Bubbles and opportunity costs – A case of “Know Your Risks”.

In moments of crisis and isolation like the present, we tend to think about human nature, and – why not? – that of investors, and analysts.

Every age, every situation, has its pathological pessimists, incorrigible optimists – and realists. But in times of crisis like the present – likely to be the worst in a century for global growth with the exception of two world wars – we see the emergence of one more, somewhat anomalous, market personality: the hyper-optimistic “cheerleader”.
We have nothing against optimism ! We have nothing in principle against always betting positively on the future of asset prices – but we do think the mask we are currently forced to use to cover our nostrils and mouth should not be extended to cover our eyes…

We have written many books, about how history repeats itself in times of financial meltdown. We found that after an asset bubble burst (example: earlier this year), the monetary authorities usually make the same mistake of planting the seeds of the next bubble – which will in turn burst, with further heavy burdens on the real economy.
Faced with evidence of previous crises, however, economic and financial agents come up with the same cry:
“This time is different”.

This time, it does not seem, to us, to “be different”.

This present essay at no time seeks to convince any investor not to surf on a pleasurable wave, such as some say may be forming on stock exchanges’ horizons, generated by the monetary easing (QE) provided by the US Federal Reserve, the European Central Bank and the Bank of Japan. But it becomes imperative that the professional investor, and also beginners, should have fully in mind the risk they are running.

In Brazil, one of the main arguments for investors’ attraction to stocks amid the pandemic is that the basic (Selic) interest rate is extremely low, so that it’s time, once again, to run risks – as if the pandemic has not influenced, or will not influence, the cash flows of various listed companies.

Standard theory tells us that in applying DCF (discounted cash flow), the interest rate that is appropriate as proxy for opportunity cost is the one determined by ke or WACC. This paper does not aim to demonstrate these methods. What we focus on is the major fallacy – perhaps opportunistic – of many advisers when they point to the basic Selic rate (in Brazil) as part of opportunity cost: the risk-free rate.