Investors need to come back down to earth before the stock market bubbles over

Stock investors appear increasingly to live in a kind of capsule sealed off from the real world. Outside, winds may moan, storms threaten and the earth tremble but all that investors see is a rosy virtual reality projected onto a screen of make-believe.

Stock markets continue to soar and bond markets climb along with them and the only thing that seems to bother capsule dwellers is deciding which of the two markets – equities or bonds – offers the most promising prospect of higher returns.

This contrast between virtual reality and true reality was very clear last week as the Organisation for Economic Cooperation and Development (OECD) warned that the world is not moving fast enough to get ahead of the Covid-19 pandemic to prevent lasting damage to the global economy. OECD Secretary-General Angel Gurría said: “There is no room for complacency. Vaccines must be deployed faster and globally. This will require better international cooperation and coordination than we have seen up to now.”

All the fiscal support in the world will be of little avail beyond the short term if vaccine roll-outs are not accelerated so that full economic activity can resume, added OECD chief economist Laurence Boone.

As she spoke, equity markets continued their dizzying climb and one prominent fund manager declared: “The time is now for investors to top up their portfolios – in both value and growth stocks – ahead of a stronger than expected global economic rebound.”

Does this yawning perception gap between capsule-dwelling investors and hands-on policymakers matter, or should we simply shrug off the “irrational exuberance” of stock markets and stay focused on real developments?

Obviously it does matter, a lot. Apart from the danger of vaccine roll-outs not happening fast enough to sustain economic recovery and prevent a fiscal crisis (or wider debt crisis), for a stock bubble to burst now could be disastrous.

By the end of 2020, the total capitalisation of equity markets around the world had reached an all-time high of US$95 trillion, according to estimates by Apollo Global Asset Management. That is more than the total value of world gross domestic product which stood at US$88 trillion at the end of 2019, as calculated by Statista services. It offers some idea of the financial leveraging potential (good or bad) of stock prices.

Magic money is blinding us to the dangerous reality of inflation

There was a time before the advent of quantitative easing (when authorities began printing money with an abandon that puts toilet roll makers to shame) in which stock prices were a barometer of economic health. The stream of corporate earnings and dividends determined stock valuations in days before the monetary taps were fully turned on – a development that washed away the apparent need for such logical or common-sense linkages.

Unfortunately, stock investors do not seem to have caught on that a stock bubble feeds on itself. It encourages the idea that all is well with the economy, which in turn encourages yet more speculative investment. We are in danger now of allowing the narrative to be dictated by asset price inflation rather than by real developments. Only when asset price tremors become an earthquake will capsular optimism be dispelled.

Yes, things are looking somewhat brighter now that the vaccine roll-out has begun in earnest (at least in some countries), and with fiscal stimulus gushing forth in the United States and some other countries.

Central banks, Boone said, will “look through” signs of inflation in goods and services prices and keep monetary taps open. Yet, the pace and duration of the recovery will depend on the race between vaccines and the virus, according to the OECD.

She also noted that while global GDP growth is projected at 5.6 per cent this year (up one percentage point from the OECD projection last December), that will only take it back to pre-pandemic levels.

To point this out is not to be too pessimistic. A reality check is needed, given the facile and unquestioning optimism of equity markets and their self-perpetuating, easy money-driven momentum.

The world’s free-spending, money-printing spree will cost us dearly in the end

Price-to-earnings ratios on US stocks are touching 90 in some cases and Japan’s Nikkei 225 stock average is returning to levels last seen in the bubbly 1980s.

Perhaps nothing should surprise us in this Alice in Wonderland world. As Nigel Green of investment group deVere notes, “there’s a risk of a debasement of the dollar” as a result of America’s US$1.9 trillion fiscal stimulus package. But instead of turning to gold, which has held its real value for centuries when paper money or fiat currencies turned to dross, investors are piling into bitcoin (whose price is close to US$60,000) and other cryptocurrencies.

As Oxford Risk said in a report: The current economic, fiscal and stock market environment, plus the recent rise in crypto-assets valuations and retail trading, has created a situation where the risk of emotional investing has hit a new peak.”

“Emotional investing”, it suggested, involves people acting on behavioural impulses, buying and selling on the back of markets rising and falling. It is surely time for investors to become less emotional and more rational.

Anthony Rowley is a veteran journalist specialising in Asian economic and financial affairs