Chris Johns: Is this time really different for stock markets’ bull run?

It is beyond cliché to point out that the most dangerous words in finance are: “This time is different.” But, like many a cliché, it happens to be true.

There are numerous examples of claims about difference preceding a stock market slump or any one of several types of financial crisis. Perhaps the most famous of all is the claim of the renowned economist Irving Fisher that "stock prices have reached a permanently high plateau" just before the 1929 crash. Despite many justifiable claims to greatness – he really was a fantastic economist – his legacy was forever tarred by one foolish forecast.

The recent boom in stock prices worldwide has taken markets into nosebleed territory. That means equities have, in lots of cases, reached valuation levels that, in the past, have typically suggested one thing: sooner or later, we will see a big fall.

On cue, we see numerous explanations advanced as to why things might be different this time. One idea is based on the observation that firms don’t invest so much these days in plant, machinery or buildings. Old-fashioned concepts of capital fail to encompass the fact that much economic activity today is “weightless”: businesses are all about idea generation that leads to an accumulation of intangible capital. Hence, the old rules about equity valuation don’t apply.

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Tech giants

The big tech companies today, for instance, have valuations many times the total worth of the physical stuff they own. Most of the worth of Google, Facebook and Apple is tied up in the value of computer code and the knowledge carried around in the heads of their employees. How do we measure that? Nobody really has a clue. The stock market has an answer: it's worth more. More than yesterday, at least.

Historically, company earnings ebb and flow with the business cycle but tend, over time, to track economic growth. Nowadays it seems that corporates have discovered financial alchemy: earnings that grow way in excess of GDP

A related idea focuses on the slightly arcane accounting topic of depreciation. Historically, accountants take what a firm invests and devalues it through time: depreciation reduces the worth of a company as equipment wears out.

What could be different this time is that depreciation no longer works like that for many knowledge-intensive firms, those with large amounts of intangible capital. Perhaps that knowledge retains its value or even increases through time – a kind of negative depreciation that boosts rather than detracts from profits. Modern accounting practices are nowhere near up to speed measuring this kind of thing. Maybe the stock market is ahead of the accountants.

One thing that is certainly different is the level of profitability of many firms around the world. Equity markets were, as usual, the first to notice that the world economy is booming. And profits have broadly followed suit.

At the end of 2016, when most forecasters were pretty gloomy about prospects everywhere – there was lots of talk of secular stagnation – US profits, for instance, started to take off. The most recent numbers suggest that US corporations are growing their bottom lines at a 15-20 per cent clip.

Analysts have fallen over themselves to catch up and now expect profits at the end of this year to be up 25-30 per cent compared with the end of 2017.

That kind of profits growth ties the Davos crowd up in knots. While personally enriched by higher equity prices, they also know that the corollary is stagnant wages. Much virtue signalling has been the result but little has emerged about what could be done about this.

UK shadow chancellor John McDonnell – a self-described Marxist – turned up this week at the Swiss ski resort to point out that the rising tide is far from lifting all boats and that he would be putting taxes up as a result. One tax he promised is a "Robin Hood" levy on financial transactions. Winston Churchill, no socialist, once opined that he wished he could make "finance less proud". I suspect McDonnell will have as much success with his project as did Churchill.

Financial alchemy

If profits continue to grow, taxed or otherwise, at anything like the current rate currently (let alone at the rates forecast by analysts), it will be further evidence that something is really different this time. Historically, company earnings ebb and flow with the business cycle but tend, over time, to track economic growth. Nowadays it seems that corporates have discovered financial alchemy: earnings that grow way in excess of GDP.

One day something will come along to derail the markets. The list of usual suspects can be rounded up Casablanca style: Trump; Brexit; North Korea; and the disappearance of any impetus to tighten up on financial regulation.

The profits renaissance coincided with the election of Trump. Markets worried for a while about his promised trade war but then cheerfully assumed it was all hot air.

The recent weaponisation of the US dollar could be the start of that trade war in an unexpected form. The Trump administration’s successful devaluation of the dollar is playing with fire. If it continues, it has the capacity to ignite the next crisis. That’s not to forecast one, but trouble is certainly brewing in the currency markets.

Excess profits are at the heart of populism. They can be brought down by recession, competition, taxation or pitchforks. It will be interesting to see which mechanism prevails.