The recent strong stock market activity, on the back of global liquidity, has caused Richard Russell, the octogenarian who writes the daily Dow Theory newsletter, to move from a bearish stance to a very bullish stance. He had previously argued that the bear market that started in 2000 would not end until values were excellent, P/E ratios would be in single figures and dividend yields above 5%. Because these levels have not been reached, the bear market would continue.
Market signals: bears turn bullish
Russell has now changed, he says that the original bull market did not end in 2000 but instead just suffered a very significant 50% correction. Following that correction, he says we are still in the bull market that started in 1983, which is now being driven much higher by continuing merger and acquisition activity, financed by global liquidity. Personally, we think that is a very big call.
In our view, it is quite possible that his change of heart might be an important market signal. It is often said that bear markets happen immediately the last bear becomes a bull and there is no doubt that this is what Richard Russell has very publicly done.
Bill Gross, manager of the PIMCO Total Return Bond Fund, has also changed his view. His essay on this subject can be read on the PIMCO website (www.pimco.com), entitled: How We Learned to Stop Worrying (so much) and Love “Da Bomb”. Da Bomb he explained is globalisation – high growth, low inflation, accelerating profits and benign interest rates. During its development, he says, he never stopped worrying. His essay which spans ten pages explains that he has now stopped worrying and now sees nothing to stop the virtuous circle favouring capital over the expense of labour and the future big threat to asset markets comes not from slower economic growth, in the short term, but from inflationary pressures towards the end of their secular timeframe.
To properly report on Richard Russell’s and Bill Gross’s change of heart would take more space than we have available. It is sufficient to say that they have changed their minds.
Market signals: greater focus on risk
Coincidental with these two changes of heart, the quality financial press has become more focused upon risk. These fears have been partly prompted by yet another icon, Anthony Bolton, who in his Fidelity leaving speech voiced very specific concerns about private equity. He said that his private equity contacts do not believe some of the loan deals they are getting and he added that this phenomenon would be destabilising for the markets generally “it is only a question of when rather than if [things go wrong]”.
Anthony Bolton’s fears were endorsed by Paul Tucker at the Bank of England who recently pointed to cov-lite loans, as a sign of “slow fuse” risk.
Financial Times journalist, Gillian Tett, quotes a senior banker as saying that he has almost never seen such bubble-like conditions in the credit markets as exist now.
John Morton, who runs Alchemy Partners, was recently interviewed by James Quinn of the Telegraph in which he said larger private equity houses threaten to spoil the party for everyone by pursuing major companies.
Gradual change, as the story of the frog illustrates, can over time catch you out. The frog, they say, will allow you to gradually heat up a pan of cold water while he’s in it, until he is boiled to death.
The market like the frog acclimatises to the changing temperature. The deals inevitably get bigger and bigger, over time forming a parabolic curve. The speed at which the deals get bigger and the amount by which they get bigger becomes unsustainable yet each deal is a logical progression of the previous deal and if the previous deal was ok, then why shouldn’t the next one be equally so.
As well as the deals getting bigger they get more expensive. The amount paid for a unit of earnings increases forcing P/E ratios to expand. It isn’t that businesses become more valuable, it’s just that investors are willing to pay more for the same unit of earnings.
In parallel with the parabolic curve formed by the bigger, more expensive deals, so a similar parabolic curve has formed based upon the nature of the credit provided. Providers of credit find themselves in a competitive market place and in order to do the next deal, have to offer more generous terms than they offered for the previous deal. Interest rates become more competitive and lending conditions (cov-lite) become more lenient. It can’t continue but at the last looking, the frog was still alive and untroubled by the rising temperature. Failure of the ever more vulnerable credit market will eventually be as sudden as the death of the frog, one minute the frog is alive – the next minute it’s dead and once dead, cannot be revived!
If, as we think, it is not different this time – which it never usually is, time is running out very fast, the chickens are anxious to come home to roost and a stock market crash (using Alan Greenspan’s word about the Chinese stock market risk) is impending.
By John Robson & Andrew Selsby at RH Asset Management Limited, as published in the Onassis Newsletter, a fortnightly newsletter that gives insight into the investment markets.
For more from RHAM, visit https://www.rhasset.co.uk/