We stopped a long time ago trying to understand today’s financial markets. Market commentators, both bullish and bearish, put forth authoritative outlooks of where the equity market is headed, complete with (seemingly) fundamentally-sound explanations. For some, this is an earnings-driven rally. For others, it’s a dangerous bubble as asset prices defy traditional valuations metrics. What is sure is that everyone will be eventually wrong, as no one can predict what will end the equity rally nor when it will happen.
In early 2009, there were very legitimate and believable reasons why the S&P 500 fell an additional -27% in the first seven weeks of the year (everyone knew that banks were insolvent and would soon become regulated like utility companies). And, as a result, in the following 45 weeks of 2009, the S&P 500 rose +66%. Today everyone knows that the central banks are incapable of raising rates and that the Trump tax cuts will boost company earnings and share buybacks.
In any case, we are confident that neither the White House nor the Federal Reserve will do anything to intentionally prick the asset bubble in equities. Trump will not talk down market (at least not intentionally) — he is too vain, basking in his stock market rally. Remember Trump, during the presidential campaign, saying at one of the debates that the stock market was in “a big, fat ugly bubble”, pointing the finger at Janet Yellen? Well, with prices +30% higher the bubble is now gone and Trump even appointed Jerome Powell to run the Fed, ensuring the Yellen status quo.
As for the Fed, the governors won’t suddenly become enlightened that they are the cause of the boom-bust equity cycle since the tech bubble. It’s outrageous how oblivious members of the Federal Reserve appear to be. These are PhD economists running the Fed, supposedly the “smartest” people in the financial world. Holding a PhD ourselves, we can confirm that the doctorate only improves your research skills and gives you an expertise in a narrow domain (your brick in the wall of knowledge). The PhD does not bring commonsense or market savvy. This is all too apparent since the Greenspan Fed. We are not going to advance the argument that the Fed has a hidden agenda, as this is not constructive thinking and only adds to conspiracy theorists’ game.
Famed investor Stan Druckenmiller gave a very poignant interview this week. The smart guys at the Fed are obsessing over a 2% inflation rate, out of fear of the bogeyman “deflation”. Putting on blinders, the Fed is less concerned about the fallout of nine-years of zero percent interest rates and misallocation of assets than not hitting their 2% inflation target. Ditto for the European Central Bank and the Bank of Japan. According to Druckenmiller, “the way you create deflation is you create an asset bubble. If I was ‘Darth Vader’ of the financial world and decided I’m going to do this nasty thing and create deflation, I would do exactly what the central banks are doing now….Every serious deflation I’ve looked at is preceded by an asset bubble and then it bursts. Think about the ’20s, a big asset bubble that burst, you have the Depression. Think about Japan. Asset bubble in the ’80s. It burst. You have the consequences that follow. Think about 2008, 2009.”
This is too stupid. The housing bubble was created by fear, on the part of the Fed, of raising rates too quickly after the 2001 recession. The Financial Crisis could have been just another recession if the Fed had not allowed an asset bubble to grow and lead to a deflationary bust. To quote Yogi Berra, “this is déjà vu all over again”. We strongly agree with Druckenmiller: the longer this goes on, the worse it’s going to be.
The root cause of the financial market boom-bust cycle is poor leadership. Both central bankers and governments have a short-term vision. They always chose a Band-Aid to resolve temporarily (during their mandate or term in office) deeper, underlying economic problems. We are still dazed at the solution engineered by central bankers to save the financial world in 2008-09. A crisis rooted in excess debt in the economy was resolved by….adding more debt to the economy. Why not cleanse the economy of bad debt and start afresh from a healthy base? Because that would involve too much economic pain and politicians would not get re-elected and central bankers would go down in history in disgrace.
The problem is that the higher financial asset prices climb on a shaky, unhealthy base, the more devastating the fall-out when the house of cards tumbles. Not everyone will make it to the exits when the bubble bursts. And many others won’t recognize that the game is over and will be trying to buy on the way down (the buy- the-dip mentality has become too ingrained).
We believe that major changes to the financial system will occur in the lifetimes of this generation of investors. The back-lash from ruined investors and savers forced out of the relatively safe fixed-income market will be enormous. There will be Congressional inquiries and lots of finger-pointing. Some high-level financial market leaders will be brought to trial (perhaps even central bank presidents). We foresee several changes that may occur to prevent short-sighted leaders from subjectively making decisions regarding the fate of the economy:
* Congress will re-write the Federal Reserve charter to limit the scope of discretionary actions that the FOMC can undertake. Quantitative easing will not be discretionary monetary policy tool.
* A rules-based algorithm will be implemented to avoid discretionary determination of short-term interest rates. Something similar to the Taylor-Rule will increase transparency in setting short-term rates.
* Central bankers will (hopefully) no longer be rock stars.
* National debts exceeding 100% of GDP will be attacked aggressively by zealous politicians siding with the savers who will have lost a significant amount of their savings following the collapse in financial markets.
In sum, we believe that the purge that began during the financial crisis, and arrested by extraordinary stop- gap measures, will eventually complete its course. This is not a rosy out-look for the intermediate-term, especially for countries that dipped too deep into the QE well. We know that the asset class(es) responsible for an asset bubble underperform in the subsequent market cycle, as we have discussed frequently (see our August 25, 2017 Commentary). Many equity markets have “borrow-forward” gains from future – annual returns may be negative for several years. The upside, for investors and managers courageous enough to resist the institutional imperative (hold U.S. index equities) is that many national stock markets (in Asia and Latin America) and certain sectors (notably natural resources) are not in bubbles and will offer positive returns over the next years for patient investors.