For the many pundits masquerading as authorities, there are precious few whom time confirms as worthy of commendation. Edward Chancellor is one of them.
As the dot.com bubble relentlessly defied history, logic, and valuation’s gravitational pull through the late 1990s—the NASDAQ composite doubling from October 1998 to October 1999 and then, remarkably, doubling again from October 1999 to March 2020—the undersigned was in search of kindred spirits. A resolute contrarian, I remember voraciously consuming two books that leaned in solitary with me, as a David against the Goliath of the prevailing speculative winds. Those were Devil Take the Hindmost: A History of Financial Speculation (published on June 1, 1999) by Edward Chancellor and Irrational Exuberance (published on March 15, 2000) by Robert Shiller. The passage-of-time crucible revealed both authoritative books to be eerily prescient.
My friend Edward Chancellor’s perspective was sweepingly historical. Chancellor surveys infamous manias, such as the 1720 South Sea Bubble, the 1920s bubble in the U.S. stock market preceding the Great Depression, Japan in the 1980s and, up to the moment (as of 1999), the dot.com bubble of the 1990s. Chancellor weaves a fascinating narrative of human dreams and folly through the centuries. As seems relevant in 2022, many social scientists view speculation as a form of gambling, believing that the “psychologies of speculation and gambling are almost indistinguishable: both are dangerously addictive habits that appeal to fortune.” During investment bubbles, speculators follow a herd mentality that rejects traditional risk analysis. Chancellor observes in 1999: “In fact, it can be argued that investors today are pursuing the Internet the same way investors in the past pursued land, gold, cars, and railroads.”
Robert Shiller, a Nobel laureate in economics, is a behavioral finance proponent, an emerging field of study which, Shiller argues, is looking less and less like a minor subfield of finance and more and more like a central pillar of serious finance theory. Shiller searches in all the unfamiliar places, overlooked by market analysts, that have often proved critical in defining speculative episodes throughout history. These fields of inquiry include economics, psychology, demography, sociology, and history. More than an ethereal right-brainer, Shiller quantifies his valuation methodology in the CAPE (cyclically adjusted price earnings ratio), upon which I have relied for many years. See the Martin Capital Management 2018 annual report.
Taken as a whole, Shiller writes in early 2000, these fields suggest that the present stock market displays the classic features of a speculative bubble:
… a situation in which temporarily high prices are sustained largely by investors’ enthusiasm rather than by consistent estimation of real value. Under these conditions, even though the market could possibly maintain or even substantially increase its price level, the outlook for the stock market into the next ten or twenty years is likely to be rather poor—and perhaps even dangerous.[1]
Shiller published the third edition of Irrational Exuberance on January 25, 2015. In the preface, he notes that the CAPE was 26 (its long-term average, 16), suggesting that, based on valuation alone, the bursting of the bubble may not be imminent. Nonetheless, he lamented:
One might think that years after the bursting of the speculative bubbles that led to the 2007–09 world financial crisis, we should be living in a distinctly different post-bubble world. One might think people would have “learned their lesson” and would not again pile into expanding markets, as so many did before the crisis, thereby worsening incipient bubbles. But evidence of bubbles has accelerated since the crisis …[2]
This coming September, Edward Chancellor’s The Price of Time will be released. In advance of its publication, Chancellor has this to say in a May 18, 2022, Breakingviews column, “Bear Severities.” Since it manifests Chancellor’s inimitable style, the column is repeated verbatim and in its entirety in the following block quote.
Before this week’s rally, the S&P 500 Index was within a hair’s breadth of a bear market. Over the last century in the United States these episodes—defined as a stock market decline of at least 20%—have been relatively brief, lasting on average less than ten months. In recent decades, they have also become less frequent. That’s largely because the Federal Reserve has always been on hand to bail out Wall Street. But the return of inflation changes everything. With the “Fed put” off the table, the next bear market could last longer and inflict more damage than those of recent memory.
If you blinked you might have missed the bear market triggered by the Covid-19 pandemic. It commenced on February 19, 2020 and lasted just 33 days from peak to trough. The downturn was reversed after the Fed slashed interest rates and printed money to support the financial system. Now that American inflation is at its highest level in forty years, however, the U.S. central bank can no longer wave its monetary wand to set everything right.
The economist Richard Duncan, author of The Money Revolution, points out that the Fed may even welcome a market correction as falling asset prices could help push inflation back towards the central bank’s target. With short-term rates at just 1%, there’s plenty of room for further hikes. And the Fed will only start to reduce its bloated balance sheet next month. Duncan predicts that a trillion dollars’ worth of quantitative tightening over the next year will push up bond yields, causing asset prices to fall.
When problems with subprime mortgage debt first appeared in early 2007, few commentators predicted that within a short time these toxic securities would threaten to bring down the global financial system.[3] An unexpectedly sharp rise in interest rates could be equally devastating.
[Chancellor cites] a comment by the Boston hedge fund manager Seth Klarman. “The idea of persistently low rates,” he writes, “has wormed its way into everything: investor thinking, market forecasts, inflation expectations, valuation models, leverage ratios, debt ratings, affordability metrics, housing prices, and corporate behavior. Moreover, by truncating downside volatility, forestalling business failures, and postponing the day of reckoning, such policies have persuaded investors that risk has gone into hibernation or simply vanished.”
Now interest rates have started to rise and risk is out of hibernation. If ultralow interest rates were responsible for inflating an “everything bubble,” it follows that everything— well, almost everything—is at risk from rising rates. The first casualties have been the most egregiously speculative investments. These “Tinkerbell” assets retained value only as long as people continued believing in them: think meme stocks, special-purpose acquisition companies, cryptocurrencies and the like. Securities whose valuations benefited most from falling interest rates have also been hit hard. The Nasdaq 100 index of technology stocks is down by almost a quarter this year; and some long-dated UK inflation-linked bonds have lost more than 40% of their value.
That’s not the end of it. Still-low interest rates continue to underpin the inflated valuations of U.S. stocks and real estate markets around the world. Easy money keeps zombie corporations afloat, enables governments to run outsized deficits, and boosts the profitability of financial and non-financial corporations.
Furthermore, unconventional monetary policies have lured investors into a variety of illiquid investments, notably venture capital and private equity. “Liquidity is the new leverage,” proclaims Henry Maxey, chief investment officer of London-based Ruffer. In a desperate search for yield, investors have taken their money out of banks and placed it in less-regulated bonds and exchange-traded funds. These funds promise daily liquidity but their underlying investments are often relatively illiquid. This is an accident waiting to happen. Already the market for new issues of leveraged loans and high-yield bonds, which are pooled into traded credit vehicles, has started to dry up.
In November 2008, China helped bring the global financial crisis to an end by launching of a massive stimulus program. Over the following years, the People’s Republic was responsible for around half the world’s total investment spending and a similar proportion of new corporate debt. That trick cannot be repeated. China’s growth miracle has come to an end, as its economy totters under a mountain of debt and its real estate bubble starts to let out air. In recent weeks, the yuan has been falling against the U.S. dollar. China’s financial imbalances are likely to be at the forefront of the next bear market.
Despite recent market declines, U.S. stocks remain far above their historic valuation. Most investors blithely ignore this inconvenient fact. Recent history is on their side. After all, during the bear markets that accompanied the dot.com crash and the global financial crisis, the stock market only briefly touched its long-run trend before taking off. Now that inflation has returned, investors may not be so fortunate next time around.
Although shares are claims on real assets, their valuations tend to be depressed when consumer prices are rising sharply. As Warren Buffett pointed out in a famous article in May 1977, inflation puts up the cost of corporate borrowing and forces companies to increase the dollar amount of working capital simply to match the previous year’s production. “Inflation,” wrote Buffett, “acts as a gigantic corporate tapeworm. The tapeworm preemptively consumes its requisite daily diet of investment dollars regardless of the health of the host organism.” Investors find this tapeworm difficult to digest.
Bear markets normally arrive and depart in short order. But the downturns of the 1970s lasted more than twice as long as recent market selloffs. More importantly, they were accompanied by a severe and prolonged decline in market valuations. In 1968, U.S. stocks traded on a cyclically adjusted price-earnings (CAPE) ratio of 24 times. By the time the “Great Inflation” ended in 1982, they sold for just 7 times average earnings of the previous 10 years. Today, the CAPE ratio for the US stock market stands at 32 times. A return to the valuations that prevailed four decades ago would be a bear market for the history books.
Edward Chancellor and Robert Shiller are featured in this post on good authority. Over the years I’ve read almost everything they have published. Both men have distinguished themselves as independent thinkers whose prophetic assessments of speculative bubbles will surely earn them a high place among the sages of 21st-century economics and finance.
I draw inspiration from their work but humbly note that I write in comparative ignominy—in the darkness of their long shadows. The third book in my trilogy, The Rise of the Phoenix, hinges on the belief that darkness, in the end, is overcome by light. Its thesis: The most persuasive case for positivism is the pervasiveness of its opposite. The vision is there, the manuscript largely complete, but it must wait patiently for circumstances to validate it. One cannot rush history. If the recently released arrow of Mr. Chancellor is reasonably close to the mark, it may not be long.
[1] Shiller, Robert J. Irrational Exuberance (p. xxvi). Princeton University Press. Kindle Edition.
[2] Shiller, Robert J. Irrational Exuberance (p. xi). Princeton University Press. Kindle Edition.
[3] See “A Perfect Storm 2.0” blog post.