Every Time It's Different and Yet It Rarely Is
Every Time It’s Different and Yet It Rarely Is
Here we are in year 7 of the post-Lehman bull market and financial journalists are ratcheting up their “bubble” talk. With the Nasdaq crossing the 5,000 mark for the first time since the dot.com mania, collectible art fetching ridiculous sums, bidding wars for real estate in quite a few metro areas, and the proliferation of billion dollar “unicorns” (including a $40B valuation for Uber), you can’t exactly blame the media for opining on when things might pop.
Valuations in certain parts of the market are certainly high versus historical metrics but that doesn’t necessarily mean that they will come down any time soon. What remains unknown is the effect on intermarket relationships that the unprecedented global monetary easing has had. Our markets have never been through a cycle where we had a zero interest rate policy for this long. We have also never seen markets around the globe so interconnected. Our interest rates are fluctuating based on how the German Bund is trading; the U.S. dollar is moving based on policy decisions out of the eurozone and Japan; commodities fall or soar based on GDP prints out of China; and our housing markets (in many cities) are being bolstered by buyers from Russia and the Middle East.
This interconnectivity presents all sorts of complexities, particularly as the Federal Reserve moves towards the first interest rate hike in nearly a decade. If Janet Yellen starts raising interest rates in the U.S. as the European Central Bank, Bank of Japan, and Peoples Bank of China are embarking on their own forms of quantitative easing we will see the U.S. dollar strengthen in a big way. While a strong dollar sounds like a good thing, it will make our exports more expensive to foreign buyers and will have a negative impact on earnings of U.S.-based multinationals. It will also put downward pressure on most commodities (i.e., oil, gold, silver, copper, etc.) as they are priced in dollars.
You may be wondering why low commodity prices are bad. Let’s look at oil as an example. We’ve seen oil prices fall from $120/barrel in 2014 to under $50/barrel at the time of this writing. Low oil prices feel good to us as consumers but at the macro level, they can be quite destructive. For starters, energy companies represent the largest segment of the high-yield bond market. Low oil prices put significant pressure on energy companies, particularly the smaller ones that rely heavily on debt financing. If oil prices stay low for long, these companies could miss interest payments triggering a wave of defaults in the high yield bond market.
Other factors to consider:
- Low oil prices hurt the economies of so many Middle Eastern countries that rely on oil revenue. This could lead to geopolitical tensions rising;
- Fewer companies in the U.S. are engaging in new drilling projects and the number of drilling rigs has fallen dramatically. This will hurt our energy independence efforts and ultimately reduce supply.
- Oil substitutes suffer in prolonged price decline. Natural gas, coal, solar energy, and electric power do not command the attention of consumers or investors with oil so cheap.
Do I think our markets are in a bubble? No. But I do believe it’s gotten too easy for people to make money and whenever that happens, something has to change. As Nassim Taleb said in his book “Fooled By Randomness”: “Lucky fools do not bear the slightest suspicion that they may be lucky fools - by definition, they do not know that they belong to such a category.”