Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 375

Have stock markets become a giant Ponzi scheme?

The past few months have exacerbated a trend we have been following with concern for some time now – the ever-increasing disconnect between financial markets and the real economy.

The COVID-19 outbreak has triggered a huge expansion of government balance sheets which in turn has enabled market darlings to reach dizzying valuation heights, to the point where financial markets might best be described as Ponzi borrowing.

This type of financial instability is not new, but when combined with the impact of a health crisis, it is particularly troubling.

Financial instability moves

Distinguished economist Hyman Minsky developed the financial instability hypothesis in the 1970s, which argued that capitalism moves between periods of financial stability to instability, with periods of stability leading to overconfidence by borrowers and lenders and encouraging excessive borrowing. This in turn increases volatility and ultimately triggers a crisis.

At the moment, Minsky’s hypothesis seems particularly relevant. The proportion of zombie companies (companies that are able to service, but not pay off, their debt) is growing, while productivity is declining, and economic growth is illusory. And if significant proportions of lending are based exclusively on an expectation of rising asset values, the result is Ponzi finance.

Worryingly, this trend shows no sign of having peaked. Indeed, the significant and long-term implications of COVID-19, and the decisive steps taken by governments and central banks around the world in response, have accelerated the pressure on stability.

At the same time, it has justified extraordinary monetary and fiscal stimulus actions that would usually be seen as overstepping mandates, and the scale of this overstepping will only increase as the system becomes increasingly unstable.

But having cried wolf too often, no-one now takes seriously the prospect of central bank balance sheet reduction or an end to monetary support.

Valuation-based investment

The disconnect between the financial system and the real economy has seen many investors lose faith in the concept of mean reversion and the strategy of valuation-based investment. Instead, the rewards seem to have flowed to those who seek ‘quality’ and ‘growth’, though perceptions of ‘quality’ seem to exhibit a high degree of subjectivity. In some ways, it can be described as chasing high multiples for market darlings and loss-making businesses that are supported by government largesse.

Exacerbating this trend is the recent growth in index investing which has constantly rewarded share price winners and punished losers without regard to fundamentals.

At Schroders, we continue to subscribe to the belief that mean reversion (at some point), and investment in real economy businesses which have not been inflated by easy money, will be rewarded, although there is no doubt that following this investment approach now has been tougher than ever.

Nonetheless, to us it seems inarguable that growth is an input to be used when valuing a business, not just an attribute to be sought at any price. On this basis, valuations of companies predicted to have attractive growth prospects have escalated far beyond realistic levels. As shown below, the top quartile Price/Earning (P/E) companies in the ASX200 have a P/E of 42 versus only 12 for the bottom quartile, a remarkable value dispersion for Australia's top companies. 

Perhaps even more worrying, they have maintained these valuations even as markets start to cool down.

Despite the fact that the global economy is presenting few growth prospects, we are seeing profit forecasts that would be unconvincing in a booming economy, let alone one that is being hit hard by a global pandemic.

Global financial casino

We continue to believe that fundamental value creation happens slowly, and that our role is to protect our investors’ hard-earned capital against the excesses of global financial markets – or perhaps what we could call the global financial casino. We remind investors that history has shown, time and again, that all bubbles burst and that growth cannot continue into perpetuity.

At the same time, we acknowledge that there will be no rapid exit from the global financial casino.

It seems more than likely that the current policies aimed at supporting the supremacy of the financial system over the real economy will continue, with a global financial casino running alongside a real economy that is increasingly fuelled by debt-funded government support.

For investors, the challenge is to identify which investment strategy is best suited to this environment.

On one hand, investors could simply abandon any realistic attempts to value companies and instead simply chase the hot streaks. But this type of herd behaviour is not ‘investment’. The share price alone is creating the appeal, not underlying value creation.

Another option is to rely on considered and realistic views of valuation, grounded in the low-growth and high-risk environment investors face. But to take this approach, investors must accept that fundamental value creation happens slowly and does not result in 200% share price gains in a quarter.

In a year when ‘social distancing’ has entered the lexicon, we continue to believe that staying away from the herd, by chasing growth with nothing to support it, is still the best path to take.

 

Martin Conlon is Head of Australian Equities at Schroders. This article contains general information only and does not take into account your personal objectives, financial situation or needs. These matters should be considered before acting on the information provided.

 

6 Comments
mark
September 23, 2020

Is mean reversion a self fulfilling prophecy?

glenn
September 21, 2020

....and corporate fund managers still generate fee income for themselves even if they're performing worse than the market, so should we buy fund managers????

Ian
September 20, 2020

All this is predicated on the stock market being considered a reasonable facility to manage capital, but it has long since stopped being that. The level of a stock market indices today is irrelevant as an indicator of value or the state of the economy. with short selling , machine trading and rampant speculation, the price paid for most shares bears no real relationship with a company's value, but is the merely a snapshot of the last speculative trade on the day. Who knows whether that trade crystalised a gain from an uptick in price due to an unreliable announcement in the news.? We need to stop calling day traders investors, and recognise that the majority of stock market movement is generated by traders who aren't particularly concerned with the actual value of a company, only share price volitility, which they are happy to exacerbate.

Mobcat
September 17, 2020

I can see Armageddon as a the market slowly decends into capitulation and the festering sore of debt burden all countries have entered into due to Covid.
The only answer is speculation for successful trading atm everyone needs mega returns or shut the door it’s game over for trading with small balls.

George
September 17, 2020

But "the market can remain irrational longer than I can remain solvent".

ron
September 17, 2020

well said george- but just one sentence more. " corporate fund management can wait indefinitely for value investment strategies to pay off but i have a finite life span "

 

Leave a Comment:

     

RELATED ARTICLES

US rate rises would challenge multi-asset diversified portfolios

A tale of the inflation genie, the Fed and the RBA

It's not all about interest rates: give me a 1980s petshop galah!

banner

Most viewed in recent weeks

Lessons when a fund manager of the year is down 25%

Every successful fund manager suffers periods of underperformance, and investors who jump from fund to fund chasing results are likely to do badly. Selecting a manager is a long-term decision but what else?

2022 election survey results: disillusion and disappointment

In almost 1,000 responses, our readers differ in voting intentions versus polling of the general population, but they have little doubt who will win and there is widespread disappointment with our politics.

Now you can earn 5% on bonds but stay with quality

Conservative investors who want the greater capital security of bonds can now lock in 5% but they should stay at the higher end of credit quality. Rises in rates and defaults mean it's not as easy as it looks.

30 ETFs in one ecosystem but is there a favourite?

In the last decade, ETFs have become a mainstay of many portfolios, with broad market access to most asset types, as well as a wide array of sectors and themes. Is there a favourite of a CEO who oversees 30 funds?

Betting markets as election predictors

Believe it or not, betting agencies are in the business of making money, not predicting outcomes. Is there anything we can learn from the current odds on the election results?

Meg on SMSFs – More on future-proofing your fund

Single-member SMSFs face challenges where the eventual beneficiaries (or support team in the event of incapacity) will be the member’s adult children. Even worse, what happens if one or more of the children live overseas?

Latest Updates

Superannuation

'It’s your money' schemes transfer super from young to old

Policy proposals allow young people to access their super for a home bought from older people who put the money back into super. It helps some first buyers into a home earlier but it may push up prices.

Investment strategies

Rising recession risk and what it means for your portfolio

In this environment, safe-haven assets like Government bonds act as a diversifier given the uncorrelated nature to equities during periods of risk-off, while offering a yield above term deposit rates.

Investment strategies

‘Multidiscipline’: the secret of Bezos' and Buffett’s wild success

A key attribute of great investors is the ability to abstract away the specifics of a particular domain, leaving only the important underlying principles upon which great investments can be made.

Superannuation

Keep mandatory super pension drawdowns halved

The Transfer Balance Cap limits the tax concessions available in super pension funds, removing the need for large, compulsory drawdowns. Plus there are no requirements to draw money out of an accumulation fund.

Shares

Confession season is upon us: What’s next for equity markets

Companies tend to pre-position weak results ahead of 30 June, leading to earnings downgrades. The next two months will be critical for investors as a shift from ‘great expectations’ to ‘clear explanations’ gets underway.

Economy

Australia, the Lucky Country again?

We may have been extremely unlucky with the unforgiving weather plaguing the East Coast of Australia this year. However, on the economic front we are by many measures in a strong position relative to the rest of the world.

Exchange traded products

LIC discounts widening with the market sell-off

Discounts on LICs and LITs vary with market conditions, and many prominent managers have seen the value of their assets fall as well as discount widen. There may be opportunities for gains if discounts narrow.

Sponsors

Alliances

© 2022 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.