What are the ultimate drivers of asset prices? Perhaps no question in investment management is more basic or more disputed. But some rules are reliable, as they depend ultimately only on economic common sense. Five are proposed below, although they are best understood as broadly correct generalisations which need, in particular circumstances, to be interpreted with care. The first rule cannot really be disputed and the next four follow, more or less, as a matter of logic.
1. Nations cannot make themselves rich by printing more money.
This is simply an elaboration of the obvious statement, “there is no such thing as a free lunch”. (Investment bank clients may sometimes think their lunches are free, but they are kidding themselves.) A crucial implication is that, however fast the money supply increases, it cannot make people better-off in the long run. The excess monetary expansion is dissipated in higher prices.
A fair generalisation is that, over periods of many decades, the growth of the money supply is related - although not identical - to the growth of nominal gross domestic product.
2. High inflation is associated with high money supply growth.
This is an extension of the first rule. As bonds have to offer a positive real return if they are to attract investors, high money supply growth is also associated with high bond yields. The crucial investment messages are, ‘if money supply growth is high and rising, sell bonds’ and, conversely, ‘if money supply growth is low and falling, buy bonds’.
A good illustration is provided by Britain in 1972 and 1973, when the annual rate of money supply growth soared into the mid-20s ahead of an appalling bear market in gilt-edged bonds (and other asset classes, including equities and commercial property) in 1974.
3. High money supply growth is likely when banks have ample capital and can easily expand their balance sheets by extending new credit.
This is because the money supply consists mostly of banks’ deposit liabilities. Further, a well-capitalised and highly profitable (an under-capitalised and unprofitable) banking system is bad (good) for bond yields, because it will try to grow quickly (contract), which will add to (subtract from) both bank credit and the quantity of money.
Japan in the 1990s exemplifies the argument. The banks suffered severe loan losses as the bubble of the late 1980s unravelled in the early 1990s. The result was a crippled banking system, a decade of stagnant bank credit and low money supply growth, and a decline in inflation which eventually became a deflation. Bond yields collapsed to the lowest ever recorded in modern times, with the yield on ten-year government debt hovering a little above 1 per cent for a few years.
4. Although high money supply leads to more inflation in the long run, it may not do so in the short run for all sorts of reasons.
Two common reasons are that the economy has a big margin of spare capacity ahead of the monetary injection or that it enjoys heavy capital inflows which cause exchange rate appreciation.
In these cases high money growth may for several quarters be accompanied by low inflation, encouraging investors to believe that the economy has achieved some sort of ‘miracle’. The bubbles in the Asian stock markets in 1993 and in the USA’s NASDAQ stocks in 1999 and early 2000 can be interpreted in these terms.
The rational investor has a difficult problem with bubbles like these. On the one hand, he knows that they must come to an end. (To repeat, there is no such thing as a free lunch.) On the other hand, an investment adviser who misses a big asset bubble may lose all his clients in the short run, while trying to prove to them that he is right in the long run. In monetary economics the short run and the long run are like Punch and Judy, and squabble with each other endlessly.
5. For any given rate of money supply growth, a large budget deficit is likely to do more damage to asset prices than a small budget deficit.
The reason is that the non-monetary financing of large budget deficits requires high short-term interest rates. High interest rates are unhelpful for medium- and long-dated bond yields, and so for other asset classes. The ideal conditions for a stock market boom are a falling budget deficit, low inflation, moderate but rising money supply growth, and a well-capitalised and profitable banking system. That is a fair description of the USA in the five years to 1999, which saw the biggest equity bull market in history. The most serious threat to a bull market of this kind is rising inflation, as indeed has been recorded in 2000 and 2001.
‘Privatization has made a great impact in the UK.The impact is only starting to be felt in much of the euro area. As inefficient state enterprises are moved to the private sector, look for efficiency gains to generate attractive returns to stockholders.’
Paul Temperton
Laurence Copeland
Laurence Copeland holds the Chair of Finance at Cardiff University. His papers in academic journals cover a range of subjects including: inflation and the Phillips Curve, exchange rates and currency markets, stock and bond markets, index futures, mutual funds, Asian markets and the impact of the 1997-8 crisis.
Books
Exchange Rates and International Finance (3rd ed.), Pearson Education, 2000
Exchange Rates and International Finance (4th ed.), FT Prentice Hall, 2004
Currencies
1. All things in moderation, especially greed.
Don’t try too hard to buy at the bottom and sell at the top. Either be a long term investor, holding through ups and downs, or be prepared to sell out when you have made a reasonable profit, even if you subsequently find you could have done better by holding on. A short term investor is a gambler, so he or she should be ready to leave something on the table when they leave.
2. Market gurus repeat themselves, but history never does.
The past often seems to provide hints about the future, but usually the hints are unreliable signposts. So exchange rates may always have risen when the central bank raised interest rates, but that doesn’t mean it’ll be the same this time around. Like the weather, there are always new records being set, and that means precedents are no help.
3. “Ripeness is all” (Shakespeare).
The fruit falls when it’s ripe. Any later and it goes rotten. Timing is everything, in the markets as elsewhere - something economists often forget. For example, it didn’t take a genius to figure out that tech stocks were overvalued long before the peak of the boom. But you could have lost a lot of money going short on the way up, and several fund managers lost their jobs because they kept out of the market bonanza. Another example is the overvaluation of the US dollar in the first half of the 1980’s. So figuring out which stocks or currencies are mispriced is no help. The key to making money is knowing when the mispricing is going to be corrected (or, as is usually the case, overcorrected).
4. The more extreme the conditions, the more efficient the market.
