Bubbles, BRICs and Benchmarks: Rethinking Risk in a Global Portfolio
The Global Savings Glut
In our digital age, the speed of communication and of capital has “flattened” the globe, heightened competition, increased economic interdependence and driven up volatility in markets around the world. Welcome to the global village.
In this new global economy emerging markets such as Brazil, Russia, India and China (the “BRICs”) are shouldering aside developed nations as rapid industrialization and natural resource exploitation fire the afterburners on their economies. Indeed, emerging economies now account for more total global commerce than the United States.
A byproduct of this explosive growth is what Federal Reserve Chairman Ben Bernanke calls a “global savings glut.” Emerging economies are generating vastly more revenues than their budding domestic consumer classes can spend. Simply by default, their savings rates are sky high. The net result is a staggering level of surplus savings throughout the developing world.
The Global Asset Shortage
The flip side of the global savings glut is what economist Ricardo Caballero refers to as a “global asset shortage.” * Emerging economies, particularly China and India, are engaged in a modernization project whose first phase is the building of an industrial infrastructure. The excess revenues from that industrialization in time will foster both a Western-style consuming class and a financial infrastructure that creates adequate stores of value for their wealth. The key phrase here, however, is “in time.” At present, emerging economies, including the oil-rich OPEC nations, have a shortage of domestic assets in which to store their wealth.
This is why an Indian industrialist is building a 27-story, 400,000 square foot “home” at a cost of $2 billion. It’s why a Russian oligarch recently paid $200 million for a “super-yacht” to sail to Norway, where he planned to stop and pick up three Monets recently bought at auction. These are cases of literally having more money than you know what to do with.
The Resulting Bubbles
As a result of this global savings glut in tandem with a global asset shortage, asset bubbles have become a distinctive feature of the global financial system. They result from the simplest intersection of supply and demand curves. Globally we have more money (demand) than we have ways to store it (supply). Hence, excess money chases after the limited supply of investment vehicles, driving up their prices in the process.
Of course investors, being human, also exhibit classic herd behavior, rushing into (and out of) the same assets at the same time. Whichever asset they rush into gets priced beyond its ability to preserve value. When this becomes evident, the herd rushes out, that asset bubble bursts, and a new asset class begins inflating. And so it goes.
This is at least part of the reason we had a bubble in technology stocks in the ‘90s, in real estate in the early ‘00s, and in oil most recently. These rolling asset bubbles have become part of the process by which our cash-rich and asset-poor global financial system seeks price equilibrium, however shifting and dynamic.
So how are investors to cope with this new bubble-prone global financial system? The most obvious answer is: Don’t chase bubbles. Don’t plow your entire portfolio into tech stocks in 1999. Don’t buy condos in Miami in 2007. And don’t load up on oil futures in July at $147 a barrel.
Of course, if everyone followed this advice, bubbles would never happen. The defining principle of a financial bubble is that rising price begets rising price. That is, bubbles are created by investors who buy an asset simply because its price has gone up a lot. Bubbles are made by people chasing them.
While this seems an easy enough lesson to learn, generally speaking, people don’t. More primal drivers of human behavior tend to override these lessons just when it’s time to heed them. Greed combined with herd behavior is one of the most powerful human motivations, second only, perhaps, to fear combined with herd behavior. You get both of these potent cocktails served in every bubble (one going up, the other going down). And with a global savings glut/asset shortage creating serial bubbles, the bar is always open.
Spreading Your Bets
The most obvious way to protect against bubbles is to diversify. For stock portfolios, modeling them on a broad index benchmark, like the S&P 500, provides a mechanical check on greed. In 1999 keeping your stock exposure weighted in line with the ten industry sectors of the S&P 500 would have kept you from plowing all your money into technology shares.
From the peak of the tech stock bubble in early 2000 to its trough in late 2002, the S&P 500 index as a whole fell 48%. The S&P tech sector alone, however, fell 82%. This is the difference between living to fight another day and not. Six years later the S&P 500 had fully recovered to a new all-time high above its peak in 2000. The tech sector is still down 62%.
Modeling your sector exposure on a broad market index can save you from putting all your eggs into one basket, but it won’t fully immunize your portfolio against the distortions of bubbles.
Is There a Bubble in Your Benchmark?
Most broad, stock market indices are “cap-weighted,” meaning each stock’s relative weight in the index reflects its market capitalization. So, for example, ExxonMobil‘s stock has 166 times the weight in the S&P 500 of Whole Foods Market because Exxon’s market cap is $415 billion while Whole Foods’ is $2.5 billion.
Cap-weighting also means the relative size of the industry sectors in the S&P 500 reflects the aggregate market cap of the stocks in each sector. So if the prices of technology stocks go up more than prices in other sectors, so does the relative size of the tech sector in the S&P 500.
When the tech stock bubble began gathering steam in 1996, technology shares made up 12% of the S&P 500. At the peak of the bubble, tech accounted for 35% of the index. So even had you weighted your portfolio according to the industry sectors of the S&P 500, you still would have been “chasing the bubble.” That is, as the tech sector grew larger and larger from 1996 through 2000, you would have put more and more of your portfolio into that sector as its share of the overall index increased.
This illustrates the chief criticism of “indexing” strategies in general. When you buy Vanguard’s S&P 500 Index Fund you do get the benefits of sector diversification – that is, you won’t put all your eggs into one sector basket. You will also, however, put more of your money into those shares and sectors that have risen most and less into shares and sectors that have risen least, simply by dint of cap-weighting. In this way, indexing is a “buy-high” strategy. And buying high is what bubbles are made of.
If bubbles are created by people chasing them, then indexers are often a large if unwitting part of the herd. Investors in today’s global financial system must be alert to the risks — both direct and indirect — that asset bubbles pose. They’re likely to be with us for a while. Avoiding them and the herd may mean consciously straying from your index. This may cost you some relative performance over the short-term, but charting a less crowded course can be highly rewarding to your long-term financial health.
* “On the Macroeconomics of Asset Shortages,” proceedings of the 4th ECB Central Banking Conference on “The Role of Money: Money and Monetary Policy in the Twenty-first Century,” Frankfurt, November 2006.