The Golden Century is the name of the period in Dutch history between 1600 and 1700 when the port city of Amsterdam was one of the richest of all cities in Western Europe due to its strong role in international trade. Many commodities crossed Amsterdam’s ports, including tulips. Tulips were first introduced to Europe from Turkey, and shortly thereafter, in 1554, these seeds were sent to Amsterdam, where their popularity began to rise. A rudimentary derivatives market in the early 1600s eventually arose so that traders could conduct trade in tulips year-round. Traders entered into tulip contracts by signing contracts for future tulip purchases. The very active tulip contract market eventually became an integral part of the overall booming Dutch tulip industry. Tulip bulb speculation even spread to exchanges in Paris and England. As the popularity grew, investors bid up the price of tulips to an extraordinary level. At the peak of what is known as “Tulip Mania,” some single bulbs sold for more than 10 times the annual income of a skilled crafts worker. In the winter of 1636-1637, the rapid ascent of tulip bulb prices ended abruptly as a default on a tulip bulb contract caused a violent market implosion as sellers overwhelmed the market and buyers virtually disappeared altogether. Within a few days, tulip bulbs were worth only a hundredth of their former price. Tulip Mania is generally considered to be the first recorded financial bubble.
At this point, you may be wondering what this story has to do with current financial markets. In our opinion, there does not appear to be excessive optimism, which generally coincides with most financial bubbles. However, we do feel irrational behavior is starting to appear in certain areas. One of these areas that has seen widespread news coverage and popularity is the crypto currencies, which act as a digital asset and digital medium of exchange. Bitcoin, the most popular crypto currency, utilizes disruptive block chain technology and seems to have relevance in an era of constant central bank stimulus, which makes its rise in price and popularity hard to question. However, upon further inspection, investor optimism may be misguided. Recently, the Wall Street Journal published an editorial about Bitcoin which contained some sobering data. Thomson Reuters GFMS estimates there were 2,155 metric tons of gold held in exchange-traded funds. If all of that were switched into Bitcoin, it would justify a price of about $5,500 for the 17 million Bitcoins currently outstanding. This is only about $500 from the $5,000 high Bitcoin reached in early September. Investor optimism is so high that the commonly traded “Bitcoin Investment Trust” recently traded at a level of 2 times the underlying net asset value of actual Bitcoin held in the trust! This would be the equivalent of paying $2 for a $1 bill.
The Federal Reserve and global central banks have worked in overdrive the past 9 years trying to mend the global economy after the Great Recession with measures such as quantitative easing, zero interest rate policy, and even negative interest rate policy in some parts of the world. While growth has been steady, it remains tepid, and inflation has been below target. Despite unprecedented monetary stimulus, developed markets have remained subject to deflationary pressures brought on by an aging population, lower productivity growth, high debt levels, and stagnant wage growth. We believe this prolonged period of monetary stimulus and zero interest rate policy has led to some complacency amongst investors. Risk does not appear to be appropriately priced in many areas of the market. Earlier this quarter European high-yield corporate bonds, which are below investment-grade bonds, traded at a lower yield than similar maturity U.S. Treasuries, which are backed by the full faith of the U.S. government. This does not make any sense to us at all and is likely a byproduct of the European Central Bank’s bond buying, which has distorted asset prices. Similarly, allocations to equities continue to increase as investors search for higher returns in a low yield environment. The opportunity set in U.S. equities is becoming less attractive with measures such as price to sales, market cap to GDP, and many others showing U.S. stocks being priced at some of the highest valuation levels in history. The Federal Reserve has embarked on its quest to normalize monetary policy by continuing to raise the federal funds rate and beginning its balance sheet reduction. We expect both of these measures to occur at a slow pace. However, as this normalization occurs, it is very possible that volatility in financial markets will increase from the historic lows we see today.
Throughout our 60+ year history, we have taken pride in navigating financial markets and working with our clients to help them achieve their goals and objectives. Our commitment to our investment philosophy and approach is as strong today as ever. We continue to favor high-quality companies with strong balance sheets, durable cash flow streams, and strong competitive advantages. In our opinion, investors are not being compensated appropriately to go out on the risk spectrum. Our valuation discipline helps guide us when determining what price we should pay for these high–quality businesses. We feel it is important to convey that today’s opportunity set and low interest rate environment likely warrants lower future investment return expectations. This could include periods of higher cash balances as we patiently wait for investment opportunities to present themselves and seek to protect capital. Helping our clients determine the correct asset allocation and staying disciplined when it is tempting to chase markets higher will likely lead to better long-term outcomes. Thank you for your continued trust and confidence in our firm.
Gamble Jones Investment Counsel