Are we living life in a bubble?

                       Debate is currently raging amongst the many market commentators and economists as to whether or not we currently sit in the middle of an asset bubble driven by the Quantitative Easing being pumped into the market by the Fed. The US has seen the S&P 500 hit new all time highs in recent weeks over 1,800 as the exuberance shows no sign of abating, whilst the FTSE 100 is up 14% for the past year, up over 60% from the depths of 2008. Meanwhile you have companies like Twitter doing an IPO and seeing a price rise over 55% from the IPO level a month ago, despite not having ever made a profit. In fact it lost $80m last year and has already lost $133.9m for the first months of this year. At the time of it’s IPO it was valued at roughly 43 times its revenue. Of course the purpose of investing in a loss making company like this at IPO is that you are there to take advantage of the fact that you believe the company is the future and will really profit in the coming medium term.

             However, there are many who believe that it is a dangerous sign of a repeat of the perils of ‘99 where tech companies where sold off for increasingly nonsensical levels which ultimately resulted in the crash, the levels of which most market indices have struggled to get back to. Meanwhile, they argue that the prices of other companies are vastly overpriced already as investors pile their money into equities as a result of the belief that with QE that this is the only viable place to get a good yield and that the money will keep on coming so prices will keep on rising. There are those that think if you’re looking for a quick buck, then stick it into the current market and you’ll be alright because all you have to get out before it crashes. It’s all beginning to sound very much like the mentality of a bubble.

Performance of FTSE100 vs S&P500 since Nov 2008

                  So is it going to burst? With all the talk of tapering some markets have already started to see a retraction in prices, mainly in emerging markets, as investors begin to pull back funds from there which they may have borrowed to invest as the cost of investing increases. It would appear to many that for all the money pumped into the economy from QE, it has mainly acted to increase asset prices without having any real effect on the economy. However this is to ignore some fundamental truths. In his most recent letter to his investors, Niels Jensonfrom Absolute Return Partners makes the point that but for the use of QE, GDP would most likely be between 5 and 15% below its current levels in the US. The UK I’d imagine would be in a similar boat. That is quite a substantial figure to recover from and we would most likely have been in a depression the likes of which we would struggle to recover from for many, many more years. Just look at Greece and the struggles it is having with its economy roughly 25% below its peak before the crash. However, as Niels Jenson also argues, the positive effects of QE have reduced steadily in each phase, including its impact on asset prices. I’ve mentioned before that the Fed needs to begin its taper as soon as possible in order to help investors wean themselves off the easy money, but also to continue to try and keep real interest rates close to their current levels. For this to work it of course requires the market to truly believe that the Fed will not adjust their base rate too soon. A lot of commentary on the incumbent Fed Chief, Janet Yellen, is that she will work to use forward guidance and reduce the threshold unemployment level required before rates will rise to 5.5% and then even 5%. This should hopefully indicate to markets that rates are likely to stay low for a further required period while the economy continues to recover and reduce any panic which may occur should tapering begin soon.

                    Where does this all leave investors as to whether they should or shouldn't put money into equities? In one of my earlier articles I spoke about the thin line between speculation and gambling and how, in the current market, trading on a daily, weekly or monthly basis is, per the textbook definition, a gamble. The risk is just too hard to really assess versus the potential return. Investors need to have a proper plan as to what they are looking to achieve. Just under 9 years ago I wrote my Masters dissertation examining whether investing in value strategies in the UK really outperforms investing in pricier stocks once you account for the extra risk involved. A value investment strategy involves buying companies who have lower fundamentals compared to other stocks. For example, low price-earnings ratio, low price-cash flow ratio or low market value to book value. The research did find it was possible to invest in a portfolio of value stocks and make superior returns over 1, 3 and 5 years without any extra risk being involved, however in order to make it work you needed to invest in a portfolio of the 200 value stocks, a pretty large financial commitment for any individual investor.  But it does show it is possible to find opportunities without having a greater level of risk, so long as you are prepared to invest for the medium to long term. But to select just a handful of these “value” stocks and gamble that they would be the winners is to misunderstand the realities of investing.

                Of course, quite possibly the greatest investor of our time began life as a value investor.  The difference is that Warren Buffett doesn’t just look at the basic fundamentals but has always spent time understanding the company itself and most everything about it in order to determine whether a potential investment was underpriced in the long run as opposed to a company being in a permanent downturn (or worse).  Buffett’s company Berkshire Hathaway only holds stakes in about 50 listed companies globally but the likelihood is all these decisions have involved careful focus on the business as well as looking at market fundamentals indicating undervaluing. Buffett’s record over the last 60 years has proved that it is possible to pick substantially more winners than losers over a sustained period of time. The most remarkable thing about Warren Buffett is that he is very open about how he decides what to invest in, seemingly making it easy for the rest of us to just follow his mantra. Such a method should give us the reassurance in the current market to continue to invest in undervalued stocks even if a bubble is in existence. The reality is that the vast majority of investors have neither the patience nor discipline to follow in the Sage of Omaha’s footsteps. He however makes sure he invests for the medium to long term in most cases.   

               Therein lies the lesson to us all. Investing in equities must be done with a realistic long term view in mind, in terms of both the businesses we’re investing in and the timeframe we’re prepared to wait for our returns. Looking for a quick buck plunging capital into the latest fad may all sound great to everyone, but who really has the foresight (or is paying enough attention) to know when that fad is at an end before it’s too late. We all want to be the one who makes the superior investment call, but often it’s better to just make the average investment call. Investing in a market index fund or ETF in the knowledge that it may soon go down, but should go further up in the long term. It may not be exciting, but at least you know you’ll be average.

So are we in a bubble which is about to pop? Quite possibly.

               Is it going to pop because of tapering of QE? Not unless the real economic fundamentals which asset values should be based on drop back at the same time. We may see an initial pullback from the current highs we’re seeing in the initial phases following a taper, but the likelihood is that we will continue to see the current levels sustained (if not increased further) so long as the economy continues to progress. We’re a long way off seeing a full recovery just yet, but so long as things don’t get worse again there is no need to panic.

And what if the bubble does burst before it’s fully formed? Then make sure now you’ve made the right choices for your time-horizon so you can weather a couple year storm. Otherwise now is the time to remove that gamble before it’s too late.

Divergence in global monetary policy could see the Eurozone left behind

                   There's not much that takes the majority of the market too much by surprise these days. The complacency that the US politicians would reach an interim deal saw markets keep their calm in the lead up this time before rising steadily since. The lead up to most interest rate (or tapering decisions) on a monthly basis is already met with economist and analyst expectations predicting in the majority what the likelihood of the decision would be, generally days before the announcement, with the various markets pricing it all in. So last Thursday, with both the BoE and ECB predicted to keep the status quo in their respective announcements, there was no reason to think any different. After all, only 3 out of 70 economists that Bloomberg surveyed felt the ECB would reduce the base rate on the Euro this month. But they hadn't accounted for Super Mario Draghi and his mates.

     To the shock of many, the ECB decided to act sooner than predicted and promptly lowered the base rate on the euro from 0.5% to 0.25%. The ECB felt forced to act as inflation has plummeted from 2.2% in January to just 0.7% this month (it was as much as 1.6% in August). With such a sudden decline in just a short period of time, the spectre looms of potential deflation and Super Mario felt the need to act now before it was too late. The euro instantly dropped over 1.5 cents against both the dollar and pound.

       Whilst for most people the idea of no inflation sounds like a good thing (after all doesn't it mean things start to cost less?) on the whole broad deflation, if sustained, can be worse in many ways than a higher inflation rate. Robert Peston goes into the consequences of deflation (as well as the impact of ECBs cut on the UK) quite well in his blog on Thursday and it is worthwhile read. As he describes "If businesses and consumers began to believe that deflation was a serious prospect, they would defer purchases and investments to take advantage of falling prices.........there would be an even greater incentive for businesses, households and banks to reduce their debts - to save as if there's no tomorrow - because of the threat of deflation increasing the real burden of those debts"

               If you believe the price of something is going to reduce, then you will wait for it to cost less before you buy it. Of course if you delay too long on your purchases then the economy itself will suffer as companies begin to stutter again as they struggle to cover their costs. They will then seek to reduce costs, which itself could be a reduction in staff or reduction in wages paid to staff, again reducing the income the population has to spend on items further depressing the situation. Meanwhile, in a similar vein that the value of money becomes less over time due to inflation, the opposite is true during a deflationary period. Any debts will begin to increase in value, unless they are paid off, and people will be tempted to put all their money under the mattress to save for when things become even more affordable (and avoid suffering deflation on investing it). The more money stored and saved up by people and companies, means less money spent on investment of any kind which ultimately becomes detrimental economic growth. Once deflation hits, the downward spiral it causes can be difficult to find a way out of, as Japan has found over the last 2 decades.

                 Given how depressed the Eurozone economy has been over the last few years, especially in the periphery, it might come as a surprise to many that the ECB has waited so long to drop it's base rate. The policy direction of the ECB now however points to significant divergence between the 3 main western monetary policy makers. In the US, talk continues apace about the possibility of the Fed beginning their taper of QE as early as December as GDP looks like growing over 2.5% for the year. Meanwhile the UK's economy continues to speed up with some analysts predicting it will have shown an increase of over 3% for the whole of 2013. Meanwhile the UK has not introduced any additional QE stimulus from its targeted £375bn total it has had for many months and the most recent forward guidance from Mark Carney had indicated the status quo would remain for at least another couple of years. Should the UK continue on it's current trajectory there is every possibility that the Bank of England may feel the need to tighten sooner, especially should inflation also continue to remain close to 3%.

                   The recovery in both the UK and US is however still tentative. In the US, the continuous threat of no real resolution on the US budget deficit and debt ceiling overhangs any recovery. Whilst here in the UK further failing retail companies (with Blockbuster and Barretts amongst the latest to go back into administration) show signs that we're still not out of the woods. However at least compared with the Eurozone there appears to be some form of recovery which can be used as a platform to move forward. The lack of real performance across the eurozone makes it a realistic prospect that rates in Europe will not only remain even lower for the foreseeable future but the ECB may need to rewrite the rulebook as a last ditch action to prevent deflation if the latest rate cut fails to work.

                 This may be easier said than done, if the Germans decide to put their foot down. Germany is especially fearful of the consequences that inflation, and specifically hyperinflation could result in, which is understandable given it's own fight with it in the 1920s and the devastating ultimate consequences of that. Whilst a focus on history can be useful in helping to make wiser decisions, too much obsession in attempting to relate history to the present can be to the detriment of the present and future. The ECB has already shown itself to be sluggish to react at times to it's recent troubles acting with caution where it's fellow central bankers abroad have been more decisive. Germany will need to accept that being part of a union requires accepting what is best for that union as a whole. The ECB has tried to act quicker this time to ensure it will stop deflation before it is too late and hopefully help stimulate the eurozone recovery as an additional consequence. Any further dithering resulting from internal national differences may not only see the eurozone left behind in any recovery but worse still could drag the US and especially UK economies back down with it.