Identifying Financial Bubbles in the System Before a Crisis (w/ Vikram Mansharamani)
VIKRAM MANSHARAMANI: Hi, Vikram Mansharamani. I'm a lecturer at Harvard University. The author of Boombustology: Spotting Financial Bubbles Before They Burst, and also the founder of Kelan Capital. At Harvard University, I teach a class called Humanity and Its Challenges, systems thinking approaches to the world's toughest problems. And I previously taught a class at Yale University called Financial Booms and Busts. Kelan Capital is an investment advisory firm where I help manage some capital on behalf of some wealthy families in the Midwestern part of the United States. One of the topics that I articulate in this next edition of Boombustology is that I believe passive investing has gotten ahead of itself, and is continuing to grow at unsustainable levels, creating a dynamic which I believe is becoming increasingly dangerous. So, what do I mean by that? The fundamental premise upon which passive investing is based is that prices are right. So, don't bother worrying about prices, you just deploy capital, the prices are accurate, the markets are efficient, and therefore, minimize your fees, don't waste dollars, time or effort on actual research or fundamental analysis. It's a waste of time, prices are right. That logic has led many people into this passive investing mantra, if you will, that says fine, minimize fees, take the market. And so, the idea is that you are a price taker as an investor if you're passively investing. The problem is, as this becomes a larger and larger percentage of the market, what we're finding is that these price takers have become price makers and flows now matter almost as much if not more than the fundamental valuation that might be applicable to a particular company. And so, what we're starting to see is when there are inflows, we're seeing good and bad companies rise. And when there are outflows, we're seeing good and bad companies fall. And so, the distinguishing qualities of a company are becoming less relevant. Why does this matter? This matters because what used to be an individual company's story investing market is becoming less and less so because prices and the signaling mechanism that prices provide are becoming less relevant. And so, this actually is the basis upon which capitalism is based, right? Capitalism believes that prices help direct capital. And so, therefore, if prices lose their validity, this creates a really dangerous dynamic in terms of the allocation of capital. And that fundamentally creates unsustainable conditions, which is the topic of Boombustology. One of the dynamics that's really disturbing is the number of active investors has been plunging. We've seen flows leave the active investment community and go towards the passive investment community. This is part of the problem. And I think the reason why it hasn't gotten enough attention is because passive investing still appears to be half or maybe even less than half or slightly more than half of all the invested dollars. So, okay, it's still not running the show so to say. I think that analysis is flawed, because what we have is a large community of the active investors that are actually closet indexers. And so, the de facto passive investing is much larger than everyone believes, because of this closet indexing that's taking place under active managers. And so, I think that we're actually closer to a problematic tipping point than perhaps some of the data might suggest. To take an extreme example, imagine if everyone was investing passively. There would be no fundamental research done. An inflow would take every stock up, an outflow would take every stock in the index down. We would have no distinguishing qualities, no distinguishing characteristics for a company that's doing well or poorly. Imagine what that would mean for the raising of capital, the most powerful companies in this domain would be those who determine the components of an index, which confuses the whole investing business so to say. What we would see is more tightly correlated performance among index components. So, all index components would go up, all index components would go down on days. And so, if we imagine a world where the S&P 500, every security went up X percent in a day, that we had inflows and every security in the S&P 500 went down on certain days, then, in fact, we would be at a place where I think you would not see any distinguishing qualities and any distinguishing performance or differentiation among the securities. The idea of passive investing resulting in higher correlations both dampens volatility and also increases volatility. And it sounds contradictory, but in the short run on a day to day basis, what you would see is a slowly virtuous cycle playing. Inflows, stocks creep up, inflows creep up, and etc. And then as we saw here in the middle of May, you'd see some vicious downdrafts where virtually all securities go down. And then vicious bounce backs or virtuous bounce backs where virtually all securities rise. And so, you're seeing a dampening as well as an increasing volatility simultaneously. And so, it creates these cross currents that are very difficult to navigate. So, this phenomenon of passive investing and this rise of index-based allocation of capital does create this schizophrenia that we're seeing in markets. And so, you'd see this almost bipolar nature to markets. I think that's a logical ramification. And by the way, I think that gets worse, not better over time, as passive continues to grow. As for when the tipping point happens, where passive eventually gets to the point where literally markets fail to allocate capital correctly, I can't say when that will happen with precision. But unfortunately, I think that the passive share is going to continue to rise for some period of time. Spotting a financial bubble is actually quite difficult, right? It's a probabilistic exercise. It's ambiguous. There's conflicting signals and what have you. So, one of the indicators that I've really loved looking at that helps spot financial bubbles and has worked in the past has been the world's tallest skyscrapers. And if you go back in time, this actually works, which is the stunning part of it. And so, we have is in 1929, we had three buildings competing for the world's tallest tower here in New York City. You had the Chrysler Building and 40 Wall Street competing only to be outdone by the Empire State Building, followed by the Great Depression. In '73 and '74, we had the Sears Tower in the World Trade Centers, and a decade of stagflation. In 1997, we had the Petronas Towers take the title of the world's tallest tower in Malaysia ground zero of the Asian financial crisis, before the financial crisis really took off. And then in 1999, actually was the start of construction. There were some delays, but Taipei 101 eventually became the world's tallest tower. And that was fueled on the back of optimism and confidence in Taipei or really, the home of the technology boom, at least in a hardware and semiconductor sense. The foundries and what have you. In 2007, the world's tallest tower title moved to Dubai where the Burj Dubai at the timeit since been relabeled the Burj Khalifa took the title in July of 2007. Within weeks of global equity markets peaking. The Guinness Book of World Records called it the world's tallest freestanding structure. So, that's really interesting. This tends to work. And so, when I've looked at why it works, it works for really three main reasons. Number one, skyscrapers, the world's tallest skyscrapers, generally are built with borrowed money. So, it's an easy money indicator. Number two, they're usually built by developers seeking to attract tenants. So, it's a build it and hopefully the tenants will come. So, it's a naturally speculative endeavor. And lastly, these things are embodiments of hubris, right? Competing to get the world's tallest tower status, that is absolutely overconfidence being manifested in this irrational way. So, that's why the indicator has worked. Now more interestingly, I would imagine would be what does this indicator say now? And what does it say about the future? And so, one thing we noticed was after 2007, the world's tallest towers under construction, likely to take the title had been in China. So, 2011, '12, '13, there's a great story, Sky City was a building that the Chinese were going to erect within 90 days at a cost of under a billion dollars. That would take the title away from the Burj Dubai. Interestingly enough, when they announced that, I said that's great, 90 days, one fifth the cost of the Burj Dubai, that's great, I'm not going in it. I'm going to make sure I stay a good couple blocks away until a good typhoon comes by. They ultimately didn't build it. Capital didn't materialize, etc. And today, it's being used as a fish farm. Literally, the foundation of Sky City is being used as a farm for fish. It's filled with water, etc., etc. So, these things actually do show hubris even before they're built. So, right now, what we have on the books are three towers competing to be the world's tallest towers. Right now, in Saudi Arabia, the Jetta Tower is scheduled to be the world's tallest tower. And then we also have the Dubai Creek Tower trying to outdo that because the folks in the UAE want to keep the title of the world's tallest. And so, by the way, this is just fascinating to me as a sociological phenomenon, because it is hubris, easy money and speculative instincts all wrapped into one. And so, this is a fun multi-lens indicator that captures those spirits to tell us when we're getting a little bubbly, if you will. Now, why this is even more concerning to me is that coming out of the Middle East at this time to have hubris and overconfidence and easy money there lines up with other equally disturbing developments. So, right now, for instance, Saudi Arabia has the world's third largest defense budget. They have a budget- they spend more on military and defense matters than Russia does. And one has to ask the question as to why. Now, that is a really concerning development to have someone spending a lot of money on military and defense, at the same time, is exhibiting signs of overconfidence and hubris. It leads me to be concerned about Middle East's stability. I think the risks are rising for a potential conflict. And so, I worry about the Middle East. The ramifications of forthcoming instability in the Middle East are really quite hard to disentangle right? You can imagine in a situation if there were a conflict and capital started to leave the region, that Saudi Arabia would decide to pump as much as possible to capture whatever capital they could. You could also imagine a scenario where the spigots get turned off and there's an oil price shock, where prices go through the roof. Sadly, I don't have a great insight into which of those two scenarios is likely. What I can say, with great confidence is Middle East instability will continue to provide volatility to the oil markets. I think that is something we can say for sure. Another one of my favorite multi-lens indicators for spotting bubbly conditions has been the common stock price of Sotheby's. Now, this is a really interesting stock chart. If you pull it back to when the company went public in 1988, or '89, the stock immediately goes vertical and then comes back down. It peaked I believe it was October of 1989. And when you go back and look at the news stories of art markets at that point in time, what we found were Japanese buyers paying world record prices for art. Sotheby's stock reflected that. The stock came off in October of '89. The Nikkei peaked in December of '89. And it hasn't gone back since. Sotheby's stock later in 1999 peaks and ends up, as not surprisingly, having been driven to that elevation by buyers from the technology, media and telecom sectors, buying art at world record prices. And sure enough, the stock peaks in 1999, the internet bubble or the NASDAQ bubble, if you will, peaked in 2000. So, it was a nice leading indicator. Again, Sotheby's stock price in 2007 hits an all new high driven on the back of world record art prices being set by Russian oligarchs, private equity billionaires and other beneficiaries of easy money. And so, sure enough, we had a credit bubble that burst shortly thereafter. Now, what's interesting is the stock has bounced around up and down a lot recently between 2013 where it was Chinese buyers paying world record art prices into Middle Eastern buyers in '15, '17 paying world record art prices. And recently, Sotheby's stock price has come off. Now, if it were to continue falling, I would be really concerned here. Because what it's saying is that the confidence of art buyers is waning. But let me just highlight most recently, the world's most expensive paintings, $400 million plus painting was purchased by Middle Eastern buyers. Now, what's interesting is when the skyscraper indicator points to Middle East instability forthcoming or unsustainable conditions, and now, art markets are saying the same thing. And then we line it up with defense budgets, you were starting to get some things pointing in a direction that make me triangulate forthcoming instability. Now, why do art markets work? And why do world record art prices telegraph financial bubbles, or telegraph forthcoming plunges, if you will? I think they work for one reason. The person who buys art for $100 million plus, presumably is an economic or corporate leader in their society. They've got a lot more presumably than the hundred million they're paying for this painting. And so, when they see dark clouds on the horizon of their professional lives as a corporate or economic leader in their society, then they are less likely to hit the gas in their bidding behavior in their personal life. And so, when we see people take their foot off the gas in terms of bidding in their personal life, what I'm trying to interpolate back is, what does that say about their confidence in their professional life? And therefore, when the stock price comes off, it's because the world record art prices are not being set anymore. Confidence is waning on the margin in terms of art markets, and that usually indicates ahead of time, that confidence is waning on the part of economic and corporate leaders. I believe technology is proving far more disruptive than globalization has been to labor markets around the world. And I'll give you an example. So, I've worked with a couple of large multinational companies, and one of them was sharing with me about their factories in the United States. And so, in the 1980s, they had 14 factories producing a particular product. Today, there's six factories producing more than they originally produced in those 14 factories. Further, the employment per factory has fallen by about 65%. So, they're using 35% of the people in each factory, and they've gotten rid of more than half of their factories. This is all within the United States. This is the impact of technology. Globalization had nothing to do with the loss of jobs in this particular manufacturing company. And so, I think more of that has been happening than people are aware of and cognizant of. This is not to say that globalization has not had an impact, it has. But the rise of this populism and nationalism, wanting to blame others for the impacts on job losses and labor markets, I think is partially unwarranted. And my hope is that this is a passing phase, that five, 10 years from now, we'll say, oh, we went through that bout of populism and nationalism, and protectionism and deglobalization. And we've since reversed it, because we realized that actually, the disruptive beast in the room was not globalization. Sure, it was contributing, but the really disruptive beast in the room was technology. And so, I think that's a really important consideration to think about when thinking about some of these big political, economic trends that are facing us. Emerging Markets investors have historically felt that India was going to be the next big thing. Even corporate investors in India believe it's the next big thing. In fact, Tim Cook of Apple suggested that India would be the next China. I just think this is bluntly false, it's not true. I don't see how the math works. There's a couple of different reasons why I believe that to be the case. So, India, I believe, has missed its opportunity to develop a large middle class by industrializing. I think they're 50 years too late. China, really starting in the '70s into the early '80s, started to industrialize. And what they did was they took the farmers to the factories, threw some capital at them, some equipment and had massive productivity increases and produced goods for the world. And the world bottomed because they were built cheaper. And labor was a large component of the cost of goods, to produce them. And as such, cheap labor and lots of it was a real advantage. Roll the clock forward to today, China's built a middle class, they're starting to consume, their economy is transitioning from an investment led economy towards a consumption led economy. India and Prime Minister Modi have looked at China with adoring eyes and suggested we too can do that. And the Indians launched the Make in India campaign. And that campaign was designed really to create a lot of jobs by bringing global manufacturing companies to India. And so, Make in India was supposed to produce 100 million jobs. And so, India has, in fact, obtained a lot of large manufacturing companies. They have come to India. The problem is India is not creating the jobs. And that is ultimately what is needed to develop a middle class. And so, India, for instance, is adding one million people per month to the labor pool. And that means you need to have one million jobs created per month to not go backwards, at least in terms of unemployment. So, I think India is miserably failing in terms of job creation. That's number one. Number two, automation is taking away the future potential of an industrialized strategy to develop a middle class. I don't think- that's not a viable option anymore. Technology and the future has come too quickly for India. Many people tell you that India has a demographic dividend coming because of its large, young population. I would argue that's not the case. Yes, they do have a large young population. But it's my suggestion, because this development strategy has shifted away from industrialization that you can't really build a large middle class based on factory jobs, that India's "demographic dividend" is, in fact, turning into a demographic news. This is actually going to be a huge burden, having lots of young people, that means you need to produce lots of jobs. And that's not something that's easy to do today. And so, I think India is a country that's got a real challenge ahead of it. If Prime Minister Modi were to ask me, Vikram, what should we do? I would say two things. Number one, you've got to educate, educate, educate, upscale your population, because there's no hope without that. And number two, you got to actually contain the population growth. The fertility rate has been falling, but just mere medical advances will mean that population is going to continue to grow for the indefinite future. And that is a problem for a country like India. I wouldn't even suggest that China and India are competing. They were running different races, right? China ran a race starting in the '70s while India was asleep at the switch. And then they won the race, but India is starting to run. And so, it's like, okay, what's going on? You need to actually develop a strategy for bringing large numbers of people into a middle class, so they consume goods and services. I'll give you a couple examples. Number one, the average Indian I think earns a salary of around $2000, $2,300 a year, something in that range. An iPhone is not going to be a large selling item in India if it represents almost half of an annual salary of an individual. Like you're not going to sell billions of iPhones in India, it's not going to happen. So, fine. That's a high price. And what about something like Starbucks. So, Starbucks has 3500 or something like that number of stores in China, and they're adding a new store every 14 hours. 14 to 15 hours, a new Starbucks store. There's huge demand, because there's a middle class there. India had something like 130 into 150 Starbucks stores, and they were adding them at the rate of one a week. India doesn't have the consumption power that China does. And so, I think there's a real challenge that the Indian government has here, not to mention that the promise made to the Indian youth is that your future is going to be bright. So, I think there's the possibility of unrest rising within India, as well, as these promises are left unfulfilled. Now, that's a longer-term development. But as we can already see, with the divisive election that's underway, the country is not as unified as some had believed. And so, is it possible that nationalism starts rearing its ugly head in an even larger way in India? Yeah, I think so. We saw a glimpse of that earlier this year with the India-Pakistan interchanges, military interchanges. And so, I think nationalism might be the way you hold it in together, but ultimately, without jobs, it's a tinderbox. Fundamentally, what I'm getting at is that technology is changing the development strategy. And technology is fundamentally changing the globalized nature of manufacturing. And so, the way I look at it is I break down the cost of a good. What percentage of producing a good was labor? What percentage of delivering the good was transportation or what have you. And I think what we're finding is that technology is increasingly displacing labor in the cost of goods. What that means is that the geography of manufacturing fundamentally needs to shift. And so, putting large manufacturing facilities in destinations with large pools of cheap labor is no longer necessary. In fact, you might, you might find that freight and transportation costs are more important than labor, in which case, you might want to actually put your factories close to your ultimate demand. So, you'd want to put them right next to the actual consumers of your goods that you're producing. So, the whole geography of manufacturing shifts away from these large population, low income societies, towards the large population, large budget consumer societies. And so, could the United States have a manufacturing Renaissance? Yeah. Could North America, could Mexico benefit because of these shifting supply chains? Definitely. You could also think about the implications that that shifting geography of manufacturing would have on an industry such as shipping. So, right now, container ships move finished goods from places with large populations of cheap labor to the consumer societies and the developed world. Well, it turns out that may not be as important as, for instance, something like dry bulk, which we'd be moving the dry, or the raw ingredients that go into manufactured goods to those destinations, but yet, you wouldn't have to bring finished goods. So, that has implications for container shipping versus dry bulk shipping. And there's huge implications for the movement of manufacturing around the world. So, ultimately, navigating uncertainty and financial markets such as those we face today, which are highly uncertain, I think requires a fundamentally different mindset. It requires you to stop worrying about generating dots and start worrying about connecting them. Stop worrying about developing really deep, deep, deep information, and instead, start worrying about connecting the information and developing breath of insight. Macro becomes more important. And I think what you ultimately have to do is take a step back and zoom out to see the big picture. It's becoming increasingly relevant. And I think in times of heightened uncertainty, it's really that approach which can give you some possibility of navigating successfully.