The great speculative era on markets is hard to kill

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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.

The writer is a financial journalist and author of ‘More: The 10,000-Year Rise of the World Economy’

In most Hollywood horror movies, the monster is incredibly hard to kill. Not until the final moments of the film will it be dispatched and, even then, enough doubt will be created to leave room for a sequel.

So it has been with the great speculative era on the financial markets. A pandemic, a Russo-Ukraine war and even substantially higher interest rates have not finished off the risk-taking bonanza.

Take the technology sector as a starter. Much of its value lies in the future profits companies are expected to earn because of their superior growth potential. When bond yields rise as they have this year, investors should in theory use a higher rate to discount those future profits taking into account the time stocks have to be held to receive them. That means valuations should fall, not rise.

But the price/earnings ratio of the US technology sector is well above its three-year average and the sector’s shares have jumped more than 50 per cent so far this year.

Second, take the overall market valuation, as measured by the cyclically adjusted price/earnings ratio, or Cape. This averages profits over 10 years to allow for the economic cycle. In March 2022, as the US Federal Reserve started to push up interest rates, the Cape was 34; on the latest figures, the ratio has dropped only to 31, still well above the historical average. And markets have continued to rally in December.

Then there is bitcoin. The late, lamented Charlie Munger, the long-term colleague of Warren Buffett, said that investing in cryptocurrencies was “absolutely crazy, stupid gambling”. As if to prove his point, the past 18 months have seen the collapse of the crypto exchange FTX, and Binance — one of its biggest competitors — suffering a $4.3bn fine for money laundering and the forced departure of its founder. There could not be more alarm bells sounding if the entire New York City fire department was racing, with sirens blazing, past investors’ doors. But the bitcoin price has more than doubled this year.

One explanation for the continuation of investors’ risk appetite is that, while nominal interest rates have risen over the past couple of years, they have been outpaced by inflation; the real returns on cash and bonds have not been attractive. That has maintained the allure of risky assets.

Now inflation has fallen, real interest rates are mildly positive in the US, making cash and bonds theoretically more appealing. But investors do not expect this to last. The stock market rally in November was driven by the widespread expectation that the Federal Reserve would be able to start cutting rates in 2024.

But there is more to the frenzy than the prospect of a change in monetary policy. Surveys show that American voters are not happy with their economy, even though it has actually been doing remarkably well. In the third quarter, gross domestic product grew at an annualised rate of 5.2 per cent.

The economy has been supported by fiscal policy, with the budget deficit running at about 5.7 per cent of GDP in the current year. In other words, American pocketbooks are sufficiently flush that they can afford a little gamble.

So what could finally bring the speculative era to an end? In any individual asset class, a collapse usually arrives when investors lose confidence in the fundamentals that have been driving prices higher.

For tech stocks, this could occur if regulation (or geopolitical tensions) severely damage their profits outlook, For cryptocurrencies, regulation is also a risk, as is the collapse of an exchange that results in big losses for institutional investors. 

However, it does not seem as if the boom in tech stocks and crypto is being driven by the use of large amounts of leverage. Historically, the trigger for a more general collapse in risk appetites has been a tightening in credit conditions.

That was the reason for the plunge in mortgage-backed securities in 2007 and 2008, which then filtered through to concern about the health of the banking system. So it might be that a sharp fall in tech stocks or cryptocurrencies would simply cause speculators to switch to another asset class. 

A more general collapse in risk appetite may require a really dramatic geopolitical event, such as war between the US and China over Taiwan, or a central bank miscalculation in monetary policy, either by failing to contain inflation or being too tight for too long and causing a deep recession. These may seem like extreme outcomes but it usually takes an explosion to kill a movie monster.