Manifest Signs of Irrational Exuberance in the Market

In December, Martin Wolf—for whom I have a lot of respect—wrote an article in the FT arguing that the stock market is not currently overvalued.

To be as fair, I’d note that his argument was based on two premises: corporate earnings would be strong and interest rates would remain ultra-low.

With the right assumptions, of course, just about any assertion can be supported.

I’d like to make a contrary case that financial markets—not just that for equities—are indeed in bubble territory.

Bubbles occur when providers of capital—lenders or investors—underestimate risk and overestimate return.

It’s relatively simple to diagnose contrary to what some “maestros” believe as I now propose to show.

Think of me as your financial Don Ho, but with a focus on larger events.

The size of the bubble is directly proportional to 

1. the acceptance of most outrageous investment theses and valuations and 
2. engagement in unsafe and unsound practices. 

For the last point, the “running with scissors” test is an apt tool.

First, signs in the equity market.

What better poster child for irrational exuberance in the equity markets than Tesla?

One does not have to be as smart as Jim Chanos to see that Tesla’s price is supported by multiple fanciful delusions about the future. “Fanciful” to distinguish these delusions from “normal” investor over optimism.

And Tesla is not the only case, but likely the most outrageous.

To measure the extent of the madness reflect on Tesla’s entry to the S&P 500.

That indicates the extent of the overvaluation of Tesla. 

It also thus suggests we have passed the frontier of “irrational exuberance” to “Brexit” level delusions.

Second, signs in the debt markets. 

Issuers with currently crippled businesses are issuing debt at record levels.

Now I am not advocating refusing loans to all companies in distress. But rather being selective.

And when doing so applying time tested practices.

One should wear a helmet when riding a motorcycle and drive at a sensible speed.

When the road is wet, it’s daylight madness not to wear a helmet and not to drive slower.

But exactly the opposite is happening.

Much of this debt is “secured” by assets that the borrowers currently cannot profitably employ.

There is also a surfeit of such unemployed assets at present.

Additionally, it is unclear what returns these assets may afford in the future. Or when that “future” may be.

The collateral value of an asset that has limited value in use is roughly equivalent to the sound of one hand clapping.

Think of planes and cruise ships.

To that add the wanton abandonment by “investors” of basic common sense credit and legal structuring.

Debt is repaid by cashflow not assets. History suggests that primary reliance on collateral for repayment is likely to be an unhappy affair.

Covenant “lite” structures offer limited legal protection and limited means to pressurize debtors. And will be of limited utility when clouds gather.

Third, signs in private equity. 

Also in December Kate Wiggins wrote an article on how canny private equity General Partners had found a solution to blocked “exits”. 

If there’s no suitable opportunity for a trade sale or an IPO, why not sell a portfolio company to yourself? Or more precisely to a so-called continuation fund.

A suitable “opportunity” is one where one doesn’t have to sell at a loss. Or face the subsequent valuation consequences of failure to sell a duff asset that there was no perceptible demand for.

But sales essentially to oneself can be “structured” to

1. deliver sufficient “return” to LPs to keep them happy
2. generate carried interest for the “deserving” GP, and
3. create the appearance of a suitable return on the selling Fund that will persuade a “sophisticated” investor to sign up for the buying Fund (the continuation fund).

One hopes that LPs from the selling fund are not the major cohort in the buying fund.

But then AA has seen some rather incredible behaviour by so-called sophisticated investors.

Fourth, signs in the retail market. 

Increased activity by the financially illiterate: the rise in the price of Bitcoin, day trading, etc. 

The past suggests that all this is not going to lead to a happy outcome. Though as you know past performance is no guarantee of future results.