Too much capital, too little return

One thing I find strange about market corrections is how nobody seems to see them coming.

Markets reach what look like peaks. People talk about how we’re at a peak. Prescient folks suggest equities are overvalued, carefully avoiding calling it a bubble. And then, one participant in the global capital markets chain accumulates enough bad news to spark a selloff.

Talking heads are quick to blame interconnectivity of global markets, but the reality is globalization began when the Chinese, Vikings and Celts started navigating the seas.

What too many opinion leaders are ignoring, though, is the demographic realities that fuel bull markets and spark bears.

When you get right down to it, demographics drive economies.

In North America, the baby boom’s kept a firm hand on the stock market’s tiller for decades. The oldest of that generation, now 69, fuelled the ’80s bull markets and bounced back from the 1987 crash with sufficient exuberance to drive markets to the tech-fuelled peaks of the late 1990s.

When that bubble burst, boomers rebounded and it took the punishing losses of 2008 to push them to eschew markets for a year or longer.

What North America has in its boomers is the largest and best-capitalized generation in history busily chasing investment returns. All at once.

Throngs of them reached critical life stages (marriage, first home, children, etc.) in close proximity. They have also, on occasion, followed each other off cliffs, as they did during the 2008 selloff. Having survived two corrections, they presumed the third downturn was the big one that would wreck their retirements.

That, of course, would turn out to be their greatest collective financial mistake. Pulling out meant they sustained huge losses; and delaying a return to markets meant bottom feeders got all the bargains. Boomers are still struggling to make up losses right as the largest wave of the generation closes in on 65.

They’ve chased returns by flooding markets with capital, and pursued the only instruments capable of providing the returns they need to keep retirement dreams intact–stocks (particularly dividend payers), certain classes of corporate debt, and alternatives.

While low interest rates bear some of the blame for that phenomenon (fewer people would be chasing equities if they could get solid fixed-income returns), a financial system swimming in capital can’t risk making that cash too expensive to borrow. Adam Smith was right about supply and demand.

In that context, is it any wonder we’re seeing a correction? It shouldn’t be, and it’s also no stretch to expect the markets to punish expensive stocks–the same way they punished a lot of resource-linked issues (and the currencies to which they’re tied) when oil and other commodities prices started sliding last year.

A correction is defined as stocks returning to prices more in line with what the underlying companies are worth. That’s what we’re seeing now. It’s not a disaster, and it shouldn’t even been viewed as unexpected.

Further, prevailing low costs for capital, and declining energy prices that will make it cheaper to move goods, should eventually mitigate dips in the value of companies whose stock prices were pushed to artificial levels. The very factors giving these stocks a haircut will, in the end, preserve some of their market caps.

If investors can resist the temptation to march off the cliff in lockstep, and be patient about returns, a recovery in the U.S. jobs market should be able to do the rest for Canadian investors.

This article originally appeared on Advisor.ca.