The End of Financial History

In a Zero Hedge blog entry notifying the world of an overnight rise in equity futures indexes, the protagonist of the movie "Fight Club" today encapsulated the essence of the new financial normal in this one sentence:

It has become virtually impossible to differentiate between actual central bank intervention, hopes of central bank intervention, and how the two interplay on what was once the "market" but is now merely the place where money printers duke it out every day in some pretense of price discovery set by those who literally print money.

In other news, the protagonists of "Finding Nemo", "The Little Mermaid", and "Frozen" will convene next week to confirm that everything is just hunky-dory in the markets, and the Fed "must" raise rates soon anyway.

A Shoeshine and a Smile

Every investing age has its own story explaining why It’s Different This Time:  

• Buy and hold with the Nifty Fifty
• Stock prices have reached a permanently high plateau
• Information technology is worth any price, because it's revolutionizing life
• Real estate can never go down
• Markets are Too Big to Fail.  Central Bankers won't allow it.

Obviously, central bankers can control market liquidity.  And market prices.  All that central bank chicanery worked after Lehman didn’t it?  See how high stocks and bonds are now.  Look at market multiples.  What could possibly go wrong?

The central bankers will use any amount of financial repression needed to keep the elites in power.  Keep rates low and funds flowing!  Drive rates negative!  Eliminate all “excess savings”!  And so it will go, until their tricks finally fail.

We've been here before.  It's another bubble cycle, and all that’s changed is that the central banks are a little more skilled today at keeping the illusion alive longer.  Market professionals know the drill well, because they lose their positions if they fail to follow the herd.  So, they chase stocks higher as fundamentals and market internals worsen.

I said it several years ago, and it is just my opinion, but I still think that we have a stochastic stopping problem.  How inflated do we expect prices to get?  If you stay in the game, you might eke out an existence, but history suggests that prospects are not good.  History even suggests there’s a fair chance that at some unknown time the bubble will burst and you’ll get something precious chopped off.

All of this financial trickery is just covering over the structural problems.  Developed economies have become zombies.  The people maintain inflated expectations.  Markets are casinos functioning purely on central bank credibility. 

There is no telling how long it will go on, or how high markets can go.  But it is increasingly obvious that central banks cannot solve the underlying problems, and that the facade is cracking.  Too much debt cannot be solved by adding more debt.  

People are catching on, and central bank credibility is at risk.

Willie Loman is out on the road again, on a shoeshine and a smile, totally deluded.

Are We There Yet?

We know that the markets are overpriced, but does that mean we are on the brink of a crash and burn?  In his Q1 letter from GMO, Jeremy Grantham gives his response to this question. 

He starts with the observation that the Fed is “bound and determined” to create another “full-fledged market bubble”.  It is hard to disagree.  Central banks of the developed world seem are caught on an unending treadmill of easy money.  They have little choice but to continue QE.

He then observes that the 21^st century Fed has a record of stimulating until it has created a bubble.  He cites the NASDAQ bubble of 2000, and the housing bubble of 2006.  It is hard to disagree, especially when the Fed has little choice but to repeat this pattern.

In Grantham’s estimation, bubble territory for the S&P 500 is around 2250, compared to around 2108 now.  He expects either a normal bear market soon, or a march to 2250 followed by a bigger disaster.  It seems prudent to forecast at least two scenarios but bold to call a specific top.  Of course, it is just one more analysis for consideration, based on one set of assumptions. 

What Grantham didn’t say is that people are catching on that central bank policies are not working.  After the housing crash, the economy came back, but only in a “new normal” way.  Disaster was averted at the cost of economic vitality.  Real wages are stagnant or falling, debt is climbing again.  Income distribution is more skewed than ever.  The economic fabric of America has been puffed up and hollowed out, and other advanced economies are in little better shape.

We are borrowing from the future to live today, rather than cutting back consumption to invest in the future.  Under these conditions, the markets are valued on policy promises, not on dollars and cents.  People are counting on the Fed to save the markets.

“It’s different this time” is not a sound foundation for investing.

The Fed pumped up the market, but how high can it pump valuations?  Without real growth, the advance just pushes PE multiples higher.  People are catching on.

What we are heading toward is a crisis of confidence.

Below Zero

Today's financial world is certainly strange.  The Fed Funds rate is nearly zero.  US Treasury bonds yield a little above zero.  Five-year German government bonds yield -0.07%. 

Now some conservative financial managers anticipate something similar – or worse – for future returns on US stocks and bonds.

The conservative asset management company GMO released its most recent forecast of anticipated future real returns for several different asset classes over a 7-year time horizon.  As of Jan 31, 2015, their 7-year forecast projects negative real returns for US stocks and bonds.  Even for emerging markets the estimated future returns are far below historical averages.

Of course, these are just estimates, which GMO accompanies by the usual caveats.  But they are not alone in taking a pessimistic view.  After several years of stock market gains and artificially low interest rates, it is not surprising that nearly every financial asset class in the world is overpriced.  There have been plenty of warnings from market observers.

Markets arrive at overpriced points like this in the normal course of events, every once in a while, but this time is hardly normal.  This time the situation is entirely artificial, the result of extreme fiscal and monetary policies intended to prop up the financial markets and the real economy.  After the 2008-2009 financial crisis, only extreme measures could stop the financial world from crashing and sending the world into a deep depression.  To many people who lost homes and jobs, it was a depression anyway.

The economy is not responding as well as wanted, and so the Fed has continued to levitate markets with QE, low interest rates, and other manipulations.

The crisis was a chain of failures caused by unreal expectations and extremes of leverage.  The Fed and regulators were supposed to prevent such extremes from recurring.  Instead, they have added fuel to the fire, and financial markets are more leveraged now than ever.

If something happens, the repercussions of a crisis could be greater than in 2008-09.

We don’t have to look far in today’s world to find escalating financial risks and potential triggers:  deflation, currency wars, soaring government debt-to-GDP ratios in the developed countries, failing economic growth.  It is just a matter of time.

I wrote about issues like this until two years ago and then figured “Why bother?  I’ve said it all before.”  But the problem is still here, and it’s getting worse.  I can’t foresee the future, but there are many reasons to believe that when the markets crack, it will not end well.