The Bull Market in Everything

In Photo: Federal Reserve Chairman Janet Yellen speaks during a news conference after the Federal Open Market Committee meetings in Washington, D.C., on September 20, 2017.

In his classic The Intelligent Investor, first published in 1949, Wall Street sage Benjamin Graham distilled what he called his secret of sound investment into three words: “margin of safety.” The price paid for a stock or a bond should allow for human error, bad luck or, indeed, many things going wrong at once.

In a troubled world of trade tiffs and nuclear braggadocio, such advice should be especially worth heeding. Rarely, however, have so many asset classes—from stocks to bonds to real estate to bitcoins—exhibited such a sense of invulnerability.

Expensive assets are hardly the product of euphoria. No one would mistake the bloodless run-up in global stock markets, credit and real estate during the past eight years for a reprise of the “roaring ’20s,” or even an echo of the dotcom mania of the late 1990s.

Nonetheless, only at the peak of those two bubbles has America’s S&P 500 been higher as a multiple of earnings measured over a 10-year cycle. Rarely have creditors demanded so little insurance against default, even on the riskiest “junk” bonds. Rarely have real-estate prices around the world towered so high. American home prices have bounced back since the financial crisis and are above their long-term average relative to rents. Those in Britain are well above it, and in Australia and Canada they are in the stratosphere. Add to this the craze for exotica, such as cryptocurrencies, and the world is in the throes of a bull market in everything.

Asset-price booms are a source of cheer, but also of anxiety. There are two immediate reasons to worry.

First, markets have been steadily rising against a backdrop of extraordinarily loose monetary policy. Central banks have kept short-term interest rates close to zero since the financial crisis of 2007-2008 and have helped depress long-term rates by purchasing $11 trillion in government bonds through quantitative easing. Only now are they starting to unwind these policies. The Federal Reserve has raised rates twice this year and will soon start to sell its bond holdings. Other central banks eventually will follow. If today’s asset prices have been propped up by central-bank largesse, its end could prompt a big correction.

Second, signs are appearing that fund managers, desperate for higher yields, are becoming increasingly incautious. Consider, for instance, investors’ recent willingness to buy Eurobonds issued by Egypt, Iraq and Ukraine at yields of around 7 percent.

There is some logic to the ongoing rise in asset prices. In part it is a response to an improving world economy. In the second quarter of this year, global GDP grew at its fastest pace since 2010, as a recovery in emerging markets added impetus to longer-standing upswings in America and Europe. Emerging-market economies have come out of testing times in far more resilient shape.

Even so, the most dangerous, anti-Graham motto of investing is, “This time is different.” It would be daft to assume that asset prices must remain high come what may. Many hazards could derail the economy and financial markets, from a debt crisis in China to an American-led trade war or an outbreak of fighting on the Korean peninsula. When the next recession comes, policy-makers will have less fiscal and monetary ammunition to fight it than they had in previous downturns. Prudence therefore suggests caution.

One option is for central bankers to raise rates more enthusiastically and less predictably, to jolt financial markets and remind investors that the world is volatile.  The tightening might prove excessive, tipping economies into recession. Moreover, with inflation in most big economies below central bankers’ targets, sharply higher rates are hard to square with their mandate.

To minimize disruption, the reversal of quantitative easing should be stretched out. The Federal Reserve has set a good precedent by proposing to reduce its bond holdings at a leisurely pace and flagging the change well in advance. When the time comes, its peers should follow suit. Of these, the European Central Bank faces the trickiest challenge, because it has acted as, in effect, a backstop for euro-zone bond markets, a mechanism that otherwise the currency bloc still lacks.

Bitter experience has shown that debt-funded assets can magnify losses, causing financial crises. For this reason banks must be able to withstand any reversal of today’s high asset prices and low defaults. That means raising bank capital in places where it is too low, especially the euro zone, and not backsliding on strenuous “stress tests” as America’s Treasury proposes.


© 2017 Economist Newspaper Ltd., London (October 7). All rights reserved. Reprinted with permission.


Image Credits: Saul Loeb/Agence France-Presse/Getty Images

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