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Why we are in a speculative bubble

2021-08-26

The news is full of headlines such as "Why The Global Economy is Recovering Faster Than Expected" (Harvard Business Review, October 2020). and "Dutch Economy Grows Again, Second Corona Low is Over" (NOS, August 2021 (in Dutch)). It completely baffles me how these articles overlook a simple explanation from Warren Buffet and Charlie Munger: we are in a massive speculative bubble.

To see why this is the case, let's look at the long-term stock price of Microsoft.

 Microsoft stock price
Stock price of Microsoft. The two red circles indicate the dot come bubble of 2000 and the housing market crash of 2007 (source: Yahoo).

Here, you can see that the price of Microsoft went up by 1000% from 1995 to 1999. Then, the dot-com bubble burst and the price halved in one year. Around 2007, a similar increase and decrease happened. Both these crises were considered big financial crises and resulted in many people losing their income. Now, compare the price in 2013 to the price today. Again, we see a 1000% increase.

So, aha. Okay. Well, that can happen you could say. Investors apparently think that Microsoft is doing very well, and I agree that they indeed are doing very well. However, are they really doing this well? Are they doing 10 times better than 2012? For example, Microsoft's annual report of 2012 reports a cash flow from operations of about $32 billion. This operational cash flow is a great number to look at since it tells how much money the company can spend freely on things like more research or paying back investors. The cash flow in 2020 is $77 billion. That is slightly more than a twofold increase and not a 10-fold increase. The only reason that this difference could be legit is when future income potential for a company is expected to improve.

As a comparison, let's go to a completely different brand that is not related to software. The brand that most of us love and know, namely WD-40.

 WD-40 Company stock price
Stock price of WD-40 Company (source: Yahoo).

Both these images show that the crises of 2000 and 2007 have affected the stock price, but what is happening now looks almost insane. WD-40 is the brand and trademarket product that can be used to get stuck things loose. The product was first sold in 1958 and in 1965, it was already being used by aviation companies in the United States. Since then, I cannot really find any evidence that they have created new products. Still, the stock increased by 200% from after the dot-com bubble to it's peak in 2007. During the 2007 financial crisis, the stock dropped by about 60%. Since this peak of 2007, the stock price has increased by 600% again. At the same time, the operating cash flow didn't even double (from $49 million in 2007 to $77 million in 2020).

If you think that I've cherry picked these companies, just look at the S&P 500. The S&P 500 is a composite index which tracks 500 large companies in the United States.

 S&P 500
Price of the S&P 500 (source: Yahoo).

Okay, so now you're thinking that it's probably only America. This is the AEX index (Amsterdam):

 AEX index (Amsterdam)
Price of the AEX index (source: Yahoo).

Or, houses:

 House price
House price index. The red circle indicates the housing market crash of 2007 (source: Economist).

Okay, so everything has increased in price. But why is that bad? To see that, let's read something about bubbles. For example, the Japanese asset price bubble of the late 1990s.

The Japanese asset price bubble (バブル景気, baburu keiki, "bubble economy") was an economic bubble in Japan from 1986 to 1991 in which real estate and stock market prices were greatly inflated. [...] More specifically, over-confidence and speculation regarding asset and stock prices were closely associated with excessive monetary easing policy at the time. [...] Even though asset prices had visibly collapsed by early 1992, the economy's decline continued for more than a decade.

The sounds exactly like the current situation. Governments are printing lots of money, and one could call it an excessive monetary easing policy. The policy is comparable to the policy used to recover from the financial crisis of 2007.

 Money supply
Federal Reserve buyback of US debt (source: Return on Time).

Note that in the figures above, we haven't had any crisis yet. Another example is the Wall Street Crash of 1929.

The "Roaring Twenties", the decade following World War I that led to the crash, was a time of wealth and excess. [...] Despite the inherent risk of speculation, it was widely believed that the stock market would continue to rise forever [...] The crash, which followed the London Stock Exchange's crash of September, signaled the beginning of the Great Depression.

Hence, the big question is: are we going into a new great depression? If you look at history, I'd say it could happen in the next months to years, but, of course, nobody knows for sure. To quote Warren Buffet in response to massive spending by the Federal Reserve (2013):

It will be interesting to watch.