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Summary

  • Financial assets worldwide now total some $156 trillion.
  • That value is unprecedented and amounts to 1.6 times world GDP.
  • There is an imbalance between financial assets and the value of the underlying real assets.
  • That imbalance will eventually correct, either through lower prices for financial assets or inflation in prices of real assets.
  • It may be time to batten down the hatches.

Business Insider recently published a chart showing the unprecedented rise in financial assets to $156 trillion worldwide - a figure approximately 1.6 times the world's GDP.

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The number shocks sensibility. While the growth in financial assets is fueled in part by growth in indebtedness from about $4 trillion in 1980 to about $75 trillion today, the real action has been the growth of "equity," the total market value of stocks. That number has grown from the $6 trillion range in 1980 to almost $90 trillion today.

Financial assets are someone's liability, be that an individual or corporation. I use "liability" in the broadest sense here, including equity which is in essence claims on a corporation's assets by its shareholders. When financial assets grow at a rate greater than real assets (by "real assets" I mean land, buildings, equipment, infrastructure and so on) the imbalance can only resolve itself in price. Either the value of the financial assets must ultimately fall or the money value of the real assets must rise. At the end of the day, assets must equal liabilities (including equity) - the cornerstone of dual entry accounting reportedly first used by Venetian Merchants in the Italian Renaissance and first documented by Friar Luca Pacioli.

The concept of valuation bubbles flows from the idea that when investors bid the price of financial assets to heights that bear no resemblance to either the cost of the real assets underpinning the financial assets or any prospect for those real assets to generate future profits that might substantiate those prices, the correction is a sharp drop in the value of the financial assets often referred to as a "crash." SA author David Trainer has pointed out cases where vast differences occur and predicted lower prices for the shares of the underlying company as the ultimate resolution.

For many years, historians assessing stock market returns have concluded that over the long run investments in equities returns before inflation adjustment average about 5.8%.

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SA Article by Nick Gogerty using data from Robert Shiller

Shiller is kind enough to make his data public and currently providing this chart of the cyclically-adjusted price to earnings ratio. At over 25 times today, this ratio has only been exceeded during market peaks of 1929 and the dot-com bubble of the year 2000 and approached one other time at the turn of the twentieth century.

Simply stated, stocks are getting expensive.

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Source: Yale, Shiller

This does not mean stock prices cannot go higher. They can and quite possibly will. What it does mean, when taken in context with the dramatic growth in financial assets, is that there is a growing disparity between financial and real assets that will adjust itself in time.

Such adjustments have historically been unpleasant for most investors. At our hearts, most of us are optimistic and therefore bullish. We tend to be fearful in times of recessions or market collapse and avoid equities until they have rebounded substantially from bottom, then timidly buy in and as confidence grows add to positions until euphoria replaces common sense and as a herd we buy with increasing fervor driving stocks to unsustainable highs.

We have had some help from central banks in driving financial assets to very high levels in the form of very low interest rates. The end of low rates is one possible trigger for a sharp selloff in both bonds and stocks.

The other resolution of the imbalance is inflation. Central banks want inflation today, an unusual circumstance for entities put in place to control inflation. Of course they want it to be controlled and modest. Controlled may be difficult to achieve in some regions. Venezuelans see inflation at 57%. Argentina has an inflation rate of 11%. Iran's inflation rate is 28%. India, Pakistan and Turkey all have inflation rates about 8%. Russia and Brazil have rates nudging 6%.

Investors should not conclude there is imminent danger. But it is a time for prudence.

At this point in the cycle with risks mounting in emerging markets but reasonable strength in North America, investors should take a global view of the outlook. Yield stocks and bonds are dangerous.

Momentum stocks are particularly vulnerable. Solid, well financed firms with reasonable valuations and strong competitive positions in a slowdown will be worth owning.

A good portfolio might include:

Long - Bank America (NYSE:BAC) and AIG (NYSE:AIG) should benefit from rates rising even if modestly. Freeport McMoRan (NYSE:FCX) and Barrick Gold (NYSE:ABX) are both pretty washed out and will survive periods of inflation. Microsoft (NASDAQ:MSFT) and Intel (NASDAQ:INTC) should both be relatively safe with low valuations, strong balance sheets and new initiatives that should build value over time. And a decent amount cash should be a central theme.

Short - Overblown tech names like Salesforce.com (NYSE:CRM), Netflix (NASDAQ:NFLX) and Twitter (NYSE:TWTR) should fall well out of favor in a market selloff. Cyclical businesses in tough industries will also see some damage, with Whirlpool (NYSE:WHR) and CP Rail (NYSE:CP) likely to trade lower from their current lofty valuations.

Fixed Income - Anyone long fixed income does not need suggestions for investing, they need therapy.

Of the foregoing, I am currently long INTC and short CP, CRM and WHR. I will very likely add FCX and ABX in the near future and may repurchase MSFT if I can find a lower entry point after booking strong gains. I have made money shorting NFLX and TWTR and may short them again or buy puts if I see premiums at levels that make sense to me.

Good luck with your investing. I don't recommend anyone follow me. If you need advice, speak to your investment professional. If you own bonds, speak to your therapist.

Source: Valuations Are Higher Than Most Think - Risks Are To The Downside

Additional disclosure: Short CRM,WHR,CP.