American sucker

American Sucker tells the true story of David Denby, the New York film critic, who got a little too caught up in the late 1990s tech bubble. After splitting up with his wife in early 2000, Mr Denby liquidated most of his family’s assets and invested them in tech stocks. With prices rising rapidly, he became completely obsessed with the ‘new economy’ boom – religiously watching CNBC, attending conferences, and striking up personal acquaintances with Henry Blodget (the former Merrill Lynch tech analyst) and the biotech entrepreneur Sam Waksal (who was eventually jailed for corruption). Like the Titantic movie, the ending is entirely predictable – he loses a fortune – but the book still provides a valuable insight into asset bubble psychology.

As the market began to fall, Denby was convinced it would bounce back. Occasionally it did, but not for long. So he hung onto his tech stocks until the very end of the downturn, by which time many of them were worthless. Unfortunately, he couldn’t accept the market was largely a bubble because he could see evidence of the ‘new economy’ all around him – computers were everywhere and communications were changing rapidly. In some ways of course, he was right. The data show the US economy genuinely changed in the late 1990s – unemployment fell dramatically without triggering rampant wage inflation, productivity accelerated significantly and, once companies focused on exploiting all the efficiency gains (ironically, after the bubble had burst), profits eventually reached a record share of national income. But, as in many bubbles, the market took an idea with some fundamental basis and simply got carried away.

While such excesses are no longer obvious in equity markets, Macro Maestro thinks you can see signs of this bubble mentality in other markets – notably the bond market. Right now, it is certainly hard to get too worried about inflation. Most major economies are running large negative output gaps and Asian exporters, concerned about maintaining market share at a time of low growth and a weak dollar, are still cutting their prices in the West. But the absence of high inflation does not imply – as the bond market seems to be assuming – that deflation is inevitable. Yet, a US ten-year yield of 2.5% seems to be pricing exactly that. And more subtlety, the momentum (and commentary) in the market seems to suggest investors are buying bonds purely because they think yields will continue to fall. This is the same basic psychology behind all bubbles and it was certainly apparent in the late 1990s stock bubble. Bond investors should also remember, of course, the state of public finances in the US and UK. Surely these warrant some kind of risk premium on the paper they are buying?

Macro Maestro doesn’t expect global deflation, but he does see another 12-18 months of weak growth and low inflation. This alone will generate significant volatility in financial markets. Most investors currently seem to have a bimodal view of the world - they are asking only whether we face deflation or inflation. As always, somewhere in-between these two extremes lies the most likely outcome. So, as the news fluctuates and investors' expectations flicker between these two scenario, asset prices will be volatile and there will be plenty of opportunities for the savvy punter to make money. (As long as they don't get drawn into dangerous momentum trades.)