I’ve been here before and, candidly, it’s not much fun. Lodged in my mind this week was the brilliant quote from the 19th century German philosopher Arthur Schopenhauer: “All truth passes through three stages: First, it is ridiculed. Second, it is violently opposed. Third, it is accepted as self-evident.”
It’s fascinating how it all works. Looking back, there was definitely a Bubble in 1999. Clearly, 2007 was one huge Bubble. Everything is obvious in hindsight, and most look back now and contend it was pretty conspicuous even at the time. Having toiled through both prolonged Bubble periods – arguing against deeply embedded bullish conventional wisdom – I can attest to the fact that the Bubble viewpoint was violently opposed at the late stages of both cycles.
I don’t feel I’m venturing out on a limb to predict that some years into the future the 2018 Bubble backdrop will be recalled as rather self-evident. Years of experimental “whatever it takes” global monetary stimulus (rates, QE and market manipulation) nurtured excess and imbalances on an unparalleled global scale. EM borrowed excessively, too much denominated in foreign (U.S. dollar!) currencies. The Federal Reserve (all central banks) held rates too low for much too long. Prices for virtually all asset classes were inflated to dangerous extremes.
The resulting Tech Bubble 2.0 dwarfed the earlier nineties version, culminating in a global technology arms race. China was a historic Bubble of reckless proportions. Protectionism and Trade wars were a scourge for markets and global growth. Unsound “money” fueled populism. In the end, the backdrop created a cauldron of deepening geopolitical animosities and flashpoints.
During the mortgage finance Bubble period, Chairman Greenspan was fond of claiming there was no national Bubble – specifically because all real estate markets were local. Missing in the analysis was the recognition that mortgage finance had evolved into very much a national market. The GSEs, MBS, subprime ABS, the repo market, derivatives, structured finance (“Wall Street finance”, more generally), the hedge funds, and money management more broadly – were all crucial to a national market of progressively loose finance.
Centralized finance linked seemingly disparate housing markets, securities markets, asset classes, financial systems and national economies. It evolved into a comprehensive Bubble of mispriced finance on both national and international scales, which over time led to deepening structural impairment to both financial systems and real economies.
Recently, a period of calm have many believing the worst of EM instabilities has passed. But this week saw the Argentine peso collapse 16.3% (down 49.5% y-t-d). The Turkish lira sank 8.2% (down 41.9%). The Colombian peso declined 3.3%, the Chilean peso 3.2%, the South African rand 3.0%, the Mexican peso 0.9% and the Indian rupee 1.5%. Italian yields jumped eight bps to 3.24% (spread to bunds at 5-yr highs!). Greek yields jumped 24 bps (4.37%) and Portuguese yields rose 10 bps (1.92%). After somewhat of a respite, “Risk Off” was back for more.
In a sign of the times, investors remain extraordinarily bullish – even on the emerging markets. EM travails are “idiosyncratic” – individual instances of Current Account Deficits and borrowing excessively in foreign currencies. By and large, the EM selloff has created value and buying opportunities. All markets are local; the notion of a global Bubble is asinine.
Most unfortunately, the Bubble is real, and it is decidedly global. It has been fueled by an unprecedented international boom in central bank Credit and sovereign debt. Underpinned by government finance and central bank liquidity backstops, over-liquefied markets accommodated unprecedented global corporate debt issuance. A comprehensive boom in global finance was fueled by a massive global leveraged speculating community, an international boom in derivatives trading and securities finance, along with a globalized market in ETFs and other passive indexed products.
Global market prices have been inflated by synchronized artificially low short-term interest rates, along with liquidity excess, again, on a globalized basis. Finance has been grossly mispriced systemically around the world.
Here in the U.S., the bullish consensus view holds that a faltering EM doesn’t matter. The U.S. economy is strong and largely immune to global factors. Profits are booming. Prospects are unequivocally positive. The mindset is uncomfortably reminiscent of the “subprime doesn’t matter” blather heading right into a devastating crisis. It’s worth recalling that U.S. GDP exceeded 2% in 2007’s 2nd, 3rd and 4th quarters, with Q4’s 2.5% expansion the strongest in a year.
Things look just rotten a market bottoms. They appear splendid at tops. It’s worth adding a little color from the perspective of George Soros’ “reflexivity”. So long as bullish perceptions sustain inflated market prices and unmatched perceived wealth, along with “animal spirits” and strong economic activity more generally, resulting “fundamentals” will tend to confirm the optimistic viewpoint.
Chuck Prince was still dancing in the summer of 2007. Everyone was locked into the dance party, as the market disregarded the subprime fiasco while rallying to record highs in mid-October 2007. By the end of 2007, few were interested in hearing another word about the Bubble. The analysis was violently opposed: Washington had it all well under control. I needed to get a life.
Our reading of financial history has left us with the impression that financial manias are replete with crazy speculators running around in fits of irrational greed and excess. I hold the view that Bubbles are much more about fits of deceptively rational behavior. The “Oracle of Omaha,” 88 years young Thursday, can drink Coke and preach the virtue of buying stocks for the long-term. Who today would take exception with such an irrefutable truth?
Mr. Buffett, along with virtually everyone, was blindsided by the 2008 crisis. This should matter but doesn’t. Amazingly, another crisis is viewed these days as an opportunity rather than a risk. Stocks, as they always do, will come roaring back. The last crisis was only an issue for those that lacked conviction and sold stocks in an irrational panic.
At this point, the bullish view that stocks must be bought and held for the long-term has surpassed rational. It’s Unassailable. Your price entry point matters little – the global backdrop even less. Politics little, geopolitics less. Holding cash is stupid, shorting much worse. Indeed, to not bet confidently on the U.S. for the long-term is an act of self-destructive irrationality. A risk-based approach, to be sure, would lead to irrational decisions. It’s been proven – repeatedly. Don’t sell.
I believe we’re nearing the end of an historic multi-decade Bubble. Risk is incredibly high, a view that has by now been thoroughly discredited. A key factor boosting risk is the overwhelming consensus view that risk is virtually nonexistent. In stark contrast, I believe this protracted period of serial boom and bust cycles has led to the accumulation of financial and economic distortions and deep structural impairment.
Determined central banks and governments have resolved a series of busts with only more powerful booms. At his point, this ensures that few contemplate a scenario where policymakers are without the capacity to sustain robust markets and economic growth.
Risk-takers have gravitated to the top – in the markets, in company management, in venture capital, at banks, and generally throughout the economy. Those attentive to risk have been pushed aside – investors, speculator, managers and entrepreneurs. Trillions have flowed into “passive” investment strategies, essentially a bet on an index over active risk management. Based on (recent) historical performance, taking a passive approach is perfectly rational. But one must ignore the reality that the Trillions that flowed into this strategy ensure latent risk of an abrupt shift in market perceptions.
There is today a perception of invincibility that goes significantly beyond 1999 and 2007. It has more in common with my reading of the history from the late-twenties Bubble period. “New Era.” “Permanent plateau of prosperity.” And at the end, “Everyone was prepared to hold their ground. But the ground gave way.” There were worries throughout the twenties period. By 1929, it was a case of acute worry fatigue. Inflation psychology dominated a deeply distorted marketplace. Stated more simply, there was too much money to be made. Greed dominated.
And let’s not miss a fundamental aspect from the “Roaring Twenties” period. The Fed was perceived to have things under control. It was a young central bank doing exciting new – and captivating – things. The perception that enlightened Fed operations had eliminated crisis risk in reality greatly exacerbated the risk of financial and economic calamity. For the current long cycle, central banks are anything but fledgling institutions. They have, however, adopted new and captivating doctrine and (whatever it takes) stimulus measures.
I am expecting EM contagion at the “periphery” to make its way to the “core.” This is in stark contrast to the consensus market view: Idiosyncratic instability in select emerging economies ensures greater financial flows to outperforming U.S. equities and fixed-income markets. Global risks ensure the Fed concludes “normalization” well before rates turn restrictive, thus working to reduce risk for U.S. financial markets and the juggernaut U.S. economy.
It won’t be viewed as such by historians, but in real time the complacent bullish view is rational. Complacency, after all, has repeatedly paid off handsomely. Never failed. The Fed and global central bankers will clearly do whatever it takes to avoid another financial crisis. They successfully responded to mounting stress in 2012 (epicenter Europe) and again in late-2015/early-2016 (epicenter China) that, in hindsight, hardly even required a policy response. Again, to bet against central bank control would at this point appear irrational.
The Nasdaq Composite traded down to 4,210 in February 2016. The index closed Friday at 8,110, some 93% higher (up 209% from 2012 lows!). Global central banks moved to adopt aggressive “whatever it takes” stimulus measures in late-2012. When global market stress reemerged in late-2015, the BOJ and ECB boosted liquidity injection operations (and market interventions) while the Fed postponed rate “normalization.” Meanwhile, Beijing implemented a number of fiscal and monetary stimulus measures. Some might see parallels to Benjamin Strong’s 1927 “coup de whisky.”
What’s my point? Today’s monetary backdrop is much different than the EM episode back in 2016. Instead of rapidly expanding, central bank liquidity is on the verge of contracting. Moreover, I would posit that the amount of central bank liquidity necessary to stabilize markets increases as market prices inflate. And this is where the proverbial analytical rubber meets the road: market players have come to have absolute faith in the efficacy of policy responses, unappreciative of crucial changes in both market structure and the liquidity backdrop.
So long as confidence holds at the “core” and speculation runs unabated, underlying fragilities remain concealed. But its wildness lies in wait – growing, strengthening and expanding, surreptitiously.
There are parallels to 2007 – as well as to the Q1 2000 (along with 1998!). The great nineties bull market culminated in a final short squeeze and derivatives-related melt-up. Options strategies had become popular both for speculating on higher prices and betting on a bursting Bubble. As they are today, the big technology stocks were at the epicenter of speculative excess, squeezes and derivative trading activity. Writing calls had become popular, often part of sophisticated options trading strategies.
When the market during Q1 2000 went into speculative blow-off mode, speculators that were caught short call options on the big tech names were forced to aggressively buy stocks into a final self-reinforcing melt-up. And, again with parallels to today’s market backdrop, this melt-up occurred right into deteriorating fundamental prospects. For at least now, I know this line of analysis will either be ridiculed or violently opposed.
Original Post 1 September 2018
Categories: Doug Noland, Perspectives