As it becomes increasingly clear the worst is behind us, did our clients actually learn anything from the greatest global financial meltdown the world has ever seen? Will they display the post-Great Depression frugality of our grandparents, or simply shrug it off and ready themselves for the next ride? We hope it's somewhere in between. Morningstar's David Walker offers the following warning-sign refresher to prepare for the next boom-bust cycle-something to share with boomer clients now, while the pain is still fresh.
- To begin with, nearly all booms involve the excessive use of debt, whether corporate debt to fund capacity overexpansion, household debt to fund unsustainable consumption, investor debt to fund speculation in property or margin debt to finance speculation in shares. Debt is seductive in a boom because it increases leverage. Right now corporate debt is more difficult to obtain, and both households and corporates are de-leveraging, but this will change and another debt buildup in at least one important sector of the economy will begin.
- Most booms have their origins in sound underlying ideas, but promoters package these into products of typically greater extravagance or outlandishness as a boom reaches its peak. The most recent example from within Australia was the over-geared infrastructure stapled security, whose origins were government withdrawal from the ownership and funding of public infrastructure and investors' search for sufficient yield at a time of low inflation and interest rates. A related symptom is expansion in the range of vehicles for investing in a concept or getting leverage to it as product providers move to cash in on the trend while the going is good.
- Justification by the financial community of increasingly absurd valuations. The rewards from selling shares or financial products are too great.
- Successful speculation by amateur investors. You know it's time to be cautious when taxi drivers and non-professionals at cocktail parties boast about their winnings on the stock market.
- Claims value investors do not understand this market. There is probably no more reliable indicator of excessive valuations than this.
- An attitude that "the prospectus is the fat bit in front of the application form." "Just get me the stock and I'll think about it later" becomes the norm.
- Similarly, entrenchment of the "greater fool" approach to investing. Investors are less interested in a rational assessment of a business's long-term prospects than whether someone else will pay more for a stock than they just paid.
- Vertical appreciation in security prices or other financial variables. The fundamentals for most established businesses are not capable of improving quickly enough that vertical share price appreciation is justified. Admittedly there will always be resource explorers and concept stocks that get lucky overnight, but even here most of the share price appreciation in a related boom is not justified by the fundamentals. It reflects only speculation or the hope someone else will pay more.