These overvaluation processes take a long time to develop, but it is impossible to determine precisely and a priori when they will end.
For years now, the word bubble has become a recurring part of the financial lexicon. We have become accustomed to living with events such as the TMT explosion at the beginning of the century, the excessive growth of the real estate market before the global financial crisis, or the rise of cryptocurrencies. These are all processes that we can identify with the concept of a bubble, understood as a boom in prices that are clearly unjustifiable in terms of their fundamentals.
When a situation of overvaluation reaches the level of a bubble, the attitude of investors bifurcates in two directions: the first is to identify that the situation makes less and less sense and act accordingly, while the second option is usually denial and the search for any justification, more or less imaginative, to continue enjoying this process of uncontrolled expansion of multiples.
Either option is difficult to manage. The do-nothing solution is usually a short-term gain and a long-term catastrophe. The first option is not risk-free either; you can make a sound judgment about the situation, but turning against the market can also destroy you if the bubble spreads over time. As always in these cases, prudence is usually the best course of action.
This is the main problem with these processes: bubbles. They take a long time to form, but it is impossible to determine precisely, and a priori, the end of the bubbles. This is because estimating the moment when a bubble will burst is a guessing game, and the ability to anticipate the future is something that should never be to a manager's credit.
Among the examples we gave above, we were missing the most recent of all, which is none other than fixed income. The year we are about to close will go down in history for losses in fixed income that have no historical comparison. In our opinion, the spectacular fall in bonds is as interesting as the process that brought bond prices to unsustainable levels.
In this same column, a few years ago, we wrote: "Every decision and action we take has a cost, and central banks are no strangers to this maxim. This cost is that, given this asset inflation, the risks are not faithfully reflected in the price of the assets. Why do investors have to finance a company or a State at negative rates, why do we have to make very long-term investments at negative rates, why does the Eurozone five-year inflation swap trade at 1.52% and the German bond at the same term has a yield of -0.36%? And he ended with a question; "Is this situation sustainable for a prolonged period of time?"
I don't know if almost four years is a long enough time or not, but what we can say is that when we wrote that we knew we were facing a process in which price and fundamentals did not match (mainly because of central bank intervention), but we had no idea when this process might normalize. If we had decided, for example, to hold an aggressive short position on long duration bonds, the market movement would have wiped out those positions. However, being aware of an abnormality that is forming allows you to not participate in it and not have to watch the market sweep away twelve years of fixed income gains in just a few months.
Howard Marks always makes the point that it's not about guessing, it's about trying to figure out where we are, and he's right. For example, right now we cannot know what will happen with inflation in the short term, if we will have some kind of escalation of war in Ukraine, or how deep the economic contraction will be, but we can do the exercise of trying to situate ourselves in the cycle, of being aware that investments can now be made at positive real rates (in the long term), of knowing that we are no longer financing companies or States at negative rates and understanding that the current rate levels are already much more consistent with economic reality and not with the interventionism of the monetary authorities.
All this should be reassuring for a fixed-income investor who, paradoxically, is much more nervous today than he was a few years ago with negative interest rates.
David Ardura is Chief Investment Officer of Finaccess Value Investments.
