"If [the] market cycle was a horror flick, this is the scene where everyone smokes dope and makes fun of their dead friend as they get the Ouija board.” -- John Hussman (Fund Manager) July 1, 2017
The longer something abnormal continues, the more normal and accepted it becomes. Terrorist attacks, war, Justin Bieber, kale consumption, Zumba…to name a few examples. Such things are often met with a cycle of shock, confusion, numbness and gradual acceptance. I often find myself marveling at the many abnormalities that have infected the financial world over the course of my career, but none are more outlandish than the major global central banks continuing to inject massive doses of stimulus into the financial markets 8 YEARS after the last crisis. The idea that unprecedented, massive global monetary stimulus would be required 8 years into a supposed recovery would have been met with shock and ridicule by many even at the height of the last panic. Somehow, 8 years on, it warrants little more than a shrug.
That this has coincided with one of the most overvalued stock markets in U.S. history should hardly be surprising.Yet, as has happened near the top of every prior stock market bubble, investors are once again attempting to justify why it’s different this time and why security prices are poised to climb ever higher.This justification has happened prior to every collapse in modern history.Every.Single.One.So, to argue that today’s nose bleed stock market valuation is destined to never deflate takes an incredible amount of hubris, a complete disregard for history and a naïve misunderstanding of math and human psychology. Reasonable people can debate how long a bubble, panic or economic cycle can last, but anyone who believes that business, economic or market cycles have magically disappeared is delusional. I warned of this very same myopia prior to the last two collapses.
This piece will focus on the granddaddy of bubble blowers, the Federal Reserve and its international sidekicks. The ivory tower academics that run these institutions have their own form of myopia. Incredibly, they claim credit for economic/financial improvement while disavowing any responsibility for panics, recessions or economic crises. They are the invincible, narcissistic teenagers of the economic world, and we’ve left them home alone with a fully-stocked bar and the keys to the car.
The Very Visible Hand
If you want to understand why the U.S. equity market is now in its third bubble since 2000, you don’t have to look any further than central bank stimulus, debt growth and multiple expansion. There are other unique factors at play which are contributing to this bubble and will ultimately exacerbate its demise, but monetary stimulus, debt and valuation are the primary culprits. Today’s focus is on the central banks. The chart to the left shows the growth in our Federal Reserve’s (Fed) balance sheet. You can see that Quantitative Easing (QE) began in late 2008 and ran until October 2014. Over this period the Fed conjured about $3.7 trillion in new money out of thin air and used it to buy bonds in the marketplace.
The leaders of the Fed believe that such action was necessary to initially stem the financial panic and then to support their mandate of balancing full employment with moderate inflation. Their actions also served to help recapitalize the banking sector. From their rhetoric, they seemed to perceive little risk or downside to their actions. They believed that they were helping to reduce interest rates which would help borrowers repay their debts and help companies borrow to invest in economically productive projects while also helping banks rebuild their balance sheets. Sounds reasonable.
Unintended Consequences
My contention from the start was that QE would ultimately lead to numerous unintended consequences. By buying high-quality Treasury and mortgage bonds, the Treasury reduced the available supply of those securities and bid up their prices, thereby reducing their yield (amount of interest they paid investors). Investors in need of fixed income were, therefore, gradually forced to buy ever-riskier securities in order to generate adequate income. This led to increased demand for junk bonds, lower-quality sovereign debt and dividend-paying stocks. You can think of this as trickle-down Fed stimulus. Thus, one of the key consequences of QE has been to push investors into riskier securities than they would traditionally have bought. The demand for ALL securities has, therefore, been artificially inflated. Just before the last crisis, you could go to your bank and buy a 6-month CD with a yield of 3.5% (see chart above). Today, you’ll get just over 0.50%. To generate any real income today, seniors must take much more risk than they’ve ever had to historically.
Another unintended consequence has been the life support provided to zombie companies. These are companies that had huge debt loads during the last downturn and by all rights should have gone out of business. Instead, investors have piled into the market for risky debt, enabling these zombie companies to refinance their debt, lower the amount of interest they pay and stay in business. The chart above shows the historical yield on European junk bonds (this is a global issue). You could buy these bonds with a yield of over 20% during the peaks of the last downturns. Today, you get a record low yield of 2.49%. There is no way investors are getting compensated for the risk they’re incurring with these bonds. In a normal economic downturn, these companies would either be liquidated or the equity investors would take a huge loss and the debt would be restructured. This would help clear the dead wood from the economy and serve to recalibrate investment expectations. It would also reward the prudent competitors with increased market share and better investment opportunities. These economic rules have largely been artificially suspended this cycle. As Jim Grant put it, “Capitalism without financial failure isn’t capitalism at all, but socialism for the rich.”
Corporations and the stock market enjoyed another unintended consequence of QE as low interest rates and a weak economic recovery encouraged companies to borrow money and buy back their own stock. With the Fed distorting the natural business cycle and with revenue growth
unimpressive, it isn’t surprising that corporate America has been hesitant to invest in their own businesses. Besides, why take the risk of pouring millions into a new production plant with uncertain future returns when artificially low interest rates allow you to borrow millions of dollars at little cost and buy back your own company stock? This reduces the number of shares outstanding and boosts earnings per share (EPS). A rising stock price and higher EPS are two key components in many corporate bonus calculations. It’s hard to blame managements for playing this game if Boards of Directors incent them to do so, but buying back overvalued shares unfortunately destroys long-term value for shareholders.
Another consequence of QE has been growing debt burdens at the sovereign level. As investors scour the investment universe for yield, they’ve bid up prices of sovereign debt around the world. I’ll offer two absurd examples of how extreme this has become. First off, Argentina just issued 100-year bonds. These are bonds which don’t mature for 100 years! Argentina, which has defaulted 8 times in the last 194 years (most recently in 2014 and 2001), just sold $2.75 billion of 100-year debt at an interest rate of just under 8%. There was actually $9.75 billion of demand for this $2.75 billion deal. The second example is the simple fact that we now have some governments that can borrow at a negative interest rate. You pay to lend them money. Think about that. It would be like going to the bank to take out a personal loan and instead of paying interest every month the bank pays you. This is all a result of investors chasing yield.
We’re not quite done yet. When interest rates are so low and money is so cheap, you can rest assured that many poor investments will be made that wouldn’t have been had the cost of capital (how much it costs a company to borrow money and issue stock) not been artificially lowered. Suddenly, every project looks like it has the potential to be a winner. One of the best examples we’ve seen over the years has been the incredible expansion of fracking and shale oil drilling, a relatively new type of oil drilling that allows oil companies to extract oil that they had to bypass in the past. While the technology itself is impressive and has increased the amount of oil available for extraction, the economics of most of these horizontal fracked wells is atrocious. Most are money losers, yet investors continue to fund them with cheap money. I would also strongly argue that current, high-growth investor-favorites like Tesla or Netflix would have found it much more difficult to fund their money-losing operations in a more normal capital environment.
The point of all of this is simply to illustrate that there are many ways in which the central bank stimulus of the last 8 years has distorted markets. This has hardly been a comprehensive list. Remarkably, the central banks themselves have primarily focused on the inflation rate and employment numbers as the scorecards for their policies. They believe they’ve done an admirable job. All they see is that the threat of deflation seems to have abated, the unemployment rate is lower and there hasn’t been a recession since 2009. The central banks have never been able to spot a bubble, in part because they remain stubbornly unaware that they have been the primary bubble blower. When the next downturn comes (and it will) we will see the true extent of the damage that has been done over these last 8 years, and there will be many surprises even for the most skeptical and concerned among us.
Stock vs. Flow
If you strongly believe, as I do, that central bank stimulus has created numerous bubbles and fostered massive malinvestment then you should be concerned about the reduction of that stimulus. This is where the concept of stock vs. flow becomes important. Stock refers to the amount of something outstanding while flow refers to the amount added or removed from the stock. Most central bankers believe that the stock of QE is the critical factor, but I couldn’t disagree more. It is the flow that matters most, and the larger the stock becomes the more flow is needed to have the same impact.
"There is no means of avoiding a final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion or later as a final and total catastrophe of the currency system involved." -- Ludwig von Mises
Recall from the chart on page 2 that the Fed ended QE back in 2014. The stock of QE has remained steady since then, but the flow has dropped to zero. If it’s the flow that matters, we might have expected the U.S. stock market bubble to have popped since then. The chart below does show that the U.S. stock market hasn’t done much since late 2014, but it certainly hasn’t collapsed.
To understand why the stock market hasn’t rolled over yet it’s important to realize that central bank stimulus isn’t limited to just the U.S. While Federal Reserve QE may have ended in 2014, other central banks have stepped on the gas pedal. Look at the next chart below. This shows the total QE from the central banks of the U.S., Europe, Japan, England and Switzerland. You can see the slight dip following the ending of U.S. QE in late 2014, but you then actually see an acceleration in the growth from early 2015. The following two charts show the path of QE for Europe and Japan. Europe stepped on the money-printing gas precisely when the U.S. stopped, and Japan has been a steady and voracious printer since 2013. Money isn’t limited by borders, so when other central banks create new currency, that money can be exchanged for dollars (or other foreign currencies) and used to buy foreign assets.
Some central banks have even resorted to less standard asset purchases. The Swiss National Bank (SNB) and the Bank of Japan have printed money and used it to buy equities directly. It has
been estimated that the SNB owns about $80 billion in U.S. stocks today (see chart to the right) and roughly $20 billion in European equities. That works out to about $10,000 in U.S. stocks for every person in Switzerland. The SNB now owns nearly 4% of Apple and about 3% of Amazon. The SNB boosted their holdings of U.S. stocks by about 25% in the first quarter of this year alone. They clearly are not concerned with fundamentals or valuation, and their actions have served to help prop up equity values…for now.
Summing It Up
QE has been the key driver of higher asset prices during this cycle. Prior to the 2008 crisis, the major central banks held roughly $4 trillion in assets. Today that figure stands at $15.1 trillion, about a 275% increase. This represents the amount of “money” that central banks have conjured from thin air to buy financial assets in the markets. You can think of this as an extra $11 trillion of newly-created money that has been funneled into the financial markets since 2008. The notion that these purchases haven’t had a profound effect on financial markets is simply ridiculous.
According to the National Bureau of Economic Research, the average length of economic expansion since 1945 has been just under 6 years. We’re supposedly in one of the longest economic expansions in our nation’s history, yet the Federal Reserve has only recently taken the most tepid steps to gradually raise short-term interest rates and has yet to start reversing QE.
The Fed was instrumental in blowing the bubbles of 2000 and 2007, but they remain blissfully unaware of the role they played. Today, it’s a global game. All of the major central banks have been busily inflating assets across the board for years, irrespective of value. Amazingly, they still claim that they aren’t able to spot bubbles. Perhaps when most asset classes are at bubble levels any one bubble becomes harder to identify. Nevertheless, the central banks have created and spent a lot of money to buy themselves a global asset bubble, but at what cost?
I strongly believe that the next downturn will dwarf the 2007-2009 experience due to the global nature of this cycle and the fact that we have a bubble in stocks, bonds and real estate in many of the major global markets. Low interest rates have also spurred a debt orgy globally which will be hard to service should interest rates rise even modestly. When a true panic starts, it is the value-oriented, fundamental investors (like us) who ultimately put the floor under markets. I can assure you that there is a huge gap between asset prices today and the levels they’d need to plumb before we start to salivate.
I’ve been discussing this slow-motion train wreck for a while now, all the time warning that this cycle could be one of the longer ones due to unprecedented global central bank support. The longer it plays out and the larger the bubble grows the bigger and more devastating the collapse will be. The Fed has ended QE (for now), made a few small moves at raising short-term interest rates and is now finally talking about trying to reduce QE later this year. If nothing else, the Fed seems to have finally realized that it needs to start stockpiling some dry powder for the next downturn. Other central banks are getting closer to raising short-term rates and/or reducing their own QE. It appears that we may finally be at a critical inflection point for global QE flows (again...for now). Less central bank liquidity coupled with rising short-term interest rates, bubble-level asset prices and massive debt loads makes for just about the worst investment environment that I can imagine.
Paul Singer is a well-respected hedge fund manager at Elliott Management Corporation. I think he sums it up well:
“Given groupthink and the determination of policy makers to do ‘whatever it takes’ to prevent the next market ‘crash,’ we think that the low-volatility levitation magic act of stocks and bonds will exist until the disenchanting moment when it does not. And then all hell will break loose (don’t ask us what hell looks like …), a lamentable scenario that will nevertheless present opportunities that are likely to be both extraordinary and ephemeral. The only way to take advantage of those opportunities is to have ready access to capital.”
If a crash does occur, we can certainly expect central bankers to rev up their QE engines again. It’s impossible to say with certainty what impact this will have, at least in the short term. The Fed aggressively eased (added stimulus) during the last two downturns, to no avail. Once investor sentiment turns negative, central banks struggle to stem the tide. More QE will, of course, ultimately mean more asset purchases. At the same time, however, the Fed and other central banks run the risk that the market will finally wake up to the fact that the central banks are themselves the primary creator of bubbles and are remarkably clueless when it comes to steering the economy. Central banks depend on credibility. Once this is lost, all bets are off…except for gold, silver, and precious metals equities. But that’s a story for another day.
Best,
Ken Bell, CFA, CFP, MBA
Aspera Financial, LLC
The Market Rubbernecker is associated with Aspera Financial, LLC, an investment management and financial planning firm based in the Cary, Raleigh, and Durham area of North Carolina. This and all Market Rubbernecker missives and musings (written, oral, or mimed) are subject to the disclaimers, disavowals, and hindquarter-coverings found at www.asperafinancial.com/aboutrubbernecker.