We’re Doing It Again

The pressure on financial investment advisors, managers and analysts is to make high returns, with benefits that accrue faster when smaller equity investments are leveraged up with larger tranches of debt. Debt generally has a fixed return, determined by the quality of the revenue flow from which it gets recouped, while equity enjoys the big, uncapped upside. So to make more money, investors tend to borrow more, counting on the ever-rising value evidenced by the recent stock market surge. With so many investors betting on the never-ending upside, there is a mutual interest in seeing asset prices rise. It’s a conspiracy of interested and over-invested parties convincing themselves of perpetual growth.

One itsy-bitsy flaw in this ointment: growth is not linear, constant and limitless. When it pauses, or when value investors suddenly realize they have over-inflated the value of assets, they begin to panic. And when enough folks panic fast enough, boom… or rather bust! Markets crash. It happened when the market slammed to the ground in the fall of 2008 in the Lehman Bros. demise. But because this country seems to be obsessed with minimal regulation of the financial markets, the value fairy has reappeared to make stuff that really isn’t worth that much seem really valuable, sprinkling pixie dust over assets that simply cannot justify the values that the market has placed on them. The signs are absolutely everywhere.

All that money has to go somewhere, and that assets all over the globe share in this over-valuation syndrome has investors sliding into “deals” because… Er… they don’t even know, but everyone else is doing it. Where have we seen this kind of behavior before? Like recently? Subprime mortgages? Credit default swaps and other “impossible to fathom” derivatives? Real estate? Does the fact that the average American’s buying power has dropped every year for over a decade suggest that the underlying economics just might not be what we think? Europeans are even worse off, and pity those in overheated Asian markets where real estate prices are falling off a cliff.

Try this sobering reminder from New York Times (July 7^th) writer, Neil Irwin: “Safe assets, like United States Treasury bonds, have been offering investors paltry returns for years, ever since the global financial crisis. What has changed in the last two years is that risky assets, like stocks, junk bonds, real estate and emerging market bonds, have also joined the party.

“Want to buy shares of American companies? At the current level of the Standard & Poor’s 500 index, every dollar invested in stocks buys you about 5.5 cents of corporate earnings, down from 7.4 cents two years ago — and lower than just before the global financial crisis in 2007-8.

“Prefer a more solid asset? The price of office and apartment building has risen similarly; office space in central business districts nationwide costs $300 per square foot on average, up from $147 in early 2010, according to Real Capital Analytics. In Manhattan, an investor in an office building can expect rent payments after expenses to add up to only a 4.4 percent return, known as the capitalization rate, lower than even in 2007, the top of the last boom.

“What about overseas investments? Spain and other Southern European countries that were the nexus of the European debt crisis are not the only places where bond rates have plummeted (even Greece was able to issue bonds at favorable rates earlier this year)… Emerging markets, which generally have higher interest rates because of higher inflation and less political stability, are offering record low interest rates as well. Bonds issued by the governments of Brazil and Malaysia, for example, are currently yielding only around 4 percent.

“The high valuations now aren’t as extreme as those of stocks in 2000 or houses in 2006; rather, what is new is that it applies to such a breadth of assets. In 2000, when the stock market was, with hindsight, a speculative bubble, other assets like bonds, emerging market investments and real estate looked reasonable.”  

Yeah, and what happens when the Fed decides that we’ve been slorpping at the cheap debt trough too long and raises interest rates? How does even the residential housing marketplace sustain the exceptional recent gains when buyers cannot afford to buy anymore because interest rates rise significant? And what happens to the next spate of mortgage foreclosures? What about all those office towers purchased by investment groups at price no one could have imagined just three years ago? Who’s going to rent all that space for all that money… when consumers just can buy that much anymore, and even the one percenters cannot make up for lost average consumption? If the government truly does pull back on “entitlements,” what replaces the spending power that such entitlements actually mean for our economy?

We’ve all been complaining about the income inequality issues that plague the developed world, none more than the United States. Those who used to have incomes with serious discretionary capacity are contracting their consuming ways. They buy cars less frequently and seem to prefer small, gas-sensitive vehicles. Average new construction for housing is making smaller average homes; open concept just makes them look bigger. Fewer kids are applying to college and even fewer still are able to graduate.

Dodd-Frank financial rules were band aids on a badly bleeding body, minimalist financial regulation in a world begging for realistic limits. Unlike Canada, which has always had pretty strict financial regulations. Our brothers and sisters in the north have never had a major overall market/housing collapse in their modern history. We have been in tons of boom or bust cycles, most recently the Great Recession (not quite the Great Depression, but horrible nonetheless), throughout our modern history… and without strict financial regulations, which we are exceptionally unlikely to pass… here we go again. Sooner than people suspect.

I’m Peter Dekom, and as I have said many times before, repeating the same behavior and expecting different results is one very clear indication of insanity… and we are definitely nuts!