Over the next few weeks, I will be writing a series of pieces on trends in the global economic landscape, and what the implications of these trends are for investors. In this edition, we continue our examination of prior well-known asset bubbles in order to better establish a context and an investment philosophy for the coming years.
Please, click the following link for part I of our piece on asset bubbles.
What goes up must come down
– Sir Isaac Newton (1642-1727)
Inflation across the world surged in the 1970s following rampant increases in commodity prices and over-spending by government in response to the baby boom in the preceding decade. The major developed economies, led by the United States, unable to maintain the gold standard due to persistent trade and current account imbalances, call on the IMF to create a new synthetic currency, which essentially severed the ties between these countries’ currencies and gold. Investors flocked to commodity markets en masse following this decision out of fear that the ability of governments to print money without retribution would cause inflation to spiral out of control. Gold enjoyed a spectacular run, rising tenfold from 1973 before peaking intraday in February 1980 at $850/oz.
Even after having adjusted for inflation, gold prices have yet to breach the highs observed almost thirty years ago. Towards the end of the mania, futures exchanges raised margin requirements in response to increased volatility and speculation in the precious metals markets, and an unanticipated bold move by Fed chairman Paul Volcker in the late 1970s to tighten policy in an attempt to rein in inflation provided the deathblow to commodity markets and also triggered a brutal global recession.
* Prices deflated by U.S. Consumer Price Inflation
Manias in the 20th century were not confined to the U.S., as investors became infatuated with Japanese shares and property in the late 1980s. Japan had been enjoying robust economic growth since the 1960s, and the deregulation of the financial industry in the early 1980s resulted in an aggressive increase in mortgage lending and small- and medium-sized loans. Property prices skyrocketed and the stock market soared. P/E ratios expanded materially and valuations became stretched, with earnings yields (calculated as 100 divided the price-to-earnings ratio) falling well below bond yields during this time. The boom in property and stocks busted after tighter monetary policy and moderating global growth in the wake of the collapse of the U.S. commercial real estate and junk bond markets and triggered an unprecedented decline in both equity and real estate prices and debt deflation. Japan is still reeling from the crisis of the early 1990s as economic growth remains lacklustre and stocks have failed to rebound materially following a 70% decline since the early 1990s.
Technology shares exploded in the late 1990s as excitement relating to the Internet and the “new economy” gripped investors globally. Nasdaq stock prices increased tenfold after the U.S. economy came out of recession in 1991, with the majority of the gains being observed in the latter portions of the decade. Consistent with previous episodes of “manic” behaviour, prices overshot fundamentals by a vast margin, with P/E ratios on the Nasdaq index soaring to over 60. Valuations, as measured by equity earnings yields relative to investment-grade corporate bond yields became ridiculous and completely detached from underlying prospects for growth (earnings yields were 1.5% compared to investment-grade corporate bond yields of approximately 7.5%.
Again, it should be fairly clear that while markets can behave normally most of the time, the fact that markets are merely an extension of human impulses makes them vulnerable to the same distortions that human behaviour can succumb to. In our next edition, we’ll take a look into one of the largest bubbles (and bursts) in human history: The financial crisis of 2008. Stay tuned!
Disclosure: No positions at the time of writing.
Disclosure: No positions