1901 Cartoon: “Wall Street bubbles – Always the same“
American financier J. P. Morgan is depicted as a bull, blowing soap bubbles for eager investors
Conventional Wisdom vs Fundamentals
Conventional Wisdom says that we’re living in a GREAT Economy.
I recognize that the Stock Market went up ~30% last year and the labor market is tightening.
.. but I question the fundamentals.
The Stock Market is not the Economy.
Are stock prices going up because of economic strength or because of weakness in other areas?
- weakness in the bond market due to the low Fed Funds rate and
- weakness in other global economies, whose investors have sent money to the US because their own economies are weak
- weakness in baby boomer retirement portfolios, where boomers are trying to “catch up” from prior low savings rates
- expectations that the federal reserve is going to have to monetize the debt and
- expectations that a “Powell Put” and quantitative easing will keep the party going at least through the election cycle
If the economy is so great, Why do I see the following trends ..
Government
- Why does the Federal Government have a $Trillion Dollar Deficit, with future deficits increasing each year as far as the eye can see? In a March 31, 2016, Washington Post interview, the president said he would eliminate yearly deficits and pay off the debt in 8 years.
- What would happen to the economy if the government wasn’t able to run such large deficits?
- How would the economy be affected if the Federal Budget had to be cut by $1 Trillion?
- Why is the Fed Cutting interest rates, with another cut expected later this year? The “boom” may continue for a while, but the fundamentals are not healthy.
- Why has the Federal Reserve resumed Quantitative Easing (sometimes imprecisely called “printing money“)?
- In 2018, the Fed tried to increase interest rates and reduce the Fed balance sheet, but the President protested and Powell relented.
- So now the Fed is back to quantitative easing. (just don’t call it that) and now the President and market are (temporarily) happy.
- But if the economy is truly strong, you don’t need to cut interest rates or print money do you?
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Moody’s Credit Ratings Agency (logo) Why, in a Real Vision Interview, did former European Central Bank Insider Etienne de Marsac talk about the US as the “hot emerging market” with a future US Government Credit Rating Downgrade when describing a December 2019 Moody’s Credit Rating report.
The Public/Labor:
- Why can’t ~40% of Americans come up with $400 in an emergency, according to a Federal Reserve Survey?
- Why are men’s wages so low and not plausibly going to catch up to productivity gains any time soon?
- Since 1979, the median male wage has gone down 5% (adjusted for inflation):
- White male: $14.42 -> 13.70
- Black male: $10.90 -> 10.63
- Hispanic male: $11.25 -> $11.00
- Wages haven’t risen much in the last 40 years, which is why households have needed to increase women’s labor participation rate to keep up with consumption habits. We’ve seen a little bit of wage movement lately, but we aren’t anywhere near returning to prior capital/labor ratios.
- Since 1979, the median male wage has gone down 5% (adjusted for inflation):
- Why is the split between labor and capital so much lower than it was in the 50s and 60s?
- 65/35 vs 60/40
Corporations
- Why is US Corporate debt so poorly rated? There are now only two AAA Companies — Microsoft and Johnson & Johnson. Many mainstream companies like McDonald’s, Ford, Kraft, and Verizon are rated just above “Junk Bond” status?
- In the event of a downturn, many companies will have a rough time recovering (which likely will lead to more layoffs and an inability to borrow and invest)
- Part of the reason for this debt downgrade is that there were perverse incentives for companies to borrow money to buy back their stocks
- Corporations bought their own stock with borrowed money, 1 combined with money from the corporate tax cuts has helped inflate the stock market
- David Rosenberg says that stock buybacks have broken the correlation between the stock market and the economy and that stocks will continue to rise regardless of fundamentals until corporations stop buying back shares.
- This is because CEOs’ bonuses depend on meeting a target stock price.
- It is easier to generate artificial results by borrowing money to buy back shares than it is to increase share price by creating genuine value.
- This is because CEOs’ bonuses depend on meeting a target stock price.
Stock Market
- Investors have been pushed out of safer assets like highly-rated bonds and into stocks because interest rates are so low and Bonds and Certificates of Deposit return less than inflation.
- My 24-month FDIC-insured Fulton Bank CD was set to roll over for at 0.4% APR. Inflation is over 1% higher than what a two-year CD pays.
- Every day I have my money in the bank it is losing purchasing power relative to inflation.
- Inflation makes it difficult to get a return unless you go into riskier assets like stocks.
- Another factor influencing stocks is that baby boomers who haven’t saved enough for retirement are taking extra risk in stocks to try to catch up after their prior low savings rate.
2008 Crisis Response:
In 2008 we had a private debt crisis in the mortgage market (in part) because of the perverse incentives caused by the rating agencies getting paid by the sellers they were grading rather than the buyers of bonds (which was a conflict of interest). Mortgage Originators like Countrywide sold mortgages to unqualified borrrowers because they knew that they could sell them to investors with a Triple-A rating from a Credit Ratings Agency. When the bubble was exposed, the Fed’s response and the Congress’s response was to indirectly and directly assume the private debt onto to the Federal Government and Federal Reserve balance sheets.
Here is the increase in debt from 2008-2020
- Federal Gov: $10 -> $22 Trillion
- Federal Reserve ~ $1 -> $4 Trillion
Then there is the Corporate Debt: now at $10 Trillion
When the Next Recession hits:
- When Baby Boomers stop working (and investing) and start to sell to fund living expenses, there will be more people selling than buying, putting downward pressure on stocks.
- This demographic pressure, coinciding with a recession will make the recession more difficult to escape. Financial Advisors sometimes advise investors to have a bond asset allocation of 100 minus your age (with caveats). Alarmingly, the typical boom has the inverse of this — an inappropriately risky 70% stock allocation. When the next recession hits, they will suffer major losses, without the ability to use wages to gradually buy back into stocks at the lower prices. This will be a scarring experience for a generation that has historically take higher risks. Raoul Pal predicts that burned Boomers will suddenly become the most risk-averse generation in history.
- Foreigners have been piling into US Markets, which inflates stock prices because the US is currently one of the few growing markets worldwide.
- The Younger (Millenials/GenX) aren’t in a position to buy sufficient amounts of stocks to compensate for the baby boomer’s retirement:
- Millennials have more student debt, and they are needing to borrow to get into the housing market.
- Their incomes are 20% lower than their parents at the same age.
- They can’t afford to buy stocks at current prices. That is to say, there is a supply vs demand imbalance.
- Federal Reserve:
- The low ~1.5% Fed Funds rate provides the Fed with less headroom to make cuts to support the economy in a downturn.
- Ben Bernake and others have talked favorably about “Modern Monetary Theory” as a way to implement a “Helicopter Money Drop” to monetize the debt.
- The Fed has talked about the need to have Fiscal Policy (spending by Congress) to respond to the next crisis.
- The Fed has talked about setting aside money for Congress to spend so Congress does fiscal stimulus.
Summary
So what am I missing? I’d love to be wrong about this.
My approach here is to throw out the perspectives I’ve heard and look for feedback.
You can send me an email or comment below:
Update:
My friend Bryan pointed me towards the St. Louis Fed Financial Stress Index, which is currently below zero, but note that the index went from zero to bailouts in only 9 months. I’m not suggesting we’re going to need bailouts in 9 months, but it’s quite likely that the Fed will have to increase quantitative easing.
My main point though is that the next recessing will be prolonged due to the fact that the interest rates are already low and corporations, governments, and consumers all have a lot of debt going into the next cycle and demographics are working against growth.
Update 2:
It looks like the current repo market action is not QE, but when QE happens, it is expected to be rolled out in a complicated way that is too technical and boring.
There is a report that Treasury Secretary Mnuchin has money available at Treasury to stimulate the hedge funds’ investment stock market using the repo market. He has the ability to force the hand of the Fed and there is nothing the Fed can do about it without blowing up the markets.
Hedge funds are levered 12-15 times and there is no growth outside the FANG and buybacks.
whose interest rates were low because of the economy’s weakness and Fed Chairman Powell’s response to the President’s very public twitter complaints about the Fed’s prior 2018 rate increases↩
