Perhaps the single greatest predicament faced by investors today is the challenge of
investing in financial assets that by historical standards are very expensive.
The cyclically adjusted price to earnings ratio (CAPE) which is widely regarded as a leading
measure of stock valuation is sitting now at about 30; which is nearly double the historical
average of 16. Interest rates on bonds are equally if not more expensive than stock when
compared to history. In fact, many government bonds today trade at negative real (and even
nominal) interest rates.
The reason for this is simple enough...compared to the past century there is a lot more wealth in the world today relative to quality financial assets. This is evident from looking at US Household Net Worth as a percent of Nominal GDP. It is also evident in the extremely low interest rates that investors are accepting on bonds.
Some call this a "Wealth Bubble" ... but as we discuss in our article on financial bubbles...its only a bubble if prices cannot be justified by any reasonable scenario. For there to be a “wealth bubble” the level of wealth concentration and resulting inequality needs to be so high that it is not sustainable.
Throughout history, societies have experienced prosperous periods of steadily rising wealth concentration followed by disastrous periods of class warfare. In many cases the result was failed attempts at communism which historically resulted in unstable dictatorships. Largely free markets are unquestionably a better system for growing prosperity even though prosperity tends to coincide with growing inequality.
Investors asking if today’s high financial asset prices are a bubble should really be
asking if today’s wealth concentration is sustainable.
Demand for financial assets increases proportionally with savings, and no one saves more than the wealthy. Opportunities for investment are largely dependent on economic growth which has been slowing globally since the end of WWII. It is simply a matter of supply steadily outpacing demand in the market for capital.
Today’s high level of wealth inequality has three primary causes. Peace, technology, and a shift in power from labor to those controlling capital.
The past 75 years since WWII have been more peaceful and stable then just about any in recorded history when measured as a percent of the population. This was conducive to investment as businesses, households and governments are more willing to invest in long term commitments and projects if they believe the future is more certain. Wars have a way of destroying wealth. At the same time...wars also increase return on investment. Rebuilding the first roads after WWII had a much higher return on investment then the last.
Technology improves at a faster rate in periods of higher investment. Faster technological progress is evident from the fall in inflation...resulting in lower prices for everyone. Software offers a uniquely compelling case for deflation because software can scale at zero cost to the consumer. The largest companies, specifically in telecommunications and finance industries have experienced the largest profit margin gains in recent decades in part because they have been the biggest beneficiaries of these new technologies.
The last cause is the shift in power from labor to those controlling capital. The biggest driver of this was the opening of international trade which really took off in the 1970s and never let up until recently. Wages in China were a tiny fraction compared to Americans in the 1970s. Today many wage rates and costs of living in China are competitive with that of Americans. This is reversing the power held by capitalists as labor in the USA is no longer as easily substitutable for cheaper prices abroad.
All three of these causes could theoretically be reversed. Wars aren’t fun to talk about
and would likely lead to a reversal of the third (technology) as any real war today would
probably end with humanity being bombed back to the stone age.
War is entirely possible, but from an investing context it is a rather moot point. The only way to truly hedge against this event would be a bunker. But if we had to assign a probability it would be low. As recently as 1915, mainstream culture still romanticized war which helped make conflict easier for governments to sell. Technology has also made intelligence, time, and data more valuable than money, land, myths, and human labor...removing nearly all the causes of historical wars.
Baring this apocalyptic scenario, only a class warfare level of tax increases and other
wealth transfers could reverse the increase in wealth concentration. Historically, that has been the case. Our tendency to latch on to patterns, however, should make us skeptical. Many aspects of everyday life today are unmeasurably different from the past, most notably the 1930s which is the last time global wealth inequality was as high as it is today.
For one thing, it is much more fun to be poor today than in the 1930s. No one starves in
the United States or Europe anymore. Poverty is real and opportunities for success are not
even close to equally distributed. But the social media, video games, drugs, and an aging
population all suggest that our “Complacent Class” is unlikely to become as extremist as the
radical communist and nationalistic uprisings of the past. People today are also vastly better
educated about history. We know the story of Mao and the cultural revolution. We know the
story of Hitler and how poverty helped fuel his attempts at genocide.
Technology moves forward, not backward, and while a quick shift toward the European
socialist welfare state would likely hurt economic growth, the shift would need to be pretty
dramatic in order to offset the wealth concentrating power of today’s telecommunication and platform technologies. Software is eating the world and ambitious entrepreneurs, effective CEOs, and genius innovators have never been able to generate more value for humanity.
For example, take the CEO of General Electric (GE) in 1896 when it was first added to
the DOW Industrial Average. Telephones were of limited use so long distance
communication was still largely dependent on written letters. Teams had to operate in the
same building. Supply chains were more often geographically concentrated and simpler.
This type of environment made it very difficult to control large organizations. This provided an advantage to small businesses and prevented many companies from being very large, even in industries that essentially produced commodities and could benefit greatly from scale. Fast forward to Facebook today and you have a truly global business with Mark Zuckerberg at the helm...communicating instantly with all employees. Changes to software can be implemented in seconds. Value creation is limited only by the value of the decision, no longer hampered by geographic boundaries, slow communication, and manual implementation.
Technology will continue to increase wealth concentration because it leverages
intellectual ability and produces services that scale at no cost. A growing percentage of GDP
is represented in bits instead of atoms. This trend is accelerating and those who contribute to it stand to gain tremendous wealth. In contrast, those who compete with automation,
machine learning, and platform technologies are going to increasingly find themselves
commoditized and poor. BioTech will accelerate this trend as precious few will be able to
directly improve our intellectual ability.
This is already true today with the greatest smartphones now priced at over $1,000. Alexa and other chatbots already help kids do their homework and plan their days. CRISPR allows us to change our genes and is simple enough to use that its already being taught by some High School teachers. There are probably already people with enhanced intelligence, but are certainly smart enough now to realize they are better off keeping the technology a secret.
So are we in a wealth bubble? We think not. A bubble implies that prices are too high to
be justified by any reasonable scenario. But there is a reasonable scenario that justifies today’s higher prices for stocks, exceedingly low interest rates, and ever rising demand for
alternative assets like real-estate and even cryptocurrencies, and that scenario is the status
Class warfare remains largely talk. Shooting wars remain rare and isolated. And
technology continues to improve and in so doing enhances natural abilities. It’s easier to
believe in revolution because that is the pattern of the past, but the evolution of today’s
economy, culture, and international interdependence is fundamentally different.
We don't see the wealth bubble popping anytime soon. So what are the implications?
1. Measure the expensiveness of assets on a relative, not on an absolute basis.
Staying out of the stock market for years at a time because of high valuations is a poor
investment strategy. Stocks have historically beaten corresponding government bonds by
4-8% a year. Yes, some years stocks fall by large amounts, but for the typical investor with
a long time horizon, the risk of staying out of the market is much greater.
2. Prepare for a scenario in which populism deflates the wealth bubble. While the
scenario seems unlikely, it is entirely possible. The most important thing to keep in mind
is that there isn’t a risky asset class exempt from this risk. Real Estate and other alternative
investments have gone up in price relative to fundamentals just like stocks and bonds. So if you start to see lots of anger at wealthy people and successful businesses materialize into dramatic wealth transfers...good luck trying to find a place to hide.
Thank you for reading our views on the Wealth Bubble! If you enjoyed this then you may want to follow us on Twitter, Medium, or SeekingAlpha.