February 1, 2010

Bubbles have been a recurring phenomenon throughout modern economic history. “Modern” in this instance refers to the period after the industrial revolution, and it is unsurprising that there were no economy-wide speculative bubbles prior to the 17th century. The two basic prerequisites for a bubble are a fair proportion of the population owning enough wealth to have a substantial impact on an asset price and a banking/monetary system that is able to expand money supply significantly, i.e. it is reasonably unimpeded by such constraints as gold standards or regal dictats.

There is no question that bubbles are exciting; eye-watering amounts of money are made. There are a small number of investors who cash out in time and live happily off their fortunes. Sadly, they are few, and there are always large economic implications after the bursting of a major bubble. Asset prices are driven painfully downwards, destroying vast amounts of wealth. As bubbles are encouraged by an increase in debt and leverage, balance sheets need to be repaired, for individuals and for financial institutions. This healing takes time, and drags heavily on economic activity.

As the outcome is painful, why do they recur?  Bubbles are intertwined with basic human behaviour. Simplistically, a bubble is created because it is awfully hard to watch your neighbour get rich. The richer they get, the harder it becomes to resist mimicking them. Higher and higher prices attract more and more buyers, the price increase of the asset goes exponential, and a bubble is born.

In most of human behaviour, being correct consistently over a year or two year period means you’re onto a good thing. Developing a good golf swing, honing skills in a trade, prescribing pharmaceuticals to treat a disease; in any of these activities, an individual will be comforted by the positive feedback that comes from daily successes.
The stock market is different. A successful investor needs to be able to separate price from value, and always maintain a feel for the intrinsic value of an asset. A price move radically beyond an asset’s underlying value is a very dangerous signal, not an encouragement to buy. It never fails to fascinate us that individuals who would hunt down a bargain when buying a consumer good can at the same time be much more comfortable buying a stock after it has gone up, not realising that it is unlikely that stock’s value has increased by the same amount.

On the institutional side, this corrosive cycle is exacerbated by the pressures faced by the financial industry. Sales people find it easiest to sell the hot, bubbly product, as investors are attracted like moths to a (deadly) flame. As for the fund managers, as Keynes once said “it is better to fail conventionally than to succeed unconventionally”. Traditional fund managers are more likely to lose their jobs by staying out of the bubble as an underperforming fund will lose clients. There is safety in numbers, doing whatever other fund managers are doing – it is difficult to fire an entire industry (no matter how appropriate that might actually be). And don’t forget that a fund manager is more likely to get rich quick by running a fund in the bubble asset than in a dull sector (although he is unlikely to get, and stay, rich by owning shares in the same fund).

Government also conspires against stable prices. Since the days of Paul Volcker, central banks have been far too wary of moving against the crowd. By focusing on narrow consumer price inflation, they voted for excessively low interest rates, and enjoyed the popularity attached to bubble economics (remember the talk of Alan Greenspan as the greatest central banker, ever, anywhere ). An especially dangerous confusion was to mistake rising market prices as a sign of success for their monetary policies.

The politicians, always with an eye on their electoral popularity, are in no hurry to disagree – bubbles while inflating make people feel happy with themselves, and thus with their current lot of politicians. The problems of the bursting of the bubble can be sorted out another day, and hopefully on someone else’s watch.

Fascinating as bubbles are, why do they concern us?  They matter for two reasons. Firstly, we at Kennox expect that there will be further bubbles in the future. They have occurred throughout history and we see no change in human behaviour to think that they have been banished to extinction. More pertinently, there is a significant risk that current expansionary economic policies (and the thinking behind them) will lead again to bubbles, sooner rather than later.

Secondly, every bull market has traits similar to the characteristics of a bubble, albeit on a much reduced scale. Assets are often overpriced, and can stay that way for long periods of time (of course, the opposite, that assts are underpriced, is often true as well). Buying overvalued assets, bubble or “only” expensive, removes one of the great advantages occasionally on offer by Mr Market, the margin of safety. The so-alluring margin of safety, offering downside protection to go with upside potential, comes from avoiding overpaying for an asset. Regularly reminding oneself of the psychology and mentality of valuation and pricing helps guard against this hazard.

At Kennox, we have done what we can to help us fight these pressures and mentalities. Having Kennox owned and controlled by its four directors who all believe in the value style of fund management creates an environment with much less pressure to “fail conventionally”. Our focus on value counteracts the temptation to buy into extended bull markets (we are likely to hold more cash at the top of a market than at the bottom), cognisant of the fact underperformance in the late bull stage of the cycle will be more than offset by capital preservation in the inevitable correction. Owning unloved, solid companies which can benefit from recovering earnings and a re-rating by the market is a powerful wealth generator, powerful enough that we don’t feel the need to play with the fire of bubbles.

Authorised and regulated by the Financial Conduct Authority (FRN: 475658)
The Company is based in Scotland, UK with the above registered address (Registered Number: SC302037).

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