June 2007

The markets are awash with money. Plentiful cash is driving equity prices higher. In the riskier credit markets, excess liquidity is forcing spreads to narrow, as even institutional investors chase higher returns. A neutral observer might be forgiven for thinking that this is the best of all possible investment worlds.

But many analysts are becoming increasingly worried by some of the extraordinary happenings in today¹s financial markets. Stock market records are being successively broken and there is record M&A activity that shows no signs of abating. Articles in the financial press reveal some highly unusual goings-on, such as the Chinese government taking a near-10% stake in one of the world¹s foremost buyout firms, or house buyers in third-world countries financing their mortgages by borrowing in Japanese yen. Developments of this nature are extreme, say the doomsayers, and do not bode well. Extremes highlight imbalances that must eventually be resolved. Imbalances create bubbles. Bubbles burst.

The worriers point to the hubris preceding the bursting of the dot-com bubble at the beginning of this century, when investors wholeheartedly abandoned common sense and succumbed to the illusion of the "new paradigm" philosophy - "it's different this time", was an oft-heard phrase in the late 1990s. Citing previous incidents of what former Federal Reserve chairman Alan Greenspan famously described as "irrational exuberance", academics warned investors then that, over time, markets correct to the mean. But few were listening in the days when even professional investors sang the praises of companies with no other assets than a hyped idea. Today¹s pessimists warn that those who do not learn the lessons of history are condemned to repeat them.

However, one striking difference between then and now is that there is no obvious over-valuation in equities, despite their having enjoyed an almost four-year bull market without a seriously prolonged correction. On most conventional valuation methods, such as price/earnings ratios, equities do not look excessively expensive (although this is not the case if less orthodox criteria, e.g. price/sales, are applied). As such, equities do not seem to pose a problem. An arguably greater threat lies in the credit markets. In February's Investment News, for example, we highlighted the growth in complex and sophisticated derivative products such as credit default swaps, the increased use of which has led to accusations of a complacency towards risk that has caused lending standards to lapse significantly.

Experienced investors know that, somewhere, trouble is brewing, but even the most prescient guru cannot be certain when and where it will break out. And that is where we find ourselves today. We know that there are unheeded dangers in the waters of the financial markets but we do not know when they will surface. Until then, there is money to be made. However, the higher the markets climb, the more vulnerable they will be to a shock and while we are content to enjoy the party now, it can do no harm to keep one eye on the exit. No matter where the catalyst for a correction begins, any downturn will hit equity markets especially badly because liquidity is a double-edged sword: it is propelling the market higher now, but it will exacerbate a market downturn, simply because the most liquid markets are where panicky investors are able to sell first. That is at least one compelling reason for remaining neutral on equities.