Major drag, huh ?

“We’re not gonna make it, are we ? People, I mean.”

“It is in your nature to destroy yourselves.”

“Yeah. Major drag, huh ?”

–       From James Cameron’s ‘Terminator 2: Judgment Day’.

Here is a thought experiment. It is January 2000. The last wild Pyrenean ibex has been found dead, squashed by a tree. America Online has just announced an agreement to buy Time Warner for $162 billion – the largest corporate merger in history. It is all very exciting. Suddenly, a sourceless wind rises; papers blow across the pavement; windows rattle; the air fills with electrical crackling. Arnold Schwarzenegger emerges from the darkness. “It is 2015,” he tells you in his distinctive Austrian drawl. “The US unemployment rate is 5.4%. The S&P 500 is at a record high. We have record M&A activity. The corporate debt markets are booming. High end real estate is on fire. A Picasso has just broken the record for artwork sold at auction.”


“So where are US interest rates ?” you ask the Austrian Oak. “Where are Fed Funds ?”


He is impassive.


“Fed Funds are at zero. The Fed Funds Target Rate for the upper bound is 0.25%.”


“Wow,” you respond.


Too right. If you could have told anyone back in 2000 just how insane monetary policy would have become by 2015, they probably wouldn’t have believed you.


But it is what it is.


Human beings are suckers for a narrative. We love stories, perhaps more than we like reality itself. A team of equity analysts at Citigroup – no stranger to boom and bust, having gone bankrupt itself at least twice – has just published “It’s bubble time”, a note on the current madness of markets.


Citi identify four key drivers to bubble conditions:

  • A ‘new paradigm’ story with convincing fundamentals
  • Excess liquidity
  • A demand / supply imbalance
  • Business risk amongst asset managers.


Doug Noland takes up the story:


“By their nature, the final phase of an epic Bubble will indeed “destroy many contrarian investors.” There’s a confluence of important dynamics at play. First, during final Bubble phases, officials are by then responding to serious fundamental deterioration with heightened policy desperation. So-called “bears” – positioned based on negative fundamental factors – are squashed by the policy whirlwind. Meanwhile, flows gravitate to the most bullish and aggressive (tending to be those content to overlook weak fundamentals and fragilities).
“Such a backdrop foments dangerous Bubble Dynamics. “Money” chases inflating risk markets, while a depleting few retain the resources or willingness to take the other side of this “bull” trade. The upshot is a self-reinforcing market supply/demand imbalance. Over time, as bull market psychology and speculative impulses build, unhinged markets succumb to upside dislocation and “melt-up” dynamics: Too many anxious buyers facing a dearth of sellers.”


There is, of course, a crowning irony in the supposed custodian of monetary stability, the Fed, being behind most of the fundamentals (overly easy monetary policy, and huge surplus liquidity), but we’ll pass over that. Janet Yellen is only human too, after all, presumably.


And there’s another gigantic irony at work – the suggestion that the financial services industry is itself hard-wired for the creation of bubbles:


“From Citi: “Business/Career risk: A weary client once defined a bubble to us: ‘something I get fired for not owning’. It is career-threatening for an asset manager to fight a big bubble. For example, the late 1990s TMT bubble almost destroyed the value-based fund management community. Any bond manager hoping that valuations were mean-reverting would have been fired many years ago. Big bubbles are especially dangerous. TMT stocks already represented a large part of equity market benchmarks when they rerated aggressively in the late 1990s. By contrast, Biotech stocks might currently be expensive but their small market cap means they are still not a big benchmark risk. You don’t get fired for not owning Biotech stocks now, but you did get fired for not owning TMT stocks in the late 1990s. Bubbles are obvious in hindsight, but they are very hard to fight in real time. Indeed, proper bubbles are so overwhelming that they force sceptical fund managers to buy into them in order to reduce benchmark risk and avoid significant asset outflows. As these sceptics capitulate, of course they contribute to the bubble and so force other sceptics to capitulate and so on and on until there are no sceptics left to capitulate. It makes sense for an asset management company to manage its business risk but this can end up contributing to the madness.”


There is a rational question to pose at this point: why follow the benchmark, in anything ? Bond indices allocate the largest weights to the most heavily indebted issuers. From the perspective of quality, this is clearly nonsense. Equity indices allocate the largest weights to yesterday’s winners, which tells you precisely nothing about the future – only that investment policy out of the rear view mirror might not be the best tactic for survival in a world of dynamic change. The rational response is to throw the benchmark out of the window and practise something more sensible.


Doug Noland, again:

“I would, however, suggest that it is not so much that “modern fund management is almost hard-wired to produce bubbles” as it is that the entire financial services complex has been transformed by central banks inflating serial Bubbles. Inflation psychology has become deeply, deeply ingrained: everything revolves around purchasing securities that will benefit from ongoing central bank market manipulations and interventions. To survive has meant to climb aboard the great bull. This ensures the entire industry is now on the same side of the “trade” – with functioning “two-way” markets relegated to history. And markets will remain seductively “abundantly liquid” only so long as bullish psychology is sustained.”


There is something exquisitely awful about the whole mess. The central bank is tasked with maintaining monetary stability and yet is in the midst of inflating the most terrifying bubble in history. Fund managers are tasked with shepherding their clients’ assets through this uncertainty and yet they are the very players gate-crashing the party even as the cop cars arrive outside.


From ‘Supermoney’ by Adam Smith:


“We are all at a wonderful ball where the champagne sparkles in every glass and soft laughter falls upon the summer air. We know, by the rules, that at some moment the Black Horsemen will come shattering through the great terrace doors, wreaking vengeance and scattering the survivors. Those who leave early are saved, but the ball is so splendid no-one wants to leave while there is still time, so that everyone keeps asking, “What time is it ? What time is it ?” But none of the clocks have any hands.”


By the time the sequel to ‘Terminator’ has come around, Arnie’s killer cyborg has morphed into an altruist fighting for humanity and not against it. “Come with me if you want to live.” The advice he might give comes straight from the American author Philip Wylie (hat-tip to Rob Chapman):


“Ignorance is not bliss – it is oblivion. Determined ignorance is the hastiest kind of oblivion.”


As investors, we have all been warned. Not by the future, but by the past.