By Barry Ritholtz
(Bloomberg View) --The financial markets of developed nations face a conundrum: They are swamped with wealth but have too few viable investment opportunities. The consequences of this are likely to be familiar to student of financial markets history.
How might this play out? Here is a possible five-step scenario:
- Wealth accumulation accelerates;
- Demand for returns leads to capital flowing into assets of all types;
- Prices rally and some start questioning whether things are getting overdone;
- Wall Street responds to investor demand by creating more products;
- Valuations get stretched until the moment of recognition that they've become untethered from reality; a crash ensues.
Let's look a bit deeper at each of those five stages.
Does anyone doubt there are trillions of dollars in wealth, as noted in Step 1? We start with net worth for households and nonprofit groups: the Federal Reserve reported an increase of $1.7 trillion last quarter, to a record $96.2 trillion. The gains were driven by the rising value of financial assets, including stocks and pension-fund holdings, and housing prices. Corporations are also flush with cash, sitting on almost $2.3 trillion. This picture encompasses the U.S. alone and doesn't even touch on Europe, Japan and China.
This is an unprecedented pool of capital.
Step 2 involves how aggressively this money is looking for a home. It has been flowing into all sorts of assets: stocks, bonds, commodities, private equity and venture capital. Consider the unprecedented pools of money sitting in private-equity firms alone; venture-capital funds have a cash problem, as well -- they have too much of it. Meanwhile, outlets for that capital haven't kept pace. The number of publicly traded stocks has declined as markets “de-equitize;” the Wilshire 5000 actually contains just 3,465 stocks today. And as we noted several years ago, there is a huge global shortage of quality long-term sovereign bonds and other investment-grade fixed-income securities.
While we can debate valuations, there is no debating that assets across the board have seen big gains since the financial crisis ended sometime in 2009. That is Step 3. Some people believe that many assets have run up not only to fair value, but have already exceeded it. They also speculate that the same thing is about to happen in Japan and Europe; and that it will eventually happen in emerging markets and frontier countries.
Whether valuations have become excessive -- unicorns, anyone? -- is also worthy of debate. I consider it poor form to argue via extreme examples of valuations rather than entire asset classes. Regardless, signs of excesses can be found. I am reminded of the phrase “Money goes to where it is treated best,” and that is what has been driving valuations.
My best guess is we are somewhere in the middle of Step 3, as some valuations are elevated and others are on their way. Note that this stage often endures much longer than many people imagine while it is happening. Consider the five years running from 1996 to 2000.
Step 4 is when Wall Street shows how savvy it is when it comes to the basic laws of economics. The natural response to demand is to satisfy it by creating more supply. Recall how the investment industry responded to the demand for higher yields in the early and mid-2000s by creating pools of subprime mortgages that were repackaged with AAA ratings, even though the underlying assets were actually junk? Demand for more assets naturally gets satisfied by the creation of more supply. There will be a spectrum ranging from worthwhile to wildly overpriced garbage.
Inevitably, things will get overdone. The supply increasingly will become lower-quality. But as long as all prices are rising, most people will ignore the warning signs.
That sets up Step 5: The market pours cash indiscriminately into everything -- even amid glimmers of recognition that some of these assets are not what they seem. It's not so much that the junk is sold, but rather that the inflows of capital start to slow. Maybe a few high-profile blow-ups occur or something else dulls buyers' ardor. Regardless, markets begin to narrow. Eventually, only a small number of dominant assets are pulling the entire train.
This sets up the inevitable crash, which may be a function of something silly, the state of the economy, random events and of course, human psychology.
I have no idea about the timeline of how this plays out -- but it wouldn't surprise me if it took years. Just don’t say you weren't warned.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Barry Ritholtz is a Bloomberg View columnist. He founded Ritholtz Wealth Management and was chief executive and director of equity research at FusionIQ, a quantitative research firm. He blogs at the Big Picture and is the author of “Bailout Nation: How Greed and Easy Money Corrupted Wall Street and Shook the World Economy.”
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