Bubbles, crashes and linear thinking - current anomalies on the capital market

In mid-February 2020, all was still well with the world. In the Chinese province of Wuhan - according to Wikipedia, even cities like Wuhan with 8.1 million inhabitants only have the status of a "sub-provincial city" in China - a previously unknown virus was raging.

As monkey brains and flying foxes are not on the menu in Europe or America, people in the western world thought they could ignore this problem. The DAX set a new historic record of 13,800 points, as did the global share index (MSCI All Countries). The economy was doing so well that there was no need to worry about rising interest rates, and unemployment had fallen sharply everywhere.

Suddenly, infections with the new virus became known in northern Italy and in the Austrian ski resort of Ischgl. Within four weeks, the stock market in Germany plummeted by almost 40% and worldwide by over 30%. Governments imposed a lockdown to severely restrict economic activity in order to stop the rapid spread of the disease.

A good six months later, the infection figures are once again rising sharply in many countries following a brief containment period, economic output is still nowhere near the level seen at the start of the year and unemployment and national debt have risen alarmingly quickly everywhere. However, the stock market seems to have forgotten about the virus; following a rapid and sharp rise in Germany and the global average, share prices are now only a few percent below their historic record levels.

The example of this brief but violent stock market crash can be used to illustrate some general characteristics of capital markets that we can and will continue to use in the future.

The value of a capital investment, including shares, is indisputably made up of all expected future income (dividends and sales proceeds). In times of extremely low interest rates, even income that will not accrue for many years has a considerable value. Once or twice a decade, however, this fact is completely forgotten by most investors - even professionals. When share prices fall sharply, they focus exclusively on the short-term price trend and start to think linearly - they simply continue the current trend.

A simple example shows where the mistake lies. The owner of an apartment building in good condition with 4 apartments with a rental income of €12,500 each wants to sell it for 20 times the total rent (€50,000), i.e. for €1,000,000. At the notary appointment, the very interested buyer explains that unfortunately he can only pay €500,000 because he has discovered that 2 apartments are vacant. Everyone will object at this point that this is nonsense, because the empty apartments would only have to be re-let in order to achieve the €50,000 total rent again. The seller will therefore at best grant a price reduction of a few thousand euros for the short-term loss of rent, but certainly not €500,000 or a 50% loss in value.

However, this is exactly what happened on the stock market in many cases. In March, analysts suddenly predicted a sharp drop in profits for most companies in the first and especially the second quarter of 2020 due to the lockdown, which later proved to be entirely accurate. But they only referred to a few months.

It is now becoming clear - once again - that linear thinking (the economy will be brought down, company profits will collapse across the board, there will be many bankruptcies, so get out of shares) does not work on the stock market. After all, capital market participants are human beings like everyone else, and they have been changing their behavior in times of crisis for millions of years, so that linear trend continuation is misleading. For decades, three key players for the economy and the capital market have undergone a drastic change of direction during a crisis:

1. company management boards are implementing drastic cost reductions that they would never have been able to push through against politicians, trade unions and works councils in normal times. At the moment, digitalization can suddenly be accelerated everywhere; those with reservations are keeping a low profile
2. Governments are helping companies with economic stimulus programs, but also with direct aid such as short-time working allowance, which means high savings in wage costs for companies. The employees affected can largely maintain their consumption so that the companies can continue to sell their products
3. The central banks injected fresh money into the economy; in the USA, checks were even sent to all unemployed people every week; this American flood of money poured out of the printing press all the way to Austria.

All three influencing factors are contributing to the stabilization and subsequent increase in company profits, so the current improvement cannot come as a surprise. The corona crisis was therefore not a linear fall into the abyss, but a short, sharp slump in share prices and the economy. Then company managements, politicians and central bankers changed their behavior massively, and a new upward trend in share prices, the economy and company profits began.

Thankfully, linear thinking is deeply rooted in the world of finance. It will also dominate briefly in the next crisis. This is unlikely to be the second coronavirus wave - the stock markets usually get used to a threatening but familiar situation very quickly. In contrast, threatening military gestures from China towards Taiwan or political chaos in the US in the event of Trump's election defeat - if Trump does not concede defeat - would perhaps be a trigger for linear thinking.

This arose during the first Iraq war in 1990/1991, the collapse of the European Monetary System in 1992, the near-bankruptcy of Russia and the huge LTCM hedge fund in the fall of 1998, the second Iraq war in 2003 and the collapse of Lehman Brothers in the fall of 2008.

In some cases, share prices more than doubled after just one and a half years, even though the augurs had reliably predicted the end of the world at the start of each crisis.

This brings us to the question of whether and where major risks exist in view of the many uncertainties on the capital market. The following chart shows that political crises such as wars or the first oil crisis triggered by the Arab-Israeli conflict did not lead to sustained dramatic price falls on the US stock market.

Speculative bubbles are more dangerous. These preceded the three biggest price collapses of the last 150 years (red text). In all three cases, years of euphoria had triggered a willingness to borrow heavily to buy shares (Great Depression 1929-1932, technology bubble 1999-2000) or real estate (financial crisis 2008-2009). The debt then necessitated panic selling at the first price falls; linear thinking set in.

Since the beginning of my professional career in 1986, I have been studying the emergence and characteristics of speculative bubbles. In doing so, it became apparent time and again that the significantly increased influence of the state on the economy after the Second World War also extended to the creation of speculative bubbles. Since then, politicians have apparently regarded the creation of speculative bubbles as a government task (please read on, even if this thesis seems very steep at first).

In order to avoid a new Great Depression or a new Hitler, many countries wanted to reduce the personal risks of individuals by massively expanding the welfare state in order to alleviate personal hardship caused by unemployment, illness or old age.

Economic stimulus programs should also protect companies from excessive slumps in sales resulting in bankruptcies, as is particularly evident in the current coronavirus crisis.

Unfortunately, this idea, which is not fundamentally wrong, was perverted by the fact that, since the 1970s, government incentives have been provided for investments that investors would not have made without such assistance.

When these incentives were particularly successful, they caused the major speculative bubbles of recent decades:

1. The double bubble in the Japanese real estate and stock market
2. The eastern real estate boom in Germany
3. The technology boom on the global stock markets
4. The "subprime" boom in the USA and the real estate boom in many European countries before 2007
5. The current bubble in government bonds, the biggest bubble of all time

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1. the double bubble in the Japanese real estate and stock market

‍Inthe early 1980s, the Japanese government wanted to solve an economic problem with investment incentives. At that time, Japan was a similarly dangerous opponent for the US government as China is today. Under President Reagan, America had begun to arm the Soviet Union to death from 1981 onwards, and after ten years it had succeeded. To do this, the national debt had to be increased significantly and the Japanese supplied the booming US economy with everything it needed.

The American trade deficit also rose sharply due to a booming dollar exchange rate. In 1985, the Reagan administration began threatening the Japanese with tariffs if they did nothing about the weak exchange rate of the yen. So far, this story is very similar to what we are experiencing today in the US-China trade war. That conflict ended with the Japanese backing down and allowing their exchange rate to rise.

In order to compensate export companies for the loss of sales, Japanese politicians invented the maximum value principle for the first and only time in the history of financial accounting. This perverse idea formed the basis for a gigantic orgy of speculation and debt, the consequences of which Japan has still not overcome 35 years later.
companies were allowed to recognize real estate they owned on their balance sheets tax-free at the current value, even if this was far higher than the value at the time of purchase, which was often a long time ago.

The management boards of the listed companies did this with great enthusiasm, as they were suddenly able to report more equity; the companies suddenly appeared much more valuable than before. Stock market prices reacted very positively to this. In addition, when buying shares, the daily price on the balance sheet date could be used instead of the purchase price if it was higher.

As a result, credit-financed share speculation became a risk-free investment for large companies. Loans were taken out on a massive scale to buy blocks of shares, causing share prices to rise further.

The declining earnings due to weak US exports no longer interested anyone, the price increases of the shares bought overshadowed everything else.

Linear thinking also applies to rising prices. At the end of December 1989, the Japanese share index Nikkei reached its highest level ever at almost 40,000 points (currently 23,000 points).

The dividend yield had reached a low of 0.4% - also unprecedented in economic history. However, government bonds were yielding 6.4% p.a. and loans to companies were even more expensive. The rental yield on real estate in Tokyo had fallen to 0.5%. After the New Year's Eve celebrations in 1989, investors realized that all these investments were highly loss-making if there were no further price rises.

The selling began. Since then, the global stock market - over 40% of which consisted of Japanese shares at the end of 1989 - has increased eightfold, while the Japanese market has almost halved. Japan's national debt has reached the highest level of any industrialized country in peacetime, and Japan has been stagnating for 30 years.

As a reminder, the trigger was the fatal idea of Japanese politicians to introduce the maximum value principle to solve a minor problem.

2. the eastern real estate boom in Germany

The federal government's attempt to rehabilitate the dilapidated real estate stock of the faded GDR through massive subsidies for private real estate investments triggered the East German real estate boom from 1991. Property buyers were allowed to immediately deduct 50% of the purchase price of an East German property from their income tax, which corresponded to a discount of over 25% of the purchase price. Due to the huge demand from tax savers, sellers were able to raise prices sharply.

My main thankless task as a 30-year-old greenhorn was to explain to seasoned entrepreneurs that they would lose a lot of money. The rental yields on these properties, taking into account the tax advantage, were at most 3%, but the mortgage interest rates reached almost 10% p.a.. I was now unpopular, but our customers were saving a lot of money.

Due to the high asset losses suffered by high earners, Germany was the sick man of Europe for ten years from 1995 onwards, forcing the ECB to keep interest rates low in the eurozone. Here, too, the state stimulus caused damage that far outweighed the benefits.

The tax-saving film and ship funds that caused German investors billions in losses fall into the same category. Here, too, we never invested.

3. the technology boom on the global stock markets

The technology boom at the end of the 1990s was a late consequence of the Japan-phobia of the 1980s (see above). In the 1980s, the Americans had begun to link the remuneration of board members and, in the case of growing technology companies, other employees to the share price by awarding share options.

If the workforce realized the gains when share prices rose, the companies were allowed to book the costs they incurred (they bought back the shares at a high price, which the employees had acquired cheaply via share options) via the equity account so that the costs did not appear in the income statement. American auditors denounced this as dubious. However, the US government allowed this misleading accounting because the heads of the major technology companies had persuaded it that the USA was only a leader in the field of software and high technology. Therefore, a high valuation of these companies had to prevent the Japanese or Europeans from buying into them.

The companies were therefore allowed to conceal the huge personnel costs with government permission. As a result, share prices rose sharply and personnel costs fell because more and more employees only wanted share options instead of a salary.

At the peak of this bubble, dividend yields in 2000 had fallen to 0.2%, below the record low in Japan in 1989; however, government bonds yielded 6.7% p.a. (USA) and interest rates on loans were much higher, so that more and more companies and investors got into difficulties. By 2003, US technology shares had fallen by 80% and the German "Neuer Markt", which had been recreated, by as much as 97%.

4. the "subprime" boom in the USA and the real estate boom in many European countries before 2007

This fourth bubble came about because of the low wage growth of employees since the beginning of globalization. Politicians wanted easy access to generous loans for property purchases so that globalization losers with low incomes could afford fancy homes and not notice their gradual decline. The investment banks came up with a clever trick for this.

Residential real estate prices in the USA had been rising for years until the mid-noughties. As a result, banks did not make losses on property loans to low-income earners if they were no longer able to service the loan. In the event of a foreclosure, the proceeds from the sale were almost always sufficient to repay the loan in full. Therefore, scientific analyses of loan defaults must have concluded that it did not matter whether the borrower was unemployed, low-income or wealthy.

During the period analyzed, the banks had not made any losses, even with customers who were not actually creditworthy, due to the increases in property prices. The rating agencies therefore gave securities made up of hundreds of thousands of "weak" real estate loans ("subprime") the top AAA rating, and the state turned a blind eye.

When prices then fell from 2006 onwards, the losses incurred by the banks, insurance companies and pension funds that had enthusiastically bought this garbage were gigantic.

German banks alone had lost hundreds of billions; the clever Americans had sold a large proportion of these "securities" abroad.

5 The current bubble in government bonds

This biggest bubble of all time came about because, regrettably, the politically desired error of shoddy ratings was not only made in the US residential real estate market.

Everywhere in Western democracies, the main aim of politicians is to enable voters to consume today, not just homes, which they may not yet or never be able to afford.

In the eurozone, politicians decided at the beginning of the monetary union that government bonds are risk-free for precisely this purpose. This is economic nonsense, as no government in the eurozone has its own central bank that can print money and buy government bonds indefinitely if necessary.

The decisive factor, however, is that banks and insurance companies are allowed to buy such bonds indefinitely because of this politically desired lack of risk.

Most private investors also believe in the state-defined absence of risk. Due to this constant excess demand for government bonds, their prices are extremely high and interest rates are absurdly low. After Mario Draghi announced in the summer of 2012 that he would print money like the other central banks had been doing since 2008 ("whatever it takes") to solve Italy and Spain's financial problems at the time, there are no longer any money problems in the eurozone.

The eurozone countries can now also add new debt to their huge mountain of old debt due to the coronavirus crisis, while interest rates remain at their lowest level ever. With the fresh money, voters can continue to consume via short-time work benefits in Germany or dollar checks in the USA, for example, even if they don't have the income to do so.

The government bonds used to finance these gifts - which are perfectly understandable from a social point of view - are still considered to be completely risk-free despite rising debt and a weak economy, just like the "subprime" bonds in the USA at the time. Hardly anyone would lend their own money to the Italian government at 1% p.a. interest for 10 years to the Italian government.

The managers of banks, insurance companies and pension funds do it anyway, because it is not their own money and because the state has created an irresistible incentive to buy with the legally stipulated absence of risk.

Central bank purchases certainly prevent price collapses and thus interest rate rises, but they also create new money that is not matched by a new supply of goods.

Inflation rates will also gradually rise due to the future decline in the proportion of the workforce in the population and de-globalization, and it will then become clear that central banks can only ensure nominal value, but not real purchasing power (for inflation risks, see Capital Market Outlook 09/20).

Even with the somewhat more solid German government bonds, you will lose a third of your wealth per decade in future. It is intellectually fascinating that such investments are not only permitted for pension products, but are also prescribed.

It is reassuring that this bubble will be the first one not to burst. Unlike bubbles no. 1 to no. 4, it was not created by governments to solve specific problems in the private sector or the real estate market.

Instead, it is supposed to ensure its own survival despite decades of mismanagement (measured by a level of debt that has been rising much faster than economic output worldwide for 40 years).

The dangerous thing about this bubble, however, is that it will infect or has already infected other forms of investment. Corporate bonds , like government bonds, have incredibly low interest yields. A number of solid companies in the eurozone, like some governments, can issue bonds with negative yields.

In a recent analysis by UBS, residential real estate prices in cities such as Munich and Frankfurt are already at bubble level.

As we can assume that the politically desired low interest rate, which is essential for the financial survival of governments, will remain in place for a very long time, there is no danger of a crash for the time being, even for very expensive residential properties. In cheaper locations, residential real estate should even be able to increase further, as too little was being built even before coronavirus and now the desire for a home office is further fueling demand.

‍Equities may no longer be cheap worldwide, but they still offer an above-average yield premium over government bonds and should generate a performance of around 5% p.a. over the next decade. Moreover, unlike in the 1970s, equities should be able to benefit from rising inflation for years to come.

The mountains of government debt do not allow interest rates to rise, and higher inflation, which is now also being officially targeted by the central banks, makes it easier to service the debt because this also increases tax revenues (even more than proportionally due to progressive income tax rates).

However, as companies' turnover also rises with higher price increases without their debts becoming more expensive, profits could benefit from inflation. In addition, digitization is currently underway. The aim is to save on personnel costs and reduce the risk of having to close the company due to this or the next pandemic.

This means that in the event of inflation, the smaller block of personnel costs, which is naturally sensitive to inflation, would have less of an impact on profits.

Overall, the outlook for equities remains good; there is currently no bubble, but one could form in the future.

Summary

Japanese equity and real estate until early 1990

• Politically initiated valuation on the pinprick that triggers the introduction of the maximum value principle in accounting
• Valuation at the pinprick that triggers the peak: dividend yield 0.4%, rental yield 0.5% and lending rates significantly higher
• Pinprick that caused the bubble to burst: Rise in long-term lending rates from 4% to over 7% p.a.

Eastern real estate Germany 1990 to 1995

• Politically initiated valuation at the pinprick, which triggers: Special depreciation East amounting to 50% of the investment sum
• Valuation at the pinprick that triggers the peak: rental yields below 3% (gross), significantly lower than lending rates
• Pinprick that caused the bubble to burst: Increase in mortgages to 10% p.a. and expiry of the special depreciation allowance

Technology boom worldwide until 2000

• Politically initiated valuation at the pinprick, which triggered: Personnel expenses were allowed to be concealed in the income statement
• Valuation at the pinprick that triggers the peak: dividend yield 0.2% and borrowing rates significantly higher
• The pinprick that caused the bubble to burst: 2% rise in long-term interest rates, mass IPOs of new companies

Real estate boom in the USA ("subprime") and Europe excl. Germany until 2007

• Politically initiated rating on the pinprick that triggers: government-tolerated embellished ratings for mortgages to borrowers with poor credit ratings
• Valuation at the pinprick that triggers the climax: rental yields well below lending rates
• Pinprick that caused the bubble to burst: Interest rate rises, waves of bankruptcies among low-income buyers

Government bonds

• Politically initiated valuation at the pinprick that triggers: Political regulations that government bonds are risk-free
• Valuation at the pinprick that triggers the peak: interest rates barely above 0% nominal even for long maturities

Hopefully, political cynicism will not prevail in the end if the further increases in the value of tangible assets (shares, real estate, gold) to be expected in the future as a result of the late effects of the government bond bubble unfortunately do not give politicians cause for self-criticism, but for well-founded tax increases for the "rich".

Thinking about an equity-based pension instead, on the other hand, is out of the question: Then there could be too many "rich" people at some point.