“The cure for boredom is curiosity. There is no cure for curiosity.” – Dorothy Parker (attrib.)

In addition to lending his name to market data tracking the downfall of US real estate, Yale economist Robert Shiller is justly famous for his biography of the stock market bubble, Irrational Exuberance (Princeton University Press, 2000). Subsequent price action would appear to vindicate Shiller and his thesis: that at the turn of the century, stock prices were grossly overvalued, and false thinking was in the driving seat.

We seem to be at another key inflection point in the evolution of the markets. What factors did Shiller originally cite to account for a herd of investors gleefully stampeding towards the cliff edge? They included:

• The arrival of the Internet during a period when corporate earnings were already high, which gave rise to an exaggerated sense of the profitability inherent in new technology;
• The decline of foreign rivals and belief systems, epitomised in the fall of the Berlin Wall in 1989, which led to a surge in western ‘free market’ triumphalism;
• Cultural changes favouring business triggered a veneration of ‘fat cat’ executive compensation;
• A Republican, tax-cutting Congress which held out the prospect of future fiscal stimulus in the US;
• The (then market-positive) demographics of the Baby Boomers;
• An expansion in media reporting of business news, though not necessarily any improvement in quality or objective analysis;
• “Grade inflation” in the facile, momentum-led forecasting of Wall Street “research”;
• An expansion in defined contribution pension plans which triggered a wave of do-it-yourself stock market investing;
• The rise of mutual funds at the expense of generic bank accounts;
• A secular decline in inflation which accentuated “money illusion” with reference to stock prices;
• An explosion, facilitated by the Internet, in mostly short term securities market trading.

That was then. But as we all know, the game has changed, and in some profound ways. An assessment of the current investment and socio-economic topography might well include:

• The ongoing disruption caused by the Internet and digital technologies across multiple industries, triggering explosive creations of new value (e.g. Google (GOOG)) and equally dramatic collapses in the value of older businesses including much traditional media);
• The arrival on the world stage of fanatical extremism, as exemplified by the terrorist attacks of September 11, 2001, which has triggered ill-conceived and costly foreign adventuring by Anglo-American interests, which has in turn discredited political authority in the eyes of the electorate;
• The rise of emerging markets, notably the BRIC economies, which has promoted a degree of concern in the west at a perceived slow handover of the baton of economic growth; the increased influence of emerging market players and sovereign wealth funds in the bail-out of ailing western banks;
• A cultural backlash against Wall Street and City interests prompted by some high profile corporate frauds at the start of the millennium but given real impetus by the subprime and credit débacles;
• Stunning declines in fiscal health amongst the western economies;
• Growing concern by individuals over their ability to provide for themselves, ignited by commodity price inflation and a deterioration in property prices;
• The rise of low-cost exchange-traded funds at the expense of high cost, questionable value-added mutual funds; the simultaneous rise of higher cost ‘absolute return’ vehicles at the expense of high cost, questionable value-added quasi-index trackers;
• Concerns at a secular turnaround in the prospects for inflation after a two-decade improvement.

In short, the world has turned around; the universal smiles of the 1990s seem now to have been replaced by a collective frown. And if there is one asset class that looks peculiarly vulnerable now, it is bonds. Government bonds – as exemplified by 10 year US Treasuries – have enjoyed a 25 year bull run. As inflation got squeezed out throughout the system, bond investors reaped the rewards.

But with apparent stagflation in the west and emerging economies now exporting inflation, in part from resources demand and in part from higher wages and the relaxation of government price controls, one has to question whether the game has changed – well into the foreseeable future – for bondholders. The duration of the move from 16% yields down toward 4% yields was the time to be invested in bonds. It is an open question whether bond investors today will be well served by their price of purchase. As The Economist recently put it,

Veteran investors may recall 1962, when the Treasury bond yield was less than 4%. Those who bought bonds then earned negative real returns over the succeeding five-, ten- and 20-year periods. They should be very careful about making the same mistake again.

As Warren Buffett has said, you can’t buy what is popular and do well. US Treasuries (and their international equivalents) have benefited from a once-in-a-generation flight to quality during an admittedly disastrous financial crisis. But on the basis that the banking sector (and property markets) ultimately stabilise, current government bond yields may end up being a bull trap. In any event, it is difficult to rationalise lending money to Her Majesty’s Government at 4.6% for 30 years, when one can get over 6.25% on deposit from (government-guaranteed) Northern Rock.

In some other respects, it would be fair to believe that the gloom is overdone. While the banking, retailing and housing sectors lick their wounds, and while equity indices seem technically poised on the verge of a potentially significant downturn, less domestically focused businesses still have the uplift of the greatest wealth creation cycle (albeit on the other side of the world) in history. The opportunities are still there; we just have to be careful about market timing (the Chinese stock market, for example, has halved in value since October 2007), and overpaying to participate in them.

• Declines from Peaks in Housing Show Big Disparity  »
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• Options Trader: Thursday Outlook  »
• Bond Expert: Thursday Outlook  »

Tim Price

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