25 June 2015

There’s a Greece in every portfolio


As the horrible troubles of Greece unwind towards their conclusion there remains one question that no one seems to ask. How on earth did anyone think the Greek economy was worth buying at a premium price in the first place?

It was not so long ago that many thought just that. Investment pros will tell you there is always plenty of ‘dumb money’ about that will invest in anything. But just a few years ago the big buyers of Greek debt included the supposed super-brains in Europe’s biggest banks and pension funds, the people who make the call on the bond investments that are supposed to keep everyone’s future sweet. Were they nuts?

No they weren’t nuts. They were victims – albeit self-selected victims – of the bubble. The end of the last decade saw what was probably the biggest credit bubble of all time, of which Greece was just one small part. The reason we had such a deep financial crash and economic recession was that the people who are paid to see these things coming didn’t see it coming. The funny thing about bubbles is that they are only visible in retrospect, in the past, like some distant galaxy. Present bubbles are usually invisible, at least to the participants (and willingly or not, that means most of us). We may look at Greece and say we are well out of that, but there is a Greece in every portfolio. Perhaps several.

Today there are bubbles a-plenty, all of which will eventually burst and leave plenty of pain behind. There is a bubble in modern art, in internet companies, in Chinese stocks… and that’s just for starters. The fact is that over-investment is embedded in market psychology. To understand how that happens, you have to enter the strange world of people who take massive financial risks for a living.

All financial investment is about confidence. A bond, like Greek government debt, is a promise, valued according to the confidence people place in that promise (that is why it is called a bond). Yet confidence is a curious thing, a crowd phenomenon, and it is everywhere the case that individuals lose their rationality when they enter membership of the crowd. Confidence can run high in the face of a multitude of strong negative signals. And it can deflate like a party balloon just when the party seems to be in full swing.

There are two very useful guides to the psychology of confidence. One is the 1978 book by the economist Charles Kindleberger, called Manias, Panics, and Crashes. The other dates from 1841: Charles Mackay’s Extraordinary Popular Delusions And The Madness Of Crowds. Both repay study.

It was Mackay who diagnosed some of the common patterns to be found in the financial collapses of earlier centuries, such as the speculative fever that gripped England in the early 1700s, which we now remember as the South Sea Bubble. The common thread is a mismatch between what instinct and senses tell us is happening, and what we want to believe will happen. Or as Mackay put it, ‘they imagined they could … carry on their schemes for ever, and stretch the cord of credit to its extremest tension, without causing it to snap asunder.’

The South Sea Bubble, or the Dutch ‘Tulipmania’ of the 16th century, or the dotcom boom and bust are just the extreme examples of bubbles. In fact there is some kind of financial boom and bust around every ten years or so. Some are rapid fire boom-and-bust cycles, but bubbles are actually more likely to develop slowly, and collapse quite slowly too. For example, the stock of the South Sea Company fell and recovered and fell again in several steps over a long period of months. The financial crash that began in 2007 followed roughly the same pattern. Investors are very reluctant to let go of their mistakes.

Another pattern that is often repeated is that markets send a crash signal well before the bubble bursts. This is when prices suddenly gyrate for no apparent reason, and then return to business as normal just as quickly. It happened a year before the last crash, when in early 2006 equity and bond markets suddenly fell out of bed, only to normalise within days. It was (as Charles Mackay wrote more than a century and half ago) the moment when the undiagnosed bubble begins ‘to quiver and shake, preparatory to its bursting.’

The trouble with signals is that you have to be tuned to receive them. Although  financial markets are full of hyper-intelligent people who trade on a claim to be better informed than anyone else, the fact is that the world’s money managers are just as susceptible to magical thinking and wilful blindness as the rest of us.

One form of self-delusion that is especially common in the morning meeting is the contention that an investment has never gone wrong before, so it will never go wrong. The eurozone had never gone wrong. BP had never gone wrong. Bricks and mortar (in the US at least) had never gone wrong. The lesson that there will be a first time for absolutely everything is one to which investors are highly resistant.

Also common when markets start behaving weirdly: it’s a correction, not a signal, and we were expecting it. The ‘quiver and shake’ that every bubble exhibits prior to bursting is always hard to read. One paradoxical reason, as Kindleberger pointed out, is that in the times of distress that precede the bursting of bubbles, it may be solid, low-risk enterprises that are hit first. Stressed money often flows to higher-risk, higher-return investments in order to maintain promised levels of profit. The closer to a bust, the more money put at risk. But history suggests that discounting extreme market movements is always a mistake. The best piece of advice here is one of the oldest: ‘the first piece of bad news is very rarely the last.’

Then there is the conviction that for some given reason valuations don’t really matter. For example, many large Chinese companies are now trading on absurdly high valuations in terms of price/earnings ratios – four, six or eight times what is considered normal elsewhere. Don’t worry, say the China boosters, China is different and earnings don’t matter. When a market reaches territory that is very difficult to interpret using the normal rational tools, then it’s oddly tempting to start believing that reason is no longer applicable, that information is irrelevant. The ultimate version of this came in the South Sea Bubble, when one company issued a prospectus for ‘carrying on an undertaking of great advantage, but nobody to know what it is.’

And then there is the inextinguishable desire to ‘time the market’. Investors often concede that prices are inexplicably high, but if they are inexplicable, why shouldn’t they go higher? Just a little longer, we might make more money. Actually it is impossible to time the market, except by accident. Or as one famous financier put it, ‘getting out too early is how I made all my money.’

Bubbles, like the financial bubble that brought Greece to its present pass, are entirely man made. Financial markets are the work of people, and people like narrative and  momentum. They like to believe, even if that means believing the unbelievable. The mess that is left when the bubble bursts can only be cleared up when people finally let go of the narrative they have constructed – and that is a difficult thing to do.

Richard Walker is a journalist and communications advisor to financial companies.