Harry Geels: The Three Amplifiers of the ‘Boom-Bust Cycle’
Harry Geels: The Three Amplifiers of the ‘Boom-Bust Cycle’
This column was originally written in Dutch. This is an English translation.
By Harry Geels
It was quite a shock recently when I updated my analysis of Chinese stocks that was published two and a half years ago. I realized that I had been misled by three ‘boosters’ of the boom-bust cycle: geopolitics, monetary policy, and mass psychology.
When I wrote the cover story for Beleggers Belangen two and a half years ago, I listed six reasons why Chinese stocks were worth buying, including the fact that they were fundamentally about 35% cheaper than American stocks and that index providers were about to include Chinese A-shares in the well-known indices. The ink on the article was barely dry when Russia invaded Ukraine, and the narrative changed. China refused to condemn the invasion, prompting many Western institutional investors to exit.
I recently reiterated my stance in a new cover story titled “Chinese Technology Stocks Dirt Cheap.” Chinese stocks have become even cheaper. Fundamentally, even the well-known Chinese technology stocks are now on average about 50% cheaper than their American counterparts. A passive investor entering the world index today would only get 2% Chinese stocks and as much as 65% American stocks. Even the UK, Canada, and France have a greater weight in the MSCI ACWI, ex USA, than China.
Four Sources of Returns
Once again, it is clear that stock prices are usually not easy to predict. In principle, there are four sources of long-term equity returns. The two most important are inflation compensation (companies raise their prices and thus roughly compensate themselves for inflation) and (reinvested) dividends. The third source of returns is ‘real earnings growth’ (the increase in profits through better business operations and automation). As long as free market forces exist, this source remains positive.
Figure 1: The Four Sources of Returns of the S&P 500 (1926-2023)
Source: Robert Shiller, Moatifull (adapted with boom-bust cycle)
Figure 1 specifically shows for the S&P 500 over the past century a fourth source of returns (purple line): the slightly increased price-to-earnings ratio (‘year p/e expansion’). Apparently, stocks, at least based on this fundamental ratio, have become somewhat more expensive over time. A possible explanation for this could be that stocks have become more mainstream or accessible over time, increasing the ‘natural’ demand, which could possibly result from better information provision by companies, reducing the risk premium and leading to higher valuations.
However, there is something odd going on in the markets. The volatility of the four return sources is nowhere near as large as that of stock prices themselves. The average dividend yield and ‘real earnings growth’ are much more stable than the prices themselves. There are large boom-bust cycles in stock prices that are fundamentally difficult to explain, although the financial industry excels in providing explanations. There are primarily three factors that drive stock prices in large cycles: geopolitics, monetary policy, and mass psychology. These can even reinforce each other into super booms and busts.
Three Causes of Boom-Bust Cycles
In the case of China, I primarily fell victim to geopolitics. The Ukraine war was the catalyst for an accelerated sell-off of Chinese stocks, within the broader context of a trade war primarily between the US and China and a COVID-19 crisis, with China as the epicenter, which reinforced the deglobalization trend that began a few years ago. The world is splitting into various economically independent blocs. Of course, this affects the profitability of companies, but not enough to explain the large differences in stock prices.
Monetary policy is also an important amplifier of market cycles. A period of abundant money drives up prices, and vice versa. The generally loose monetary policy of recent decades can partly be held responsible for the ‘p/e expansion.’ If the money supply is greater than economic growth, it can lead to price inflation, but also to ‘asset’ inflation.
Finally, there is mass psychology: investors who start believing in a certain narrative, such as the internet in the 1990s or AI now. On the other hand, fear can strike, as in the credit crisis.
The Short vs. the Long Term
In 2013, Eugene Fama, whose hypothesis states that prices are primarily formed rationally, and Robert Shiller, who argues that prices fluctuate much more than fundamentals justify, jointly received the Nobel Prize in Economics. At first glance, a strange award for two conflicting views. But on closer inspection, it makes sense. Fama is correct that in the long term, the (four) fundamental factors determine returns. Shiller is right that prices fluctuate irrationally and deviate from equilibrium values for shorter or longer periods.
Especially due to the cocktail of geopolitics, monetary policy, and mass psychology, prices sometimes seem disconnected from reality. It is essential for investors not to get drunk on this or suffer a hangover, no matter how difficult it is due to the many ‘behavioral biases’ and fallacies. Especially the ‘narrative fallacy’—thinking you have an explanation for the highly divergent prices—can be disastrous for investment results. Those who focus on the fundamentals for the long term should make a profit.
Perhaps some extra returns can even be achieved by daring to be contrarian occasionally, for example, by buying Chinese (technology) stocks now.
This article contains a personal opinion from Harry Geels