By chance last week I found myself rereading a favourite passage from a classic stock market text, The Money Game. The author, Wall Street veteran George Goodman, recalls the time back in the 1960s when the book’s trader hero, known only as The Great Winfield, hired three “kids out of college” to do some trading in the mad bull market of those far-off days.
The strength of the kids, so the trader explains, is “that they are too young to remember anything bad and they are making so much money they feel invincible”, while older investors are too haunted by the memories of past phases of euphoria.
The “kids” see nothing wrong in paying 100 times earnings for a computer-leasing company, or anything that sounds whizzy, even if it means leveraging the position with cheap borrowed money. In bull markets there are always “theme stocks” that attract flows of hot money on the back of a plausible growth story. One of the kids in the story – a detail I had forgotten – pipes up with one such idea he is chasing.
“Sir 1,” said Sheldon the Kid. “The western United States is sitting on a pool of oil five times as big as all the known reserves in the world – shale oil. Technology is coming along fast. When it comes, Equity Oil can earn even $150 a share. It’s selling at $24. The first commercial underground nuclear test is coming up. The possibilities are so big no one can comprehend them.”
Talk about nothing new under the sun. Remember that this was the late 1960s, when oil was selling for less than $5 a barrel and cars were still as wide and as guzzly as a bus. What is more, the point Mr Goodman was making, even then, was that the young kid’s enthusiasm for shale oil was not even the first time this dream of energy independence was being touted round Wall Street. Something similar had happened in the 1950s too.
Of course, there are plenty of differences between today’s financial markets and those of the go-go years of the 1960s, let alone the uncannily reminiscent technology, media and telecommunication bubble years of 1998-2000. With oil at more than $100 a barrel, and fracking technology well established, it does appear that the shale oil revolution – so often just around the corner – may finally be coming to fruition in the US.
Today’s equity market participants display none of the mindless euphoria of those earlier bull market episodes. The memories of what transpired in the great financial crisis five years ago are still too fresh.
And yet the echoes in market behaviour and attitudes from the period leading up to the crisis cannot be ignored entirely. The source of momentum may be different, but the psychology is converging.
Five years of easy monetary policy in developed markets have successfully kept asset prices higher than they would otherwise have been, but have done little to restore past levels of economic growth. The US stock market has added $32tn in market value since March 2009, while the economy has grown by just $1tn.
The massive amounts of liquidity provided by the US Federal Reserve and other central banks have helped to bolster bank balance sheets, but little of the monetary stimulus has so far found its way into the real economy.
More importantly, with only a modest increase in nominal gross domestic product, it has proved impossible to make serious inroads into the mountains of unrepayable debt that were accumulated in the run-up to (or added in the resolution of) the global financial crisis.
Indeed, in one way the problem may be getting worse.
William White, former chief economist at the Bank for International Settlements, the central bankers’ bank, was one of the few to warn about the dangers of the build-up of debt before the crisis. He is now sounding the alarm again over the way history appears to be in danger of repeating itself.
As investors scour the world for yield, the price of risk has been tumbling. Credit spreads are back down to the level they reached in 2007, while high-risk leveraged loans now account for 45 per cent of the total syndicated debt market.
In the equity markets, the cyclical bull market that began in 2009 is well established – indeed, long in the tooth by the standard of more normal past historical cycles. Nobody could describe market sentiment as euphoric, which is one reason why it is perfectly plausible that the equity market surge we have this year can be sustained for some time yet.
The Federal Reserve’s decision not to taper looks likely to keep equity momentum going. But the number of late-cycle bull market signals is multiplying: look at the levels of margin debt, the rise in valuations and the rise in mergers and acquisitions.
The equity market behaviour is taking place despite the fact that if you believe in mean reversion, expected ten-year returns for both the S&P 500 and a bog standard 60-40 equity-bond portfolio are now the lowest in recorded history, save for the bubble years of 1998, 1999 and 2000, as Deutsche Bank points out in its asset-class study.
Other than by comparing it with the even worse prospective returns from bonds, it is hard to see how this deliberately induced bull market in equities can continue to justify itself.
To enjoy these markets to the full, without anxiety, you need to be young and free from the scars of long experience.