The return of Irrational Exuberance!

For those readers that weren’t around in the 1990’s, from an equity perspective, the latter half were crazy years! With most “anal”-ysts (yes, them again!) expecting just just mild equity gains after a storming run from the 1987 crash that was punctuated with a few 10-20% correction bouts, markets, as ever, confounded the majority, shooting up by dramatic amounts in 1998 and 1999 as so called “Y2K” and dotcom (com?!) fever gipped investors. It was in fact one of the greatest bullish periods in memory. There was no need to carefully pick the right shares, simply sticking a pin in the paper and waiting a few weeks for the share(s) to inevitably rise was strategy enough. Really! The long rise experienced by equities of course attracted more and more investors to the market and a common citizen was turned into a seemingly successful investor.

Kicking of the 90’s, the year of 1990 was in fact a negative year for the S&P 500, but after that it rose for three consecutive years. In 1994, the index returned to a negative record but the mild decrease of 1.5% was covered by dividends paid during that year. From that point, the Greenspan coined phrase “irrational exuberance” certainly gained momentum and in just 5 years, the S&P 500 rose a stunning 220%. Joyous times! After the Great Financial Crisis, experienced during 2007-2009 in the U.S., many are now asking comparing the current 5-year rally with the crazy late 1990s. Is the situation really similar and are the markets going to re-accelerate confounding bears like us?

During the 1990s, the U.S economy was in very good shape and the international environment was strangely not much different than what we see today. Japan was deleveraging and emerging markets experienced some rough years after the 1997 currency crisis. This time around we still have certain emerging markets in trouble due to the cutback in monetary easing by the Fed and overvalued currencies and Europe is acting as the Japan substitute being the deleveraging country. In terms of monetary policy, the dynamics behind it are also similar to what they were during the 1990s. In fact, there are two different periods in the history of monetary policy during the 20^th century: the last 30 years and the period before that. Before the abolition of the gold standard in the 1970’s, the Federal Reserve in particular was quite “passive” in the application of monetary policy but in the last 30 years, they have become ever more aggressive in their policy moves.

So, at first glance, there seem to be parallels with the 1990’s but if we dig a little deeper, we will see that this party may actually be over much before than that seen during the 1990s.

A peculiar quirk, although in fact if you think about it, it is not that surprising, is that crises have become more and more frequent during the last 30 years. Instead of fine-tuning the economy while allowing for it to readjust itself and recover, the Federal Reserve has acted in an increasingly interventionists manner. While during the 1990s the FED largely pursued a dovish policy, the major difference is that it was not carrying a balance sheet with some $4 trillion in assets sat on it. The FED alone currently represents, a stunning 25% of the US GDP, being bigger than the German economy. We suspect that much of the exuberance of the stock market in recent years is squarely down to the actions of the enlarged FED balance sheet. As soon as this FED starts deleveraging (which it is in the nascent stages of doing now with the so called “tapering” of bond asset purchases), we will be left with an American economy that isn’t much different from the European economy of today or the Japanese economy of 20 years ago. The Fed has been absorbing the troubles of the US economy but most importantly, not solving them.

During 1991 and 2000, the compound average growth rate (CAGR) of the U.S economy was near 3.5%. An excellent average for a 10 year period. But when we take into account the period between 2001 and 2013, the growth rate is halved to 1.75%. Even when we discard the crisis period and look only at the period between 2010 and 2013, the CAGR has been 2.2%, which is very small indeed for for an economy recovering from one of the deepest recessions in living memory.

If we also compare the evolution of corporate profits with the price evolution of the S&P 500, we see that when there is a disjoint between them – and a potential harbinger of a crash. The basis behind this is very simple: no matter how creative you try to be with accounting, in the end if there’s no profits, prices must come down to earth.

During the 1990s, analysts reinvented the wheel with very creative new valuation measures. Instead of the simple P/E ratio, they used value per click and value per user, which allowed for absurd P/E ratios above 200x. But, in the end, inevitably many of those clicks and users never turned into all important paying clients, which means the profits never came…

Today we have Facebook, Linkedin, Twitter et al as modern day example of the like of Boo.com that crashed to the ground. These companies are currently trading on totally stupid messages-per-user values and the like. Well, if those messages don’t turn into dollars soon then prices will need to catch up with the traditional fundamentals. Read – south and sharply.

For the market overall, corporate profits have been rising in recent years and margins are at a record high. If they revert back to mean then this will also spell problems for the wider market.