis of the valuation measures most strongly correlated with actual subsequent market returns (and that have fully retained that correlation even across recent market cycles), current extremes imply 40-55% market losses over the completion of the current market cycle, with zero nominal and negative real total returns for the S&P 500 on a 10-12 year horizon. These are not worst-case scenarios, but run-of-the-mill expectations.
The risk cycle has already turned, and the familiar canaries in the coalmine - market internals and credit spreads - have been deteriorating persistently, in the same way that deteriorating internals and subprime defaultswere the first warning signs to emerge in 2007. A clear improvement on these measures would not improve the long-term outlook, but would significantly reduce the immediacy of our near-term concerns. We don’t observe that at present. To the contrary, particularly on the international front, the consequences of years of distorted capital flows and yield-seeking are already unfolding. As Carmen Reinhart observed last week, “From a historical perspective, the emerging economies seem to be headed toward a major crisis. Of course, they may prove more resilient than their predecessors. But we shouldn’t count on it.”
The Big Short
Over the holiday, we went with a group of friends to see The Big Short, based on the book by Michael Lewis about the global financial crisis. The film is deeply critical of Wall Street and weak banking regulation, most of which I see as valid. The one thing missing was that the film didn’t clarify why the mortgage bubble emerged in the first place, which I would have liked Margot Robbie to have mentioned while she was explaining mortgage-backed securities in the bubble bath.
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