In this week's MacroVoices podcast, Erik Townsend interviews Francesco Filia, a fund manager at Fasanara Capital. After exchanging pleasantries, Townsend begins the interview by asking Filia, an analysts who's widely regarded for his research about how post-crisis monetary policy has
impacted distorted markets, about the different metrics he uses to determine whether a certain asset is in a bubble.
Filia begins by ticking off a laundry list of metrics that all point to the same conclusion: That today’s market is more overvalued than at any point in recent history – including the run-up to the financial crisis.
Thank you, Erik. I think the equity bubble is quite uncontroversial, is quite unambiguous. There are a lot of different valuation metrics for those that care to look into them. They’ve been valid for over a hundred years of modern financial markets. And this time is no different in that respect.
There are the usual metrics that the valuation guys are looking at, like financial assets to disposable income that shows that this market is way more expensive than at any point in history including the big dot com bubble and the Lehman moment in 2007-2008.
But there are other metrics like the Buffett Indicator (market cap on GDP), the median debt on total assets, the corporate debt to GDP, the price on sales, the price to book, enterprise value on sales, enterprise value on EBITDA – there are a number of different metrics. They all convene that this is a market bubble that has not been seen before in history.
Filia said he created his own valuation metric that is loosely based on the famous Shiller PE (or CAPE) ratio. Economist Robert Shiller, who teaches at Yale School of Management. Filia's ratio helps filter out distortions caused by the drop off in corporate earnings caused by the crisis.
But we at Fasanara, we developed our own indicator just to try to add something to what was available already. And we started with one of the most famous of all the indicators in this respect, which is the Shiller adjusted PE ratio, or the CAPE ratio. This is the most famous of them. Professor Shiller got a Nobel Prize in 2013 for it. And for his studies on market inefficiencies and for the ability to infer future expected returns from valuation metrics such as the Shiller PE.
And, based on the Shiller PE, what it does is simply to compare current prices to not spot earnings of foreign earnings, but a more reliable measure of the average of the last ten years and adjusted for inflation. So the average of the last ten years of real earnings. And on the basis of this index, we find out that the market is as expensive and just a little bit less expensive than it was in 1929 during the Great Depression, the peak of the market before the biggest collapse in equity prices ever seen, and the year 2000. So just slightly cheaper than the year 2000.
Filia's ratio is loosely based on the work of John Hussman of the Hussman funds, who was the first to utilize peak earnings instead of average earnings in his PE ratio calculations.
What we do is an evolution of the Hussman PE ratio (which is taken from the Shiller ratio) which is to compare – kind of putting all in the basket. So we put the peak earnings as opposed to average earnings, and for peak earnings we really mean the peak. We take the two top quarters over the last 40 quarters. So we cannot really be seen as being any more generous to the current markets, we take the two peak quarters of the last 40 quarters. And then what we do is we compare these peak earnings to potential growth, or trend growth.
Because the point here is that what you pay in terms of stocks, should compare, not just to the past or the earnings of proposition, but also to the overall economy generally. Because if the overall economy has a lower potential growth you should be expecting to be able to pay less in terms of multiples than otherwise. The overall economy has a big correlation to earnings and to profit margins, so you should expect the potential growth rate of the economy to be quite relevant when it comes to PE multiples.
Of course, what makes modern markets so uniquely precarious is the fact that investors are struggling with twin bubbles in bonds and equities. However, the former is often overlooked because the public doesn’t have as nuanced an understanding of the bond market. Yet historically speaking, bonds are even more closely correlated with metrics like inflation, as the chart below shows.
However, NIRP and ZIRP has created distortions in bond valuations that have left them extremely overvalued compared with history, meaning that the inevitable regression to the mean will likely take the form of a vicious selloff.
And our point is, look at bonds and look at how they compare to history and how they compare to metrics such as inflation and the GDP – to which historically they are very well correlated – and you find out what this chart on this page, which is showing that we are in totally uncharted territory at present.
What is this chart? This chart compares the real rate on German bunds – which are some of the most expensive government bonds on earth and in history – and takes, basically, the real rate on German bunds and compares them to the growth currently experienced by Germany. So the idea – and you see that also in the next slide – the idea is that the real rates in Germany are heavily negative at present.
Because what you had was, at the turn of the year, at the end of 2016, inflation started to resurface. So you had deflation and you had a pickup in inflation, which is exactly what you see on the next slide.
You see that inflation picked up, whereas nominal rates on German bunds continued their descent. And they continued deeper into negative territory because, obviously, of the ECB policy, of the policies of the central bank. At that point you had a gap opening up between nominal rates and inflation, which means that the real yields were becoming very, very negative. And you see here a table with the negative yields being minus 2.5 on average.
And the other thing that interest rates are correlated to is growth. We know that very well, that long-term interest rates, they tend to converge on nominal growth expectations for the economy. So here, in this one indicator which we call the real rate of growth ratio, we put it all together so we compare the nominal rate to inflation to growth. And we end up seeing this.
That these bonds have never been so expensive, because they are in deep negative territory – despite a GDP which has resurfaced. It’s not any more zero negative; it is close to 2% as far as Germany is concerned.
Having discussed the bubbles in equity and bond markets, Townsend proceeds to the next logical question. Now that we know we’re in a bubble, how can we tell if the bubble is going to burst? To his credit, Filia admitted he has no idea what the catalyst might be. Furthermore, there doesn’t necessarily need to be a catalyst for these bubbles to burst – but once their valuations have reached a kind of tipping point, they could implode on their own.
There can be a catalyst. Or there can be no catalyst. If you talk about catalysts, I could argue that can be inflation, for example. At the moment, we have seen that inflation resurfaced. We have seen some tightness in the job market. It has not translated yet into wages growth and therefore inflation. But we could just be about to see that. And, in that case, rates would rise and they would provoke as a catalyst the kind of downfall that we expect. Or the catalyst could be political. A lot of quantitative easing is being created and it is benefiting only the top 1% of the population. And it is resulting in this so-called income inequality concept.
And, so much, the central banks are pushing the wealth effect as they try to make people easier for them to spend more in the economy. But in reality what they are really triggering is income inequality. The consequence of income inequality is populism. Populism can provoke a regime change. Regime change can then affect quantitative easing if the result was not to help the real economy and the middle classes but only the top 1%.
So the catalyst could be political.
But I can also argue the catalyst could be China. China has a huge problem over indebtedness. It is said to be between 300% and 600% of GDP. GDP is $11 trillion. So it is a monumental credit bubble that could give troubles at any point. And if it gives troubles you can expect the whole world to listen carefully like it did in August of 2015 and January of 2016, and even more than that.
I think that it can be also no catalyst. And why is it no catalyst? Because at moments in which the market is overvalued you can never know for sure how much further the bubble can go. But at some point, it reaches a tipping point, a critical mass, where the probability is higher and higher for it to fall down.
At a certain point, swollen valuations reach a level where they no longer make sense, bids evaporate, and prices plunge. But it’s exceedingly difficult to pinpoint just when that point might be.