6 warnings about investment risks right now

Keynes on Crashes

This is the July 2017 update on this Investment Risk ‘red alert’ Insight that I’ve been running for some time now.

What’s that quote about?

John Maynard Keynes, in case you’re unaware, was (and still is) considered by many to be one of the greatest economics thinkers of all time.

And he made that statement just 2 years before the start of the great depression that took c. 85% off the price of the wider US stock-market in just three years – between 1929 and 1932.

Of course a lot of companies went bust in that depression. So, investors in those shares lost 100% of their money.

And that’s probably what happened to the character in this famous image.

So this is to remind you that calming words from experts count for nothing when markets get overheated and then investors take fright and panic.

Interestingly, from the middle part of last year, the ‘experts’ have started warning us about the increased risks in markets.

Warning 1 – the experts are now worried

In the Financial Times, October 14, 2016, Gillian Tett shared the concerns of Axel Weber (head of UBS and former head of Germany’s Bundesbank) about what’s really shaping markets now.

Their shared concern – in a nutshell – was that

markets are not true (free) markets now.

‘this point needs to be proclaimed with a megaphone’, said Tett.

I agree (and have done for some time) and I think most informed commentators agree too.

The actions of the world’s central banks have distorted markets for years now.

The trouble is that we’re only now waking up to the RISKS of their actions.

It’s quite clear that holding down the price of money (interest rates) has seriously pumped up the price of other assets.

Just look at the prices of property, shares and bonds. They’re all ‘off the scale’ against any normal measure.

Indeed, if you’re looking for a sure sign of a bubble  – check out where your local council is speculating. In 2007 they were depositing your money with Icelandic banks. now they’re speculating in over priced commercial properties 🙁

Local Council's speculate on property

So, the central banks have quite clearly let this super low interest rate ‘game’ run on for too long.

Meanwhile, the Investment bankers (who can see trouble ahead as the game unwinds) are queuing up to warn us now.

In October 2016, Murray Gunn, head of technical analysis for HSBC, said that based on the price action of stocks over the past few weeks he was on “red alert” for an imminent sell-off in stocks. He also said (in September) that the stock market’s moves looked eerily similar to those just before the 1987 stock market crash.

And in case you’re not familiar with that one . . .

. . . that was when the FTSE 100 lost c. 35% of its value in a month.

Tom Fitzpatrick (from Citi Bank) has also talked about the parallels with 1987.

Of course, this ‘allegedly’ technical analysis cannot give us any reliable forecast. (That much is clear from the fact that these calls have been wrong so far)

But if major banks feel inclined to issue such warnings, perhaps we should ask if there’s a cause for concern that runs deeper than the ‘shape’ of price charts.

I think there is. So, let’s look at some evidence.

Warning 2 – this Economic expansion is getting old

This first chart looks at the length of US Economic expansions since the second world war

Obviously we can’t tell how long this expansion might run for but it’s clearly ‘long in the tooth’ already.

Perhaps a more interesting question is what’s been driving growth (in the economy and asset prices) in the US, the UK and elsewhere around the world, for the past 40+ Years?

Has it all come from the ‘white heat’ of technological advancement?

Well some of it yes, for sure.

But if you read Professor Steve Keen’s excellent new book, ‘Can we avoid another financial crisis?’  you’ll find these charts which reveal another, more disturbing reason for it.

Simply put, a lot of the growth we’ve experienced in recent decades, has been an illusion.

It’s come about simply because of these constantly increasing private debt piles.

And that’s not a trend that can carry on indefinitely.

Warning 3 – investors have borrowed too much

This indicator has been flashing RED since around 2013.

Which I guess proves that, like earthquakes, hidden pressures in market systems can build, but we can never know when crashes will strike.

Earthquake

Incidentally, we know from the data that the frequency and size of stock market moves are similar to those of earthquakes.

Market movements do not follow a ‘normal distribution of returns’ – contrary to what is taught to investment advisers in their exams!

So, that’s a big issue and one I’ll come back to another time.

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What we know for sure is that markets do crash (very quickly) from time to time.

And those falls normally come after a lot of buying pressure has built up – to take the market well above it’s normal valuation range (more on that below)

So, let’s see if there has been a build up of buying pressure  – for clues on the risk of this trend reversing.

Okay, so what is this red alert about?

Well, it’s about investors who borrow – to invest!

And this excellent chart (from Doug Short at Advisor Perspectives) tells the story.

Margin debt on the New York Stock Exchange

You can find more of Doug’s Insights here

What the chart tells us

Look at how that blue line (of the US stock market) has a nasty habit of overheating (ramping up) and then crashing.

And notice how the overheating happens when investors borrow a lot (the red bars)

So, investors have borrowed heavily in recent years?

Exactly right – and who can blame them?

After all, interest rates have been at all-time lows.

And they’re several percentage points below what anyone would describe as ‘normal’

Borrowing has been mega cheap – whilst the return on your money left in the bank has been mega awful!

So, there’s been a double incentive to borrow to invest!

Warning 4 – interest rates could rise – a lot

Of course interest rates are low at the moment  – and they might stay low a while longer.

But they are now starting to move up again in the USA.

And, based on recent votes and comments from members of the Bank Of England’s rate setting committee . . .

. . . Interest rates could well start heading back up in the UK soon too.

Indeed, as the FT reported (25 June 17) the Bank for International settlements (the central bank for all other central banks!) is now warning that:

“Keeping interest rates too low for long could raise financial stability and macroeconomic risks further down the road, as debt continues to pile up and risk-taking in financial markets gathers steam”

They realise that raising rates too quickly could cause a panic in markets that have grown used to cheap central bank cash.

But they’re warning that delays to rate increases could mean rates having to rise further and faster to prevent the next crisis.

So the mood music around interest rates has changed, quite dramatically now. 

As the cost of borrowing rises – and people start to see better returns on their money at the bank . . .

. . . that double incentive goes into reverse.

So, those borrowing (aka ‘leveraged’) investors will likely cut their borrowings.

Indeed, you can see from the chart (red bars, right hand side) that they started doing exactly that last year.

On that occasion, these leveraged investors appear to have gotten excited again (about the prospects for even more gains) . . .

. . . and they started borrowing again – to buy back in.

Perhaps they think that Mr Trump can help the stock-market ‘defy gravity’ for a little longer.

Who knows?

Okay, but so what?

Well, notice how the big market crashes tend to come, when those borrowing investors ‘cash out’ of their shares to pay back their debts.

So, this is potentially a nasty situation.

And whilst it’s fair to say that some big risks in stock markets that never materialise – this is one more key indicator that’s not looking good right now.

Warning 5 – stock-markets have risen – a lot

Now before we get into this one – let’s be clear about one thing.

If you don’t yet have a large sum invested and you’re saving regularly over the long term – then this issue may be less of a worry for you.

Indeed, a big market correction early on in your regular savings journey, could very well be to your advantage – as you get to buy in at lower prices.

On the other hand if you do have large sums invested in the markets and you will want to encash some or all of them over the next few years (perhaps for your retirement income) then market risks are more important as I explained here.

Either way, we need to recognise that markets (in stocks and property) worldwide have boomed because of the incredibly low interest rates we’ve had for so many years now.

And such ‘asset price parties’ always end eventually . . .

Central bank policymakers appear to be questioning the wisdom of letting this party run on any longer  – so it certainly could end sooner rather than later.

Remember that the US stock-market is up by c. 260% (including reinvested income) since March 2009.

The UK stock-market is up by more than 190% on the same basis.

So, these have been incredible returns compared to what you’d have earned from money at the bank.

And whilst that’s all very nice for those lucky enough to have been fully invested over that time – the question for investors is . . .

Can such returns be repeated from now?

Well, as you may have guessed, I’m in the camp of people who think that’s unlikely.

Yes, it’s possible but it seems unlikely given how ‘stretched’ the valuations are today.

We need to remember that the stock-market in the USA (the world’s largest by a long way) has only been up at its current valuation levels on two previous occasions in the past 130 years.

As you can see, those years were 1929 and 2000.

And both occasions were followed by a crash!

You can read more about this powerful market valuation indicator here

But for now it’s worth knowing that Professor Robert Shiller – the Nobel Prize winning creator of the CAPE indicator – expects real returns on the US stock-market to be around 1% p.a. over the next 10 years.

And, if you think about that – in most investment products that would mean no real returns – or a loss after charges.

Now, clearly there’s no certainty in that estimate and returns could be higher or lower than that.

This picture gives you a feel for the range of returns  – with CAPE at various starting points – borrowed from this useful paper from  Star Capital

CAPE vs Investment Returns

I suggest that you ignore those ‘outlier’ red dots for Denmark  – which are there to make a point about unpredictability! . . .

. . . and just focus on the world’s largest stock markets of the past 50 years (The USA and Japan) to get a clue as to how Professor Shiller has arrived at his estimate. (I’ve highlighted it in yellow) 

So, what does all this mean for YOUR money?

Well, that, as ever depends on your capacity to endure market downturns – and without knowing anything about that  – I’m not going to advise you on it.

However, I think we can say that if you take ‘next to nothing’ (in real terms) as your central estimate for returns on the US stock-market over the next 10 or so years . . .

. . . and then you factor in the possibility of some very big bumps along the way . . . well,

this might make you question the wisdom of having too much in stock markets right now.Click To Tweet

And Professor Shiller is far from the most ‘downbeat’ expert on markets right now.

If you really want to hear the bear case – listen to Marc Faber’s warning about markets here

His view is that markets could fall 40% or more from current levels!

Of course, Faber isn’t always right with his predictions. No one is.

But he is worth listening to – if only to balance out the perennial optimism you’ll find elsewhere.

And he offers some useful investment wisdom nuggets here also.

The bottom line – as ever – is that YOU have to decide, with or without guidance, what to do with your money.

My general guidance is very clear and it’s this.

The right answer depends completely upon your personal circumstances.

There’s no silver bullet and no single investment to suit everyone’s situation.

We really are all different.More on that here.

So, when you think about your investments, you need to understand your own personal ‘appetite for investment risk’.

And, more importantly, you need to understand your own, personal ‘capacity for loss’ on the funds you’re allocating to each of your investment goals.

Only when you know these things can you invest intelligently.

Warning 6 – some financial advisers ignore market valuations!

A lot of financial advisers ignore market valuations in giving advice.Click To Tweet

They will tell you that stock markets are priced perfectly at all times AND that they’ll always produce good long term returns, regardless of when you go in.

Now, I have to tell you – that’s not clever advice.

Get that sort of advice – as many do – at the wrong time and it could be very damaging to your wealth.

So be careful how you choose your adviser/wealth manager and know what to ask them – before you appoint one.

All advisers are not the same.

Quote of the day

– and I’m grateful to my friends at Money Week for this one . . .

. . . Samuel Lloyd, an English financier, once observed that:

No warning can save a people determined to grow suddenly richClick To Tweet

But that’s not going to stop me from issuing these warnings . . .

Take care out there

Paul

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Discuss this article

  • Cwijetunge

    Great article. I’ve been assuming interest rates would rise for years… still waiting! What do you think would trigger a rate rise, given that even the decline in the pound hasn’t seemed to have had an impact…

  • Great question Caroline – and one that’s worth a fresh Insight. I’ll write one and let you know when I’ve posted it 🙂

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