“Despite Kurodamania and record stock prices, I contend that the great global Credit Bubble has been pierced.” –Doug Noland
What drives the stock market? In theory it is driven by the fundamentals of the economy, the business cycle, corporate earnings, interest rates, etc. In reality, none of these have been shown statistically to correlate strongly to the stock market over the next year or longer. Sure there are short term effects on news announcements, but when it comes to investment decisions for the next year or five years, forget it. The current valuation of the S&P 500 is approximately 174% of its historical mean value. Notice I did not say 174% over-valued. Who am I to decide? The market will and always has decided valuations. It is just that valuations do not matter to market timing and investing in the short term.
Historically, looking back 100 years at market valuation models, you will see long 30-40 year cycles from high valued markets to low valued markets. Much of the gains in bull markets are not from increased earnings, but from stocks trading at ever increasing multiples of those earnings or ever decreasing multiples of those earnings during bear markets. The economy, interest rates, corporate earnings can all move opposite to the valuation trend. We have been in a period of high valued markets for some time. The market bottom of 2009 merely returned to the historical mean valuation of the stock market. In 2014, we are again at high valuations. Strong statistical support does exist for the correlation of long-term returns (10 years) and market valuations, so based on current valuations we do not expect the real returns of the stock market to perform well over the next 10 years.
Looking back the last 20 years, the stock market has been on a roller coaster ride of bubbles. First was the stock market bubble and then the housing bubble and now a global government debt bubble. Each bubble was driven by loose monetary policy, increasingly on a global scale. The world’s financial system has become more unstable as a result and the final bubble–the global debt bubble appears to have been pierced in the graph below, but don’t bank on it. What is missing from the Federal Debt line below is the 4 trillion dollars the Federal Reserve has taken on its balance sheet. (Note: FRED stands for the Federal Reserve Economic Data)
Three Federal Reserve US Bubbles (from the Federal Reserve Bank of St. Louis Economic Data)
During the same 20 years, the real economy (Main Street) has not recovered as evidenced by the real median household income level since 1998. Without financial bubbles, the US economic fundamentals, not to mention tax revenues, depend simply on the incomes of the average American. In 2012, the top 10% captured over 50% of the total US income so the chart of the real medium household income is more revealing than total income levels. The US government has added trillions in debt since 1998 to bailout the financial sphere (and drive asset markets up – stocks and house prices) yet this is not translating to growth in the real economy – wages. And you can be sure the average American will bear the brunt of tackling the debt in the future through continued interest rates repressed below inflation, higher taxes and government obligations not met.
Household Income (from the Federal Reserve Bank of St. Louis Data)
The piercing of the global debt bubble (if it has occurred) will not immediately translate into a US market crash. On the contrary, as the Central Banks panic and fight the deflationary affects with more QE, the S&P 500 index will get a boost and not just from US investors. But QE did not prevent the last two bear markets. And the next bear market may be the one to take us below the mean historical valuation of the stock market. Both financial gravity and the increasing loss of confidence in the Central Banks to save the day that will result in the next sharp reset of market valuations.
The Federal Reserve ended its program of QE on 4 November, but global QE just got another “unexpected” boost by Japan on the following day. It should be noted that other Central Banks are not restricted from buying into equity markets to include the US so maybe we can party on a little while longer. But make sure you exit before the party is over. To put the word “panic” into perspective consider that Japan’s Government Debt to GDP is already over 227% as seen in the graph below. The fact is Japan is in a debt trap. With corporate savings and pension savings no longer available to buy government debt, the Bank of Japan will have to increasingly monetize its debt (print money) to finance its government.
I have read commentary that states, not to worry because much of Japan’s government debt is just owed to another government agency. This is like saying don’t worry about the Social Security Trust Fund Debt because it is just money the government owes to itself implying all the government has to do is default on it and other government obligations like pensions. What is missing from this thought process is that defaulting on these sources of income would have devastating impacts to the economy since 99% of it is spent on basic needs of its recipients. Japan will be required to print money to pay its pensions and other obligations. Japan’s printing will devalue Japan’s currency and is one of the reasons much of the printing is leaking to other markets…like the US stock market.
Doug Noland’s analysis of the ongoing Global Credit Bubble is a must read for those with an interest in the global credit bubble. Dr. Hussmann provides more focus on market analysis as it relates to investing.
In his November 3rd commentary, Dr. Hussman provides the following commentary:
“The fact is that financial repression – suppressing nominal interest rates and attempting to drive real interest rates to negative levels – does nothing to help the real economy…
As the central bank creates more money and interest rates move lower, people don’t suddenly go out and consume goods and services, they simply reach for yield in more and more speculative assets such as mortgage debt, and junk debt, and equities. Consumers don’t consume just because their assets have taken a different form. Businesses don’t invest just because their assets have taken a different form. The only activities that are stimulated by zero interest rates are those where interest rates are the primary cost of doing business: financial transactions…
What central banks around the world seem to overlook is that by changing the mix of government liabilities that the public is forced to hold, away from bonds and toward currency and bank reserves, the only material outcome of QE is the distortion of financial markets, turning the global economy into one massive speculative carry trade. The monetary base, interest rates, and velocity are jointly determined, and absent some exogenous shock to velocity or interest rates, creating more base money simply results in that base money being turned over at a slower rate.
With regard to the recent move by the Bank of Japan, seeking to offset deflation by expanding the creation of base money, the move has the earmarks of a panic, which is counterproductive.”
Doug Noland’s October 31st commentary supports the idea that the Bank of Japan’s unexpected QE was a panic of seeing the Yen carry trade coming undone if the Yen appreciated:
“But in a world of increasingly vulnerable speculators and a heightened risk of de-leveraging, a yen rally could have very well pushed European debt markets over the cliff. When it comes to global monetary policymaking, I do not believe in coincidences. Kuroda to the rescue…
One of these days, global central banks will lose control. For now, they will continue to print “money,” spur destabilizing speculation and exacerbate global imbalances. Importantly, their measures continue to promote wealth redistribution and inequality – within nations and among nations.”
But what’s Doug Noland’s view about the stock market’s great Bull Run the last few years. Did you see the movie The Truman Show?
“I never bought into the notion that Fed “money” printing was about U.S. jobs. I don’t believe Kuroda’s move Friday was about Japanese inflation. Policy responses have been akin to Benjamin Strong’s 1927 “coup de Whiskey,” but on a multi-shot global basis (with chaser). And over the past two years we’ve witnessed a 1927 to 1929-like market response, again on a globalized basis…
There remain these two parallel universes. There’s the Truman Show World: Kuroda has essentially nothing to do with the great U.S. bull market. It is instead driven by robust economic fundamentals, including strong GDP and corporate profits…
The alternative universe is a totally different world: Kuroda is one of a very select group of leading central bankers working desperately to sustain a runaway global financial Bubble. There’s a historic experiment in “money” printing that is at the brink of failure. Around the world there are speculative financial market bubbles of unprecedented proportions at risk of bursting. History’s Greatest Credit Bubble already has serious cracks. Moreover, the incredible widening gap between (Truman Show) securities prices and deteriorating (bursting Bubble) fundamental prospects boosts the likelihood of a global market accident.”
Categories: The Smart Bird