TSP Charts: How to Pop a Bubble

The TSP S fund (small caps) has performed the best over the last year.  It usually does outperform during rallies, but over the long term it stays pretty close to its big brother which tracks the SP500 index, the TSP C fund.  Which means it under-performs during market corrections and bear markets.  So be careful.

Anyone who is a regular reader of my commentary knows I think we are (in the words of a certain candidate) in a “big, fat, ugly bubble”.  He also recognized that all it would take to pop the bubble was to raise interest rates which may explain why the President is now a low interest rate guy.  Meanwhile, the Fed is raising interest rates – finally.

It is pretty obvious looking at the charts, the “bubble” is the creation of central bank financial asset buying and not the economy or corporate profits. The new Fed chairman is worried about financial stability.  As you know, bubbles are not very stable.

Fed Chairman Powell tells us he is raising interest rates in part to avoid financial stability issues.  I think this is a tad funny since the Fed is about seven years too late in reigning in emergency monetary policy.  But they had their many reasons to keep the monetary spigots open to the global financial system.  One was Europe’s banking crisis in 2011.

Solved with more debt of course.

Since 2011 the European Central Bank has taken over financial market manipulation in Europe and it is not going so well.  Europe’s a basket case.  Investors are selling Italy and Spain’s financial assets at inflated prices while they can to buy German bonds.  It is a sovereign (entire country) financial system run and the European Central Bank is enabling it.

Country Run

How’s that International  (I) fund doing these days.  It invests primary in Europe and Japan and the financial sector makes up about a quarter of the fund. It is hard to determine where all of this is headed, but the outcome will be political and not determined by free markets.  Free markets are becoming extinct in much of the world.

The Bank of Japan has been buying into their stock market for years to “save it” and the fund is still under-performing.  But at least the stock market in Japan is “performing” because Japan’s government bond market is not . You could say Japan’s government bond market is very “stable” since it has many days where no one buys or sells.  Why bother, the government commands the price and interest rate which is presently 0.1% on its 10-year bond.

Which brings us to the US stock market.  I usually show Dr. Hussman’s valuation charts, but this week we will look at Doug Short’s chart of Warren Buffett’s favorite valuation model – the ratio of the Total US Stock Market to Gross National Product. Don’t look now, but we just passed the 2000 stock market bubble based on Warren Buffet’s favorite model.

That 2000 bubble top makes the current bubble top seem normal, but as a reminder nine years after the 2000 top, the SP500 was down 54%. Yes, it took two bear markets for valuations to return to pre-bubble era average valuations. In other words, the markets were doing what they had done for the last 100 years – revert to mean.

And then the central banks cranked up their money machines and started buying financial assets from the formerly free markets.  So today’s stock market bubble is larger and the world is much, much deeper in debt.  There is a connection.

 

Bubble Buffet

As a reminder, you can not time a market based on market valuations.  But they do tell you a lot about long-term future returns.  At some point, the smart investors will decide to start taking risk off the table for the other half of the market cycle – the bear market.

We watch for those indications.  I expect it to happen soon since there are a lot of needles poking at that largest bubble in history.

So how do you pop a bubble? 

First you end emergency monetary policy after global US dollar debt levels hit record highs by attempting to raise interest rates above inflation as we are doing in the US.  As the US raises interest rates the other global central banks start to have issues keeping a lid on their interest rate suppression policies. Some are forced to raise rates even though their economy is struggling to avoid currency issues.

To ensure this bubble pops spectacularly, you cut taxes in the US and create huge deficits which have to be financed.  The massive increase in supply of US government bonds forces interest rates up (regardless of inflation or the Fed’s target).  Higher interest rates start popping debt bubbles globally, that in turn pops stock market bubbles. It’s actually a slow deceptive process in the beginning since most of the early damage is overseas.

The beauty of the situation is that a global flight-to-safety causes money to flow into the US markets since we are the world’s reserve currency and so much of the world’s debt is now priced in US dollars.  This prolongs the run up in the US markets which forces the Federal Reserve to keep tightening US monetary policy (with negative global effects).  A nice little doom loop occurs.

And to ensure there is no coordinated political response to the unfolding situation, you start trade wars with everyone which like a nuclear war, really can’t be won. It just gets everyone in a non-cooperative mood. Maybe even hostile.

One last thing about bubbles.  They tend to put in their best performance towards the end as they pull in the last holdouts.  This one will be unique in that the central banks have developed a lot of “tools” that they will use much sooner than last time – like the “Target-2 balance” system seen in the chart above.  Think of putting pennies in the fuse box.  It keeps the electricity flowing right up until the house burns down.

It should be interesting to watch.

 

Our Summer Current Situation Report is posted for Full-Access Members.

 


TSP & Vanguard Smart Investor



Categories: Perspectives, TSP Charts