The boom in credit in all its forms may foreshadow a run up in share prices.
Are we about to enter a stock market bubble?
Charles P. Kindleberger, in Manias, Panics and Crashes, a book about financial crises, says that all bubbles are due to 'loose credit' or when it is easy to borrow money.
Arguably, loose credit has already caused speculative mania in some asset classes, notably residential housing.
There is also a good argument that the boom in the price of commodities is partly down to speculation funded with borrowed money. In support of this view, last week, a hedge fund, Amaranth Advisors, said that it lost $6 billion betting that the price of natural gas would rise, when it fell.
The ease with which companies and individuals can borrow money is partly because of new-fangled instruments that financial institutions trade between themselves, called "credit derivatives".
One of the effects of such instruments has been to allow banks to get loans off their balance sheets, so freeing up resources to lend more money. This is one reason why it is so easy to get a mortgage these days. Another effect of them is that, should a downturn occur, the big banks like Barclays
(LSE: BARC)
and HSBC
(LSE: HSBA)
may not suffer as they have done in the past.
Booming borrowings mean a number of things to stock market investors, including:
- Companies can afford to borrow more, making their balance sheets "leaner". This could mean that companies can achieve better returns on equity and therefore returns to shareholders. One example of a company taking advantage of this is Vodafone
(LSE: VOD)
which recently issued a large number of bonds. Unfortunately, high levels of gearing can also mean businesses are more susceptible to a downturn.
- The ease of borrowing means share prices should rise because because private equity firms and other companies are finding it easy to raise money to finance acquisitions. An example, is Ferrovial
(LSE: GRF)
, the Spanish transport group, that recently acquired BAA, the company the operates Heathrow, Stansted and Gatwick airports.
- Private investors can also take advantage of this boom in borrowing. Both spread betting and contracts for difference are two of the ways for private investors to gear up, increasing the possible gains, but also their losses.
Of course, a borrowing binge has a downside. If asset prices fall, banks start to call in loans and speculators can find themselves insolvent. This can turn into a contagion that spreads to the banks bringing the entire financial system to a stand-still.
But perhaps crashes will be few and far between these days. Timothy Geithner, president of the Reserve Bank of New York, and one of the luminaries who watches over Wall Street said on September 15, that the new financial instruments may increase the resilience of the financial system because they spread risk. But, he warned, when they go wrong shocks to the financial system may be even more devastating.
At the moment, the speculative mania for some asset classes has not spilled over into the stock market. This means the stock market is undervalued compared to alternative homes for an investor's cash, and should provide better returns.
Paul owns shares in Vodafone.
