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Bubbles and the corruption of risk

I have previously warned that the combination of the demographic avalanche of retiring baby boomers, low interest rates and a disproportionately large amount of their wealth in cash would mean that stocks and property would continue to rise for a while. I call it ‘The Boom We Have to Have.’ But like all booms, this one will also bust.

These conditions, especially low rates forcing a big part of the population into riskier products, corrupt investors’ sense of risk. Rising prices amid a wave of buying reinforces the behaviour of investors and their brokers who believe their thesis is correct.

New listings and credit point to problems

I am not alone in the view that at some point in the next six to eighteen months, there is a real chance that baby boomer retirement plans may sink thanks to their inability to avoid repeating the investment mistakes of their past. Stanley Druckenmiller is an American hedge fund manager, famous for being the lead portfolio manager for George Soros’s Quantum Fund. In 2010, Druckenmiller handed back the billions he had been managing for 30 years through his firm Duquesne Capital. He remains a noted philanthropist, keen golfer and speaker on the global investment and macroeconomic circuit.

Druckenmiller should be heeded. He observed that low rates have skewed peoples’ sense of risk, particularly in two markets – new share listings (IPO’s) and credit. He pointed out that 80% of companies listed in 2014 have “never made a dime”. In 1999, just before the tech crash, that number was 83%.

(As an aside, over the Christmas break, I read You Only Have To Be Right Once: The Unprecedented Rise of the Instant Tech Billionaires. Including Twitter, Facebook, Instagram, the book was a who’s who of the world’s biggest tech companies and the backgrounds to their stunning rises. But I couldn’t help noticing that all the references to billions had little or nothing to do with profits or in some cases even revenues. Some of the businesses discussed, which were sold for billions, not only had no revenue but no revenue model either).

Druckenmiller had another warning on credit markets. Last year, speaking on CNBC, Druckenmiller said, “When I look at credit … corporate credit is growing at a record rate, far faster than it grew in 2007. And S&P pointed out that 70% of debt issued has a B-rating or worse. To put that in perspective, in the ’90s, that number was 31%. Do you remember the hullabaloo in 2007 about covenant-light loans? Companies issued $100 billion of them in 2007, and 38% was B-rated. This year we’re going to $300 billion, up from $260 billion last year and $90 billion a year earlier, and 58% of them were B-rated.”

At the more recent speech, Druckenmiller also observed, “There are some really weird things going on in the credit market … but there are already early signs starting to emerge. And if I had a message out here, I know you’re frustrated about zero rates, I know that it’s so tempting to go ahead and make investments and it looks good for today, but when this thing ends … I think it could end very badly.”

Why is Druckenmiller so worried? It’s simple. If interest rates rise, many investors in corporate debt will want to exit at the wrong time. Australian investors in bank hybrids and corporate bonds (G8 Education is a recent example of a popular corporate bond issuer) should consider the warning too. And if interest rates don’t rise, but the economy weakens significantly, then some industries will be unable to cover their debt costs. Either way, investors will face problems at some stage.

Low rates support asset prices

Low interest rates are here to stay for a while and that will support asset prices. Eventually however the price of those assets (stocks and property) will be pushed way too high (we think a strong bull market is likely for some part of this year) as people panic buy amid a fear of missing out when their income is eroded from low rates on cash. After that, a large number of investors will, sadly, suffer financially again – from buying too late and paying too much.

There is a way to avoid it. You must be invested in high quality businesses with bright prospects and buy them when they are cheap. We can think of only a handful of stocks that meet this criteria currently. When we cannot find such opportunities, the only safe alternative is cash (even though rates are low) and we are 20-30% invested in cash at the moment.

If you are invested in a high-performing fund that is fully invested in stocks like REA Group (P/E ratio 44 times), Dominos Pizza (68 times), or many of the expensive stocks below, consider switching at least some of your retirement nest egg to a larger cash weighting. The cash won’t make your investment 100% immune to a declining market but it will allow additional purchases at cheaper prices, which offers the opportunity to significantly reduce the time to recovery. In Table 1, PER is Price to Earnings ratio.

Table 1. Expensive stocks? You be the judge…

RM Picture1 270215

RM Picture1 270215

Of course if interest rates stay at zero, the party could last a while yet, but as I have warned previously, be sure to be dancing close to the door in case you need to leave. Druckenmiller refers to a “phony asset bubble”, with a bunch of investors ploughing money into assets which will “pop”. Then we’ll see how many people are still enjoying the party.

 

Roger Montgomery is the founder and Chief Investment Officer of Montgomery Investment Management.

6 Comments
Brendon
January 19, 2018

"Markets can remain irrational for longer than you can remain solvent"

Large allocation to cash over this period has missed quite a run, but it can't continue forever.

Dancing close to the door remains a valid concept :)

Adrian
January 18, 2018

"at some point in the next six to eighteen months, there is a real chance that baby boomer retirement plans may sink thanks to their inability to avoid repeating the investment mistakes of their past"

Feb 2015 plus 18 months = Aug 2016

Sorry if it sounds smart in hindsight, but I question what exactly are the mistakes of the past. Maybe trying to time the market is a bigger mistake for most people instead of sticking to a consistent plan and an asset allocation that suits one's situation and personality.

Frank O'Connor
March 03, 2015

Mmmm ... we're all pretty much along for the ride at the moment, with no indication that anyone has a plan (or, more importantly the capability) to head the various Bubbles off at the pass.
The Reserve is pretty much locked into lower and lower interest rates to sustain housing and share values and avoid a Crash, the banks are hoping that this protects their mortgages and loan portfolios, corporate Australia seeks remedies (lower wages, less government controls, reduction of costs etc) that suit them temporarily but will bring on the financial blood bath that drowns the Golden Goose, the government continues to promote policies that encourage the Bubble (negative gearing, corporate tax initiatives, letting go the controls, cutting back expenditures, and hence demand, whilst ignoring a host of revenue issues, middle class welfare etc etc), and everyone else is out there pretty looking out for their own short term interests without any comprehension of how fragile the foundations are.
Gotta love this country. :)

Gelert of Birrong
March 03, 2015

Don't be too harsh on all boomers. Many started with nothing; and are the first generation to be caring for their parents while still looking after older kids at home, and grandchildren. Far from stealing from anyone, they are sandwiched in a situation where they are providing care for three generations. And, the younger generations will inherit what wealth is left. Boomers are not living the luxury of your straw man example. They are great examples of hard working, caring people. The sort of people that any country depends upon.

Mark
March 03, 2015

Unemployment highest in over 10 years and will get worse, terms of trade to get worse, low inflation, interest rates heading to Nil, budget deficit to continue, lowest income growth, no mining boom this time round, Sydney now 9 times debt to income. It's not guessing, it's analysing data over a period and knowing that this will only end badly, tell me, how does Australia grow over the next ten years?? My advice would be to pay down as much debt as possible, although I still have time.

Peter
March 03, 2015

Investing is a bit like you and a friend trying to out running a lion. You don't need to be faster than the lion, just your friend. The Oz market has had a stellar run, but just about every indicator is touching the red line. The case for a correction has been viable for years (it just hasn't happened). What I'm seeing now is an irrational exuberance. House prices can go beyond affordability, bank stocks can rise higher than potential returns, mining bust is inconsequential, moribund government doesn't matter.
There's really nothing driving the stock market up these days other than a fervent hope that we want/need it to. Historically, most major crashes were preceded by a period of welcome boom.

 

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