Transforming personal finance since 2011

#14 — Reasons we might not be heading for a crash...

October 17th, 2016

By Andrew Craig

Reading time: ~ 7 minutes

Last week I wrote about the many reasons we may well be headed for a big stock market crash. At the end I wrote: “Next time I will … talk about how you might consider investing given what is going on.”

So here are some follow up thoughts:

The first thing I will say is... drum roll... I really have no idea what is going to happen.

Crucially, however...neither does anyone else, whether politician, central banker, investment banker, economist or taxi driver (I would suggest that this list is roughly in order of the fundamentally misguided level of confidence each of those groups have in their ability to predict things).

In the last article, I would like to think I produced a reasonable amount of evidence for why the stock market looks poised for a significant correction. Towards the end, however, I introduced two themes which could well drive stock markets even further up from here. As a reminder these were:

  1. A discussion around nominal vs. real numbers.
  2. The idea that technology could save us this time.

Let’s look at these in turn.

1. Nominal vs. real numbers

The difference between nominal and real numbers is something I have found to be very poorly understood by many people. Put simply, the difference between nominal and real prices (e.g. stock market levels, house prices and so on) is that nominal does not take account of inflation (either at all or, more frequently, sufficiently accurately) and real does.

I have written in the past about how people suffer a thing called money illusion where they fail to account for real inflation when thinking about what the change in the price of something has been.

As a simple example: If the price of your house has increased tenfold (in terms of pounds) over the course of, say, twenty years, you have not actually grown your wealth at all in real terms if the price of everything else in your life has also gone up by a factor of ten (eggs, pints, cars, flights, clothes etc…). All that has happened is that the value of pounds (or dollars, euros or yen, for that matter) has gone down by a factor of ten. (Of course house prices in many places have gone up a great deal in real terms in recent years but not nearly as much as you think in real terms if you are taking account of real inflation).

Similarly, if the stock market has ‘doubled’ over a period of time where the value of the money it is measured in (pounds or dollars for e.g.) has halved, then the stock market is actually flat in real terms – i.e. it hasn’t budged at all.

It should be noted that in these two examples you will have been better served by having your money in property or in the stock market than in cash. In the first example – your house has preserved your real wealth vs. holding cash (where you would have lost 90% of it) and in the second example, the stock market has also preserved your real wealth vs. cash - where you would have seen your real wealth cut in half.

In my experience, people find this whole concept very hard to grasp but the phenomenon is very real and crucial to understand if you want to succeed financially over time. Measuring things over the medium to long term using any fiat currency is like using an infinitely elastic ruler.

“Why is this relevant to whether there is a stock market crash or not?”

The answer is that stock markets may continue to ‘go up’ in nominal terms. Central banks all over the world are inventing money out of thin air, much of which is ending up in the stock market (as I wrote about last week). This devalues the money but drives the nominal level of the market up, all other things being equal.

If you understand this, you will see that a rising stock market is potentially something of a zero sum gain - i.e. it goes up but the value of the money it is priced in is going down so it doesn’t mean much in real terms.

I would argue that this is what has been going on for the last few years to a certain extent. Very few people understand this – which is why they say things like ‘cash is king’ or ‘the stock market is risky’. Whilst central banks continue to invent money out of thin air and buy up vast quantities of assets these statements will continue to be 180 degrees incorrect: Cash will continue to lose its real value at speed, and the stock market will continue to ‘go up’ (in nominal terms). If you are not invested, your wealth will get more or less rapidly destroyed. This is why I am so against cash ISAs which get you absolutely nowhere financially and see them as inherently ‘riskier’ than the stock market for this very reason.

2. Technology to the rescue…

The second, and slightly happier theme, is that technology might save us. When the stock market went up to ludicrous levels in the boom of the late nineties, a large proportion of that “value” was based on truly science fiction ideas of the value of hundreds, if not thousands of early stage technology companies that contributed to that stock market boom.

The valuation was science fiction because none, or at least very few, of these companies were making any actual profit. Today the technology and biotechnology companies which have been a big part of the performance of the stock market in recent years (Google, Apple, Amgen, Gilead, Novartis and many others etc…) make billions in profits (as compared to losing billions like last time around). You can argue that they may still be overvalued (hence a possible correction) but the fact remains that today’s stock market valuation is hung on a much higher level of profitability and genuine wealth creation than it was in 2000.

…and this situation may very well be just about to get even better as we make giant leaps with robotics, green / clean energy generation, electric cars, self-driving cars, advanced construction techniques, new aviation and space technologies and, my old favourite (given it is the sector I work in every day) – truly amazing advances in medical and bio-technology. The list goes on and on. Might we actually be at some kind of wonderful tipping point in the history of human development? This is certainly a happier thing to focus on than Trump, Clinton, Brexit, Syria and all of that ‘orrible and depressing noise that our papers and broadcast media seem determined to focus on every day.

In pictures - you might argue that most of us think we are here:

…but there is increasing evidence that we might actually be here:

source: Wait But Why

…in which case all bets are off and the stock market will continue to be the biggest mechanism for human enrichment we have ever invented (as it has been for about 300 years already).

This is certainly a happy thought even if we might endure some volatility along the way.

Having said all the above, I now come to my most important point in terms of how to think about all of this and how to invest on the back of it all.

I have already said that I have no idea what is going to happen. I don’t have a crystal ball. I can see reasons why markets will carry on to the moon - in nominal terms at the very least given the actions of central banks, but even quite possibly in real terms given the potential explosion in technological progress we may be just about to enjoy. I can also see the scope for stock markets, bond markets and property markets the world over to get absolutely smashed at some point reasonably soon as I outlined last week.

Here I am - just like every other financial commentator sitting annoyingly and squarely on the fence and failing to add any value (boo!). BUT… Here is where I come to the most important point. Are you ready for this?

I don’t really care what is going to happen and neither should you.

By which I mean:

I can arrange my financial affairs such that I am comfortable that whether there is a massive crash or whether stock markets power ahead, my ability to meet my longer-run financial goals will be largely unaffected.

You should feel comfortable you can do this too.

Given that this piece is already running longer than usual, I will explain why this is in more detail next time…  Please watch this space.   For now,  please don’t hesitate to get in touch with any questions or thoughts and don’t hesitate to forward or share these thoughts with anyone you think might find them interesting or benefit from sorting their finances out (i.e. most people!).