Have you ever found yourself standing in a field surrounded by cows? I learned that it is a situation made more stressful when accompanied by two children and a partner who does not share your philosophy of bovine encounters. Just as my wife started reading our last rites an apparition appeared, in the form of a jovial dairy farmer. He explained that the cows were curious, that we should stand our ground and that as they drew closer one of them would scare the herd into submission. Sure, enough one twitched and they all beat a hasty retreat.
This experience stuck with me as a lesson in the behaviour of crowds. The ebullient young cows egged each other on, until for no good reason they all decided to leg it.
The current euphoria in financial markets looks increasingly driven by animal spirits. The commitment of central banks to support markets seems to have removed all fear of losing money and get-rich-quick stories are being transmitted through social media, drawing in newcomers who want a share of the action. As a value investor I am sceptical of “this time it’s different” narratives. We are living through an era of extreme change, but history suggests that this is no reason for complacency.
It seems that financial markets are being increasingly dominated by price insensitive buyers. This label applies equally to the passive index investor who implicitly accepts current prices as the best guide to true value, the speculator who hopes to flip their purchase to a “greater fool” and the optimist who believes a company is so destined for success that there is no price at which it is too expensive.
Investing based on the perceived value of what you are buying requires analysis that links financial markets to the real economy. It is time consuming and offers few high-octane thrills. The growth in passive investment products is a good thing – but rests on the premise that everyone else is doing their homework to tether prices to a pragmatic view of what the future holds. In a world where prices are set on a whim it makes less sense, especially given the increased concentration of many indices into a narrow group of companies.
It is concerning that capital markets are increasingly detached from the economic activity that underpins them. Being a business owner and getting to share in its profits is a good way to build wealth and the stock market provides a convenient mechanism to democratise access to this. However, a speculative bubble will risk perpetuating the view that markets are a form of legalised gambling set up to serve the interests of those who work in them.
This brings me back to the cows.
When you study market history the end of a speculative mania rarely has a clear explanation for the herd’s retreat. The cows, it turned out, did not have much conviction in their need to get close and so it did not take much to frighten them. To this end when the current market euphoria breaks, I suspect it will be for a seemingly inexplicable reason. History suggests that the same animal spirits that lift markets will also work in reverse, with a small twitch rapidly turning into a mass exodus.
It is the corners of the market where prices appear most detached from real economic activity that present this risk – the same parts of the market that will draw in new participants hoping to get rich quick.
The desire for a comfortable retirement is an almost universal goal and the investment industry exists, in a large part, to serve this need. I am deeply sceptical that democratising leveraged derivatives speculation will prove to be a good way to help an aging workforce retire in comfort. At worse today’s euphoric markets have the potential to turn an entire generation away from responsible pension saving and I think it is in the interests of the financial services industry to make sure that this does not happen.
Perhaps this requires a shift of mindset with a redoubled focus on the true role of capital markets? At their heart they are democratic – because they allow all of us to own a slice of the real economy. Much like a farmer watching over his herd, we need to act as responsible stewards of other people’s money.