Investment Pros: Clock Ticking on Bubble Markets
By the Curmudgeon with Victor Sperandeo
For this Memorial Day weekend, we forego our unique comment and analysis save for Victors Conclusions. Instead, we include excerpts of recent reports which I hope youll find valuable and of special interest. The major theme throughout is how unusual the last 14 months have been for both pandemic policy responses (Fed and U.S. government) and the frothy financial markets.
Readers are urged to consider if this is the new normal and all of financial history has been repealed? If not, caution and risk control are now more important than ever.
Excerpts from Noted Professionals:
Steven Roach, The Ghost of Arthur Burns
The Fed poured fuel on the Great Inflation by allowing real interest rates to plunge into negative territory in the 1970s. Today, the federal funds rate is currently more than 2.5 percentage points below the inflation rate (i.e., negative real interest rate). Now, add open-ended quantitative easing some $120 billion per month injected into frothy financial markets and the largest fiscal stimulus in post-World War II history. All of this is occurring precisely when a post-pandemic boom is absorbing slack capacity at an unprecedented rate. This policy gambit is in a league of its own.
Sentiment Trader (via email):
Now that there has been a spike in inflation gauges, the earnings yield on the S&P 500 has turned negative. This is not a condition that investors have had to tackle much over the past 70 years.
When an investor in the S&P adds up his or her dividend check and share of earnings, then subtracts the loss of purchasing power from inflation, he or she is barely coming out even. This is a record low, dating back to 1970, just eclipsing the prior low from March 2000.
If we ignore dividends, then there have been five other times when the S&P 500's inflation-adjusted earnings yield turned negative. The S&P failed to rally more than 7% at its best point within the next two years after all but one signal.
Steve Blumenthal of CMG Capital Management Group (via email):
If valuations were better and interest rates higher today, wed have less reason for concern (think 2009). Of course, that is not the case at this particular moment in time. Note the spike in valuations over the last year in this graph:
Keith McCullough of Hedgeye (via email):
In case you didnt already know, being permanently bullish (or bearish) on Stocks, Gold, Bitcoin, etc. is how many (if not most) fund managers get paid. They have no repeatable investing process. Its all about asset gathering and marketing. Gather assets or fade away into the sunset
Allianz Global Investors' Head of Global Strategy Stefan Hofrichter: "As we have seen, most but not all of the criteria required for bubbles are waving red flags, and there are many similarities between the current period and the tech bubble of the late 1990s."
Investor psychology at the moment leads Hofrichter to believe stocks are in a bubble right now. He said there is too much optimism around the degree of economic growth in the years ahead, evidenced by the bullish earnings expectation revisions for some tech firms over the next three-to-five years.
"All financial bubbles in history took place against the backdrop of 'easy' financing conditions provided by central banks. In that respect, this bubble indicator is clearly present today. Central banks have not only cut rates close to zero or even lower but they have flooded the system with levels of liquidity that are unprecedented in peacetime."
Stanley Druckenmiller, USC Student Investment Fund Annual Meeting Keynote: Why do I say this period is so unique?
Well first of all, the COVID-induced decline that we experienced last spring was both violent and abrupt, and, to put it into math terms, we had five times the decline in the average recession in 25% of the time. Think about that.
Monetary and fiscal policy response to that was equally unprecedented. It's not pleasant to remember back last spring, but if you think about that period, I think we were all terrified that we were experiencing a potential black hole, not only in our lives, but the but the in the economy itself with potentially catastrophic circumstances consequences.
If you look at the policy response it was extremely aggressive, led by the Cares Act. In three months, we increased the government deficit more than the last five recessions combined.
If you added up all those recessions effect on our budget, and the size of the budget deficit, combined, they do not equal how much the budget deficit increased in three months last spring.
The Fed response was equally aggressive and unprecedented, they did more QE in six weeks last spring, than they did in the entire period from 2009 to 2018. Which was unprecedented in and of itself, and a lot of people were questioning the size of that.
The peak month during that nine-year period was when then Fed Chairman Ben Bernanke did $85 billion in QE, we're still buying $120 billion (per month) in securities well after the six weeks that I talked about.
The final thing that happened last spring was the Fed crossed a lot of red lines in terms of what they would backstop in terms of the corporate debt. Also in the municipal market.
The results were very emphatic: corporations increased their debt in a recession by over a trillion dollars in response to the Fed backstopping that debt. I dont believe its ever happened before.
Just to put that into perspective in the great financial crisis, they shrunk their balance sheets $500 billion, which is much more consistent with historical activity.
The good news is this resulted (I'd say pleasantly surprisingly) in a very abrupt and strong recovery. And in that context, it was a good risk reward to enact policy expecting a deep and protracted recession in the spring of 2020. It worked. It was dynamic, it was bold.
However, a lot has changed since then. By the fall, the outlook had already brightened considerably, and policy makers continue to accelerate fiscal deficits; they are going to reach 30% of GDP and just under two years.
This is a chart of the cumulative fiscal deficit from the start of the recession, of all the recessions mentioned earlier, since 1980:
The top five lines are the four recessions that preceded this one. The black line represents all those added up together. Remarkably, the red line is what we're doing in 2020 and 2021.
Again, the boldness of what they did and the beginning of that chart when you'd say first five or six or seven months, makes a lot of sense. But what's very surprising, is we're continuing to double down on these policies, even after it's quite apparent, you've had a very strong recovery in the economy.
The Feds easy money printing is almost two times all previous fed incursions into money printing.
The Fed is constantly
reminding us of monetary policy ads with long and variable lags.
· Why, then, is the Fed still providing emergency financial conditions when their recoveryas I've shownis in full acceleration?
· Why is the Fed buying $40 billion in mortgages a month, when we are clearly running out of housing supply?
· Not only is the Fed still providing record amounts of accommodation; it is promising not to raise rates until after 2023. Even when the recession is already over.
· If the Fed raised rates in the first quarter of 2024, as indicated, it will be 41 months after recovering 70% of the drawdown and unemployment. That was the chart I showed with the red line earlier.
· What do you think the average number of months is before the Feds first hike after a 70% employment recovery in the post-war period? Chairman Powell is predicting 41 months before Feds first rate hike.
· What do you think the average after that kind of recovery has been since World War Two? Four months. Four!
· And according to the Chair, they are not even thinking about ending $120 billion a month in bond purchases. Simply put, the fastest and strongest recovery from any post-war recession is being met with the Feds easiest response on record by a mile. Policymakers say, We need to go big to avoid downside risks and avoid this stagnation experienced after the great financial crisis.
· But as
I have shown, comparisons with the great financial crisis are completely
What about the risks of financial stability? The worst economic periods of the last century have followed the bursting of asset bubblesthink the 1930s after the 1929 bubble burst and think about the great financial crisis after the housing bubble burst.
With Dogecoin, which was started as a joke, with a $60 billion market cap, and they have NFTs (non-fungible tokens) on everything you can spell out there, is there any doubt in anybody's mind that we are in a bubblenot to mention the stock market, and the GDP is well above any level that we've seen in the past century?
What about the risk of fiscal dominance and loss of our reserve currency status? Foreigners have started to lose confidence in the U.S. dollar as theyve aggressively sold U.S. Treasuries in the last year. Thats reflected in this chart:
Asians and others have been purchasing Chinese assets. China has not done QE and provided much less fiscal stimulus in response to COVID. Yet Chinas economy and markets are doing just fine while the Yuan has appreciated.
China represents 20% of world GDP, but only 1.6% of global portfolios. The U.S. represents 25% of GDP, but 28% of world portfolios. Do you think those ratios will now change?
GMO Quarterly Letter: Speculation and Investment, by Ben Inker:
Speculative booms provide both entertainment and outsized profits while they are happening, but they do generally burst painfully. This is particularly true in equity markets, where the demand growth is ordinarily met with increased supply from savvy capitalists. Maintaining excess demand in the face of growing supply becomes ever more difficult and eventually proves impossible.
In this cycle, the supply growth (see chart below of U.S. equity issuance) is particularly impressive in both its scale and the flexibility it has to migrate wherever speculation is most rampant. That does not seem like a good sign for an extended continuation of this boom. Whether the end means a fall for just the more speculative end of the market, or the market as a whole is harder to predict at this point, although even if the rest of the market holds up for now it will require a difficult economic balancing act to keep it aloft indefinitely.
U.S. EQUITY ISSUANCE AS PERCENT OF U.S. GDP:
Issuance doubled as a percent of U.S. GDP at the height of the internet bubble, but the recent burst has been even more impressive. Not only has the last year seen the highest level of issuance since the data Im using began, it did so from what had been desultory levels over the previous half decade.
The U.S. stock market of 2017-2019 may well have been quite expensive relative to history, but it didnt show many of the other classic symptoms of a speculative bubble. That has now changed.
As striking as this burst of issuance is, Id argue that the form of the issuance this time is particularly laser-focused on giving speculators what they hunger for. SPACs, among their other interesting features, give their promoters the ability to create more of whatever type of stock is coveted in the market with impressive speed. And while it is easy to say that the burst in SPAC issuance in recent months is unprecedented, lots of things are unprecedented.
What makes speculative bubbles distinct is that the investment side of the equation becomes an insignificant driver of transactions, with both the rationale for trades and participants expectations for returns from them driven overwhelmingly by speculation.
Well have rising consumer prices in the U.S. through at least the end of July. The market knows that and that real interest rates are deeply negative (as per Steven Roachs comments above). While the Fed is concerned that tapering or raising rates might cause a market crash, it has recently been draining extra cash in the repo market.
Reuters reports that the amount of money flowing into the Feds reverse repurchase (RRP) facility [1.] hit an all-time high of $485 billion on Thursday, further repressing key short-term interest rates, which risk falling below zero. Cash-heavy financial institutions have been loaning money to the U.S. central bank overnight at 0% interest in increasing amounts since March.
Note 1. The Fed launched its reverse repo program in 2013 to soak up extra cash in the repo market and create a strict floor under market rates, especially its Fed Funds policy rate.
This move by the Fed is to show the world that yes, they do care about too much money printing! But this is just a signal. If they keep rolling the reverse repos theyll be draining liquidity, which will have economic effects. The Fed can end this drain anytime so the markets will be watching! Beware of the Fed trying to look good to its critics.
A market does not culminate in one grand blaze of glory. Neither does it end with a sudden reversal of form. A market can and does often cease to be a bull market long before prices generally begin to break.
Jesse Lauriston Livermore
Stay safe, be healthy, take care of yourself and each other, and till next time
Follow the Curmudgeon on Twitter @ajwdct247
Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.
Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.
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