Notes, Views, and the Occasional Provocation June / July 2015 

The world markets are offering a graduate seminar in investment risk right now, with simultaneous financial crises in Greece and China, and a burgeoning technology bubble in the U.S. As always with such events, it seems a surprise that anyone’s surprised, since the market developments are playing out in textbook fashion.

In the meantime, I hope you're tuning out the headlines and enjoying a relaxing summer.

Best regards,

Milo Benningfield

The Morality Tale of Market Booms & Busts
Though the details and names may change, when it comes to capital-market booms and busts, the basic story remains the same – yet the crises remain as difficult as ever to avoid. more

BFA Media Quotes
Recent media quotes. more

The Morality Tale of Market Booms & Busts
Market booms and busts are as much a feature of the investment landscape as rocks on the moon. A well-regarded book, Manias, Panics and Crashes, written by MIT professor Charles Kindleberger in the 1970’s and updated periodically, attempts to educate investors about such crises and thereby inoculate them against future losses. But as professor Kindleberger notes, financial crises are a “hardy perennial” and education has provided no cure.

In fact, it’s often the smartest people in the room who lose significant money in financial crises. English physicist and mathematician Sir Isaac Newton gave us calculus and explained the law of gravity, but lost a small fortune in the South Sea Bubble of the early 18th century. As he put it, “I can calculate the movement of stars, but not the madness of men.”

Scottish journalist Charles Mackay explored the South Sea Bubble and other famous crises such as the 17th century Dutch tulip mania in his popular book Extraordinary Popular Delusions and the Madness of Crowds. But a few years after publishing it, he, too, lost his shirt in the British Railway Mania of the 1840’s.

As countless other examples suggest, stock market bubbles appear as difficult to avoid as a case of influenza. But why is that?

Greed, for one thing. No matter how disciplined you are, it’s difficult to watch friends and family earning tons of easy money in the markets while you sit on the sidelines – or to avoid running alongside them for the exits during a panic.

Also, it’s not that easy to calculate and profit from the fair value of a stock or bond. Valuing assets means estimating future cash flows and other factors in the face of uncertainty. Even if you peg the value correctly, you need other investors to reach a similar conclusion in order to reap much reward.

There are many other causa proxima and causa remota of financial crises that we might discuss, but underlying them all is one unifying element: capital.

We rely on capital to build our roads and hospitals, make and transport our goods, and generate the music that fills our lives. But it is the easy availability of capital that fuels all market booms and busts. As MIT economics professor Robert Solow stated in the preface to Manias, Panics, and Crashes, “Any reader of this book will come away with the distinct notion that large quantities of liquid capital sloshing around the world should raise the possibility that they will overflow the container.”

Alas, if there were just one container and one way for capital to flow, it might be a simple matter to tell when it was about to breach the top. But the global capital markets are more like a giant outdoor souk filled with all manner of containers large and small, some placed conspicuously in front of stalls, others hidden in dark rooms, accessible only to a privileged few. In the magic of the markets, there is not, moreover, a finite limit to what the containers can hold. Rather, the containers themselves can grow to accommodate new inflows of capital.

Despite this multifaceted complexity, whenever a financial crisis occurs, it typically gets reduced to a two-dimensional morality tale – as we’re seeing now in Greece, China, and soon, it would seem, in Silicon Valley.

Greece’s financial system is crumbling; it may soon have to leave the European Union. Many people ask, why can’t the Greeks clean up their government, start collecting taxes, and cut their welfare payments to sustainable levels? From this vantage point, it is Greece’s moral laxity that has led to a tragic end.

But is Greece alone to blame for the capital? European banks lent freely, despite Greece’s reputation as a serial defaulter over the past century and a half, and why the capital flowed is a complex mix of profit-seeking, politics, and sentimental fondness for the “cradle of democracy.” Sure, it would be nice if Greece were, well, a little more German in their fiscal governance, but the availability of capital played an equal, if not larger role in the current drama.

Across the seas, nascent capitalism sent Chinese stock markets soaring over the past year, doubling their value. In the past three weeks, the stocks plummeted by a third. China’s white-hot economic growth and its decision to adopt more of a market economy caused the capital to flow, creating the usual complex problems. But the media narrative is that mom & pop Chinese investors were too naïve and too greedy to avoid commonplace mistakes such as buying stocks with borrowed money. Taking stock tips from hairdressers is so last century. The pundits are calling the crash “China’s 1929” and seem to chuckle as they say, Didn’t they see the movie?

But if the plot of most financial crises is the same, the details of each boom and bust continue to vary, providing another reason for why they are difficult to avoid.

Over the past few years, we’ve been experiencing an asset boom here in the U.S. A financial economist would tell us that we can’t prove that it amounts to a true bubble, but the stock market is exhibiting the telltale signs, particularly in the technology sector.

For example, Facebook has been trading barely three years, but last month its market capitalization exceeded that of Walmart, despite having a small fraction of Walmart’s revenue, profits, employees, and real estate. Other publicly traded technology companies have also experienced price surges.

But this time around, the interesting action for tech is in the private market, with the so-called “unicorns” and “deca-unicorns,” privately held companies valued at $1 billion and $10 billion. Even more than Apple, Google, and Facebook, private companies such as Uber, Airbnb, and Palantir are generating a buzz unheard since the dot-com days of the late 1990’s.

There’s so much buzz in the San Francisco Bay Area – as well as a real estate bubble that typically accompanies a stock-market bubble – that investors are going out of their way to describe why this tech cycle is different from the last.

In the 1990’s, they say, dot-com’s only had “eyeballs” and “clicks” to justify their valuations; today’s companies have real revenue. The Internet was young and naïve then; we’re older and wiser now.

The biggest difference, though, between then and now is that companies are taking longer to do an IPO in order to publicly trade their shares. Why? Easy money.

In today’s low-interest rate world, there’s an overabundance of capital available to technology companies from investors seeking higher returns. Pension funds, sovereign-wealth funds, and even Fidelity mutual funds are asking tech companies to please take their money.

Meanwhile, new regulations from the 2012 JOBS Act have allowed companies to hold onto their capital longer before having to register shares with the SEC and make their financial secrets public. In the past, a company had to register its shares – and thus might as well do an IPO, for a variety of reasons – once it had more than 500 shareholders. Today, with certain qualifications, a company can have as many as 2,000 shareholders before it has to register.

Thus, today’s unicorns don’t look so much smarter than yesterday’s dot-com’s as better situated. Capital is . . . sloshing around, and it sure looks like a tech bubble similar to the one in the late 1990’s, simply earlier in the equity pipeline.

Perhaps Uber will earn every dollar required to justify its $50 billion valuation. But if the tech surge continues, the chances are good that not a few investors will soon resemble the Greeks and Chinese that the morality narratives ridicule now. Investors who avoid concentrating their bets, diversify their portfolios, and maintain their composure when the market correction finally comes should get far better treatment in the subsequent movie.

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BFA Media Quotes
Money Magazine, June 6, 2015
Milo was quoted in an article by Ian Salisbury, “Three Strategies for Rebuilding Your Emergency Fund,” which discussed how to replenish cash reserves depleted by unexpected expenses. Milo recommended selling short-term bonds in a taxable account and reallocating bonds in tax-deferred accounts to replenish savings quickly in the most tax-efficient way.

Thank you for reading. Please look for our next newsletter in September.

Best regards,

Milo Benningfield

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