Today's Headlines: Is Everything Overvalued?

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Today's Headlines: Is Everything Overvalued?
July 22, 2014
A “Savings Glut” or Poor Investment Options?

The Fed and other central banks worldwide have been pursuing a low interest rate strategy to produce economic growth for quite some time now, and in particular, the Fed has been pumping huge amounts of money into the economy through bond and other asset purchases. The Fed currently holds over $4.4 trillion in assets, nearly five times the assets it held in mid-2008. Yet for all that stimulus, we have minimal growth. Why?

Part of the answer is that much of the money injected into the system remains in the hands of banks and investors who are hanging onto it. Is this a “savings glut”, a phrase Ben Bernanke used some years ago, or does this reflect overpriced assets and a lack of good options for investor’s money?

One could argue the Fed’s actions, and those of other central banks, are skewing basic supply and demand in an unintended way. They hold so much of the supply of worldwide investments that private investors have to fight over the leftovers, thus driving up prices for investments without producing any real underlying economic growth.

“The Everything Bubble”

Neil Irwin of the New York Times has been running a series of articles regarding collective overvaluation, a phenomenon he refers to as “The Everything Boom” that may be leading to “The Everything Bubble”. It doesn’t draw as much attention as the more spectacular stock prices in 2000 or the more recent housing bubble, but it is pervasive.

Within a particular class of investments, there are always going to be relative bargains that outperform their peers. But Irwin’s point is that considering overall classes of investments, there isn’t much to be had in the way of bargains.

Few things are massively overvalued, according to this view, but virtually everything is significantly overvalued in historical terms – from stocks to real estate to bonds of emerging markets – leaving investors few alternative choices to the stock market for predictable growth.

What’s Next?

Irwin’s premise is that one of three endings to this bubble will occur, which he calls “The Good, The Bad, and The Ugly” (cue the iconic theme music).

The Good: The economy will grow into its current overvaluation and stabilize, much as the way your teenager grows into his or her oversized shoes.

The Bad: We settle into a Japanese-style economic state of suspended animation, with persistent low rates, extremely low growth and low inflation.

The Ugly: Extended use of central bank and government “economic toolkits” do not produce the desired result and impose unintended consequences. Imagine price spikes and inflation without corresponding economic growth, or concerns about collective global debt undermining the confidence in markets worldwide, leading to declines in investment values and rising interest rates.

The Takeaway

Irwin doesn’t predict a final outcome, but suggests the “Bad” path appears more likely despite the fact most pundits are predicting either the “Good” or “Ugly” scenarios in the relatively short term.

Economics still has roots in behavioral science – investors and markets do not always play by the rules of economic theories. Combine that with occasional hubris and frustration from economists, policymakers, and politicians who are annoyed that they cannot precisely fine-tune the economy like adjusting the volume level on their iPods, and irrational actions are always possible that can lead to the “Ugly” outcome.

However, it seems more likely that we are in for a short-term dose of the “Bad” scenario with slow growth and perhaps a moderate correction over the next year or two, eventually leading to the “Good” scenario of full growth. As assets are currently overvalued, there should be a lag time between growth and larger returns.

In such a market, if you need greater short-term return on assets you will need to assume a higher risk profile, and you may have difficulty finding suitable investments. In the long term, the classic advice should still win out – keep diversified, rebalance your portfolio regularly to account for changing risks and returns, and don’t try to time the market. Especially, don’t try to time this market.

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