In all likelihood the market bottomed in March and the great bear market of 2007-2009 is over. It is not clear whether a new bull market has begun nor if the market will trend sideways for a while but in either case the base is forming now for the excesses which will characterise and eventually end the next bull market, even if that end comes 10 years from now. The last two years have devastated and scarred us all and it is worth remembering our lessons from this and other busts. What should we take away to prepare ourselves for the next boom-bust cycle?
How to recognise a boom
First it is worth thinking about how to recognise a boom so prudent investors can know when to become more cautious. Some of the symptoms of a boom are:
1. Nearly all booms involve the excessive use of debt, whether corporate debt to fund capacity overexpansion, household debt to fund unsustainable consumption, investor debt to fund speculation in property or margin debt to finance speculation in shares. Debt is seductive in a boom because it increases leverage. Right now corporate debt is more difficult to obtain and both households and corporates are deleveraging but this will change and another debt buildup in at least one important sector of the economy will begin.
2. Most booms have their origins in sound underlying ideas but promoters package these into products of typically greater extravagance or outlandishness as a boom reaches its peak. The most recent example from within Australia was the overgeared infrastructure stapled security, whose origins were government withdrawal from the ownership and funding of public infrastructure and investors' search for sufficient yield at a time of low inflation and interest rates. A related symptom is expansion in the range of vehicles for investing in a concept or getting leverage to it as product providers move to cash in on the trend while the going is good.
3. Justification by the financial community of increasingly absurd valuations. The rewards from selling shares or financial products are too great.
4. Successful speculation by amateur investors. You know it's time to be cautious when taxi drivers and non-professionals at cocktail parties boast about their winnings on the stock market.
5. Claims value investors do not understand this market. There is probably no more reliable indicator of excessive valuations than this.
6. An attitude that "the prospectus is the fat bit in front of the application form". "Just get me the stock and I'll think about it later" becomes the norm.
7. Similarly, entrenchment of the 'greater fool' approach to investing. Investors are less interested in a rational assessment of a business's long-term prospects than whether someone else will pay more for a stock than they just paid.
8. Vertical appreciation in security prices or other financial variables. The fundamentals for most established businesses are not capable of improving quickly enough that vertical share price appreciation is justified. Admittedly there will always be resource explorers and concept stocks which get lucky overnight but even here most of the share price appreciation in a related boom is not justified by the fundamentals. It reflects only speculation or the hope someone else will pay more.
Investors should not rely on regulation to protect them
Every major financial crisis or market bust triggers a public outcry and vows by politicians that such a disaster will never be allowed to happen again. New regulations, new regulatory bodies and volumes of legislation concerning companies, the securities industry and the financial advisory industry follow. The objective is to protect the public and make the system more responsive to its needs. Curiously this latest bust was preceded by the US Congress undoing many previous highly sensible regulatory reforms, not the least of which was the uptick rule to partly control shorting and the various Gramm-Rudman measures introduced after 1932 to prevent abuses of the banking system. Congress sure unlocked some evil genies.
Despite regulatory measures, and the prosecution/incarceration of malefactors from the last boom, large numbers of investors continue to lose fortunes in market busts and related company collapses. One reason is the high returns available in a boom attract enormous resources focused on circumventing existing laws. It is too difficult for regulators and politicians to foresee every aspect of the next boom and the result is legislative flaws which become loopholes. Sometimes a regulator takes court action to shut down an abusive practice but is not legally able to move before the collapse happens. This was the case in the Westpoint disaster.
It is difficult for legislators and regulators to prevent the excessive selling and mis-selling of dubious loans and investment products when the promoters, who in many cases are employed by trusted institutions like banks, achieve extravagant financial rewards for increasing sales volumes, business in force or funds under management/administration. This is the reason for the current movement to replace promoter commissions to financial planners with fees for advice. Even after this happens no doubt someone will find a way around it in the next boom. It is difficult to discourage intending wrongdoers with the possibility of conviction when the legal system prosecutes only illegal, not improper, behaviour. Therefore, investors cannot rely on the law to protect them. They need to take to heart the message of caveat emptor, or buyer beware: the buck stops with me and I must understand what I do.
The author also suspects regulation, licensing and the concentration of advice in branded, respected institutions that can afford the soaring cost of compliance with new laws create an aura of competence and trustworthiness which is not always justified. People want to believe they have found a money tree they can shake, making the aura seductive in a boom when there are good returns to be made. Meanwhile, the increasing proportion of the population who do not have English as their first language and without an understanding of the local system are vulnerable to advisers who meet the nominal legal requirements but are sharp salespeople. This was another feature of the Westpoint case.
Galbraith, in The Great Crash 1929, has the seminal comment on regulation: "…it is neither public regulation nor the improving moral tone of [the industry] which prevents these recurrent outbreaks and their aftermath. It is the recollection of how, on some past occasion, illusion replaced reality and people got rimmed…By the 60s this memory had dimmed. Almost everything described in this book had reappeared, sometimes in only a slightly different guise."
Politicians themselves are sometimes the culprits in causing disastrous booms and busts. Many fingers have been pointed at "capitalism", "extreme capitalism", "bankers" or "globalisation" as the cause of the subprime catastrophe but this crisis had its origins in explicit, well-intentioned public policy by the Carter and Clinton Administrations to make credit more available to low-income minorities who would not normally qualify for loans. Government-sponsored mortgage securitisers Freddie Mac and Fannie Mae were actually instructed to buy and securitise more sub-prime loans to grow the secondary sub-prime loan market and increase the supply of funds available for sub-prime loans. We are all now familiar with what happened to these sub-prime loans.
The lessons from history
The emotional brain is not evolving as quickly as the technological, demographic and industrial developments which inspire investment booms. Consequently greed, fear and herd behaviour are likely to remain dominant in driving financial behaviour 50 years and probably centuries from now. Even though we have just lived through the worst bear market since the Great Depression there will be more heady booms and damaging busts.
Some lessons from history include:
Speculative, debt-funded booms in particular asset classes or market sectors will recur.
The bright lights of so many appearing to make easy money attracts too many to invest at the top of the boom.
Just because people think a particular kind of boom will not recur does not guarantee this.
When a boom does occur the financial community will tend to reinforce prevailing valuations and make it easy for the public to invest or speculate in the underlying concept.
The inevitable bust will trigger enquiries, reforms and reams of legislation which will not prevent past abuses and excesses reappearing in a different form.
An understanding of booms, emotions and crowd behaviour is a better guard against getting fleeced than legislation, which does not stop incompetence and malpractice.
The bottom line is the safest time to buy is when there is blood in the streets and the immediate months up to a year or so after the event. During these times stronger companies grow their market shares at the expense of the weak. In the current market, if it does trend sideways before the next bull market emerges, the dips will be buying opportunities.
David Walker is a Morningstar equity analyst based in Australia.
