‘2018 was a lesson learned. The tightening of Central Banks all around the world wasn’t intended to cause a downturn, wasn’t intended to cause what it did.
‘But I think lessons were learned from that. And I think it was really a marker that we’ve probably seen the end of the boom-bust cycle.’
These aren’t my words, they’re Bob Prince’s. The co-chief investment officer of Bridgewater Associates. Ray Dalio’s infamous hedge fund.
Prince made these remarks during an interview with Bloomberg TV from Davos. The site of the annual World Economic Forum. An event dedicated to mapping out the future of global growth, amongst other things.
Prince though, has taken things to a new extreme. His comments are startling. Especially for a hedge fund manager.
Saying that booms and busts as we know it are over, is like saying business as we know it is over.
Cycles have underpinned macroeconomic theory since the days of Adam Smith himself.
As long as credit exists, cycles will follow. Or at least they should…
Prince’s point is that credit and cash are no longer what they used to be.
Central Banks, who are desperate to fuel growth, keep lowering interest rates. An effort that has been largely in vain as inflation still refuses to budge.
As a result, the fundamentals are all screwed up. A fact that Prince is well aware of:
‘Central Banks have taken cash and bonds and they’ve made it a funding vehicle, not an investment vehicle.’
In other words, if you’ve got money on the sidelines or in ‘safer’ investments, it’s doing nothing for you. Pushing more investors into riskier assets (like stocks) in search of returns.
A remarkable year
Now I realise macro topics can be pretty dull. Just typing the words ‘cash’ and ‘bonds’ has me nodding off slightly.
But, when someone with Prince’s experience says booms and busts are over, you’ve got to listen. Even if you don’t agree with what he is saying — the fact that he is saying anything at all is telling.
For the sake of argument though, I’m going to play along with his proposition.
So, let’s assume cash and bonds are dead investment strategies. The logical alternative now is stocks. A conclusion that we’re seeing unfold before our very eyes.
The US market in particular went nuts last year:
– S&P 500: Up 29%
– Dow Jones Industrial Average: Up 22%
– Nasdaq Composite: Up 35%
Those are some staggering gains. And following Prince’s logic, they have been fuelled by the lax monetary policy from the Fed. A decision that is forcing the hand of some investors.
See, it’s not the case that stocks are delivering incredible value. It’s just that money is pouring into the market in search of a return. A huge surge of liquidity that is pushing up prices.
This is an important distinction, namely because it is a distortion. As Price notes:
‘I’ll tell you what’s mispriced. Interest rates.
‘It’s not that assets are cheap. Assets are expensive. It’s that interest rates are low.
‘Interest rates are unusually low for the level of economic activity. And they’re set there intentionally to keep this thing going.’
That is the kicker, dear reader.
The lax monetary policy we currently have is on purpose. The Fed, like most Central Banks, is too afraid to raise interest rates. They want to keep the good times rolling. Or at least, the good times in the stock market rolling.
At some point though, the good times have to come to an end…
The bust is brewing
I’ll give Prince this, he has perfectly called the situation.
Central bankers have backed us into a corner we can’t easily get out of. In fact, they’re doubling down and making it worse.
Booms and busts aren’t over, they’re just building up.
There is no denying that we’re in a boom right now. Markets in the US and locally are going gangbusters. And they could continue to do so for weeks, months, or years to come.
No one knows when it will turn, but I can tell you it will happen.
Here’s the thing though, not every part of the market will react the same. Cheap and abundant money impacts different stocks in different ways. As does its absence.
At the top end of town, where most of the money will flow, it will do little to generate real value. Investors will pile into companies like BHP or Amazon for example. And the share price will likely rise because demand for stocks will rise.
But, the intrinsic value of these companies isn’t likely to improve at all. Short of some external miracle, more capital isn’t likely to grow these businesses. Not in line with rising share prices anyway.
These big companies don’t really have a need for more cash. But, they’re getting it and it is distorting valuations. When the bust comes though, it will all be corrected.
Valuations will be shredded, share prices will fall, and investors will be burned.
That’s the reality that most will face.
But, it is not the only reality.
Smaller is better
Beyond the BHPs and Amazons of the world, there is a plethora of tiny and unknown companies.
What we call small-caps.
And the thing about these small-caps is that they do have a use for cheap and abundant cash. They need it to build out their operations, fund their development, and grow their bottom line.
Better yet, they thrive in these low interest environments. Take this snippet from CNBC:
‘Historically, small caps have outperformed large caps when the U.S. central bank is lowering rates.
‘Small caps average a 12-month return of 27.9% after the Fed embarks on an easing cycle, Jefferies data shows. Large caps, meanwhile, average a gain of nearly 15% in that time.’
This is why I believe any investor should consider small-caps. Not because they are immune to a bust, but because they tend to do well in the lead up to it.
As the hunt for a decent return continues, I expect small-caps will be the eventual winner. They’ve just got far more to offer in terms of potential, in my view.
Maybe I’m wrong though. Maybe booms and busts really are a thing of the past.
I wouldn’t count on it though.
Editor, Money Weekend
PS: Download your free report now and discover Ryan Dinse’s three small-cap tech stock picks that could be set to boom in 2020. Click here to download a copy.