Of all the delusions that have infected the minds of economists, central bankers, and the investing public in recent years, perhaps none is as short-sighted and pernicious as the idea that aggressively low interest rates are “good” for the economy and the financial markets.
There is, of course, a certain truth to that idea, roughly equivalent to proposing that snorting amphetamine-laced cocaine is “good” for one’s energy, or that walking into a bar and randomly choosing partners while wearing a blindfold is “good” for one’s love life. In each case, however, the validity of the claim comes from subverting the word “good” to mean nothing more than a short-lived burst of very bad choices.
Back in 2003, Alan Greenspan mixed the soap of what would become the housing bubble by holding interest rates to just 1%. Investors responded to the uncomfortably low yields on Treasury bills by looking for alternatives that offered a seemingly safe “pickup” in yield. They found that alternative in mortgage securities. Wall Street was more than happy to satisfy the demand for more “product,” as they called it, by creating more mortgage bonds. But see, creating a mortgage bond requires you to actually make a mortgage loan to someone, which is how we got zero-down, no-doc, interest-only loans. “No credit? No problem!” Well, no problem in the short-term. Over the next few years, that bubble of Fed-induced yield-seeking speculation would reach its peak, and then collapse, producing the worst financial crisis since the Great Depression.
In my 2003 piece outlining that developing bubble, I began, “T.S. Eliot once wrote ‘Only those who risk going too far can possibly find out how far one can go.’ It seems that the U.S. financial system is bound and determined to find out… the real question is this: why is anybody willing to hold this low interest rate paper if the borrowers issuing it are so vulnerable to default risk? That’s the secret. The borrowers don’t actually issue it directly. Instead, much of the worst credit risk in the U.S. financial system is actually swapped into instruments that end up being partially backed by the U.S. government. These are held by investors precisely because they piggyback on the good faith and credit of Uncle Sam.”
In the Federal Reserve’s attempt to bring the U.S. out of the crisis of its own making, the Fed has produced conditions that make another collapse inevitable. Unfortunately, the scale of the present bubble is far grander, and the consequences are likely to be more severe. By the completion of this cycle, I continue to expect the S&P 500 to lose roughly two-thirds of the market capitalization it reached at its September 20 peak. Mountains of covenant-lite debt and leveraged loans, this cycle’s version of “sub-prime” mortgages, will go into default. Worse, “covenant-lite” means that lenders have much less protection in the event of defaults, so recovery rates will plunge to levels that investors have never experienced.
After 8 years of Fed-induced yield-seeking speculation, financial valuations have been driven to the most offensive extremes in history, with the most reliable equity valuation measures recently matching or exceeding their 1929 and 2000 peaks. Accordingly, prospective long-term investment returns for stocks and bonds have been driven to strikingly low levels.
At the September peak, we estimated that a conventional portfolio mix invested 60% in the S&P 500, 30% in Treasury bonds, and 10% in Treasury bills was likely to produce total returns averaging just 0.48% annually over the coming 12-year horizon. The only time passive investors faced lower expected 12-year returns was during the 3 weeks immediately surrounding the 1929 market peak. After a recent increase in bond yields and a mild -10% decline in the S&P 500, that estimate increased to just 1.29%. With most pension funds assuming expected future returns on the order of 7% annually, the coming years are likely to include a rather severe pension funding crisis. (...)
With the most reliable measures of market valuation still over 2.5 times their historical norms, there are essentially two ways to normalize valuations. One is for the market to lose about -60% of its value. The other is for fundamentals to grow while leaving stock prices unchanged. So the question is: how many years of growth would be required in order to normalize valuations? The answer is ln(2.5)/ln(1.04) = over 23 years. Though prices would be unchanged, you’d also get a dividend yield of about 2% while you wait.
In my view, there will likely be very large changes in economic conditions and market psychology long before then, so my sense is that a major price collapse like 2000-2002 and 2007-2009 is the most likely way this bubble will be resolved. Meanwhile, it’s worth noting that it would not even take a decline to historically run-of-the-mill valuations to wipe out every bit of S&P 500 total return that the index has enjoyed since 2000.
While successfully engineering inflation seems like a tempting way to avoid major market losses, it’s important to remember again that the best equity valuation measures remain over 2.5 times their historical norms. Though higher inflation isn’t required for valuations to normalize, it would almost certainly accelerate that normalization. That’s another way of saying that the CPI would have to far more than double before the positive effects of inflation on nominal growth would begin to overcome the negative effects of inflation on market valuations.
In the Federal Reserve’s attempt to bring the U.S. out of the crisis of its own making, the Fed has produced conditions that make another collapse inevitable. Unfortunately, the scale of the present bubble is far grander, and the consequences are likely to be more severe.
Put simply, the extraordinary and experimental policies of quantitative easing and zero interest rates have not been “good” except in the myopic sense of encouraging a short-term burst of very bad choices and misallocations of capital. While it’s unfortunately necessary to tolerate cartoonish rants on CNBC about a potential Fed “policy error” as it normalizes interest rates, the fact is that the policy error is way, way behind us, and the Fed already made it.
The financial markets have already experienced years of aggressive yield-seeking speculation, record valuation extremes, and eager issuance of new “product” – in the form of covenant lite debt and leveraged loans – to satisfy the need of investors to “earn something greater than zero.” Now all we have is an unfortunate situation. With the total capitalization of U.S. corporate equities recently pushing $40 trillion, I continue to expect that $20 trillion or more of what investors count as “wealth” will vanish over the completion of this cycle.
Bubbles and hot potatoes
Over the completion of this cycle, you’re going to hear a lot of misinformation about monetary policy, along with a great deal of misplaced blame. The initial blame will be directed at whatever immediately accompanies the downturn. If a market collapse happens to fall on the same day that an organ grinder’s monkey throws a coconut at the bronze bull on Wall Street, they’re going to blame the crash on the monkey.
Additional rounds of blame will be directed at whatever advances the agenda of the person talking. Republicans will blame Democrats. Democrats will blame Republicans. Dogs will blame cats. Cats will blame mice. Everyone on financial TV will blame Jay Powell at the Fed for the “policy mistake” of even trying to normalize interest rates. But the true object deserving of blame will be the thing that made a financial collapse inevitable in the first place: the yield-seeking carnival of speculation engineered by the Bernanke-Yellen Fed.
Let’s walk through some of the mechanics of how monetary policy actually works, and how recent policies encouraged a bubble and collapse that is now baked-in-the-cake. The discussion will help to clear up some misconceptions (like the insufferable phrase “cash on the sidelines”), as well as some widely-believed cause-and-effect relationships that have no basis in fact.
There is, of course, a certain truth to that idea, roughly equivalent to proposing that snorting amphetamine-laced cocaine is “good” for one’s energy, or that walking into a bar and randomly choosing partners while wearing a blindfold is “good” for one’s love life. In each case, however, the validity of the claim comes from subverting the word “good” to mean nothing more than a short-lived burst of very bad choices.
Back in 2003, Alan Greenspan mixed the soap of what would become the housing bubble by holding interest rates to just 1%. Investors responded to the uncomfortably low yields on Treasury bills by looking for alternatives that offered a seemingly safe “pickup” in yield. They found that alternative in mortgage securities. Wall Street was more than happy to satisfy the demand for more “product,” as they called it, by creating more mortgage bonds. But see, creating a mortgage bond requires you to actually make a mortgage loan to someone, which is how we got zero-down, no-doc, interest-only loans. “No credit? No problem!” Well, no problem in the short-term. Over the next few years, that bubble of Fed-induced yield-seeking speculation would reach its peak, and then collapse, producing the worst financial crisis since the Great Depression.
In my 2003 piece outlining that developing bubble, I began, “T.S. Eliot once wrote ‘Only those who risk going too far can possibly find out how far one can go.’ It seems that the U.S. financial system is bound and determined to find out… the real question is this: why is anybody willing to hold this low interest rate paper if the borrowers issuing it are so vulnerable to default risk? That’s the secret. The borrowers don’t actually issue it directly. Instead, much of the worst credit risk in the U.S. financial system is actually swapped into instruments that end up being partially backed by the U.S. government. These are held by investors precisely because they piggyback on the good faith and credit of Uncle Sam.”
In the Federal Reserve’s attempt to bring the U.S. out of the crisis of its own making, the Fed has produced conditions that make another collapse inevitable. Unfortunately, the scale of the present bubble is far grander, and the consequences are likely to be more severe. By the completion of this cycle, I continue to expect the S&P 500 to lose roughly two-thirds of the market capitalization it reached at its September 20 peak. Mountains of covenant-lite debt and leveraged loans, this cycle’s version of “sub-prime” mortgages, will go into default. Worse, “covenant-lite” means that lenders have much less protection in the event of defaults, so recovery rates will plunge to levels that investors have never experienced.
After 8 years of Fed-induced yield-seeking speculation, financial valuations have been driven to the most offensive extremes in history, with the most reliable equity valuation measures recently matching or exceeding their 1929 and 2000 peaks. Accordingly, prospective long-term investment returns for stocks and bonds have been driven to strikingly low levels.
At the September peak, we estimated that a conventional portfolio mix invested 60% in the S&P 500, 30% in Treasury bonds, and 10% in Treasury bills was likely to produce total returns averaging just 0.48% annually over the coming 12-year horizon. The only time passive investors faced lower expected 12-year returns was during the 3 weeks immediately surrounding the 1929 market peak. After a recent increase in bond yields and a mild -10% decline in the S&P 500, that estimate increased to just 1.29%. With most pension funds assuming expected future returns on the order of 7% annually, the coming years are likely to include a rather severe pension funding crisis. (...)
With the most reliable measures of market valuation still over 2.5 times their historical norms, there are essentially two ways to normalize valuations. One is for the market to lose about -60% of its value. The other is for fundamentals to grow while leaving stock prices unchanged. So the question is: how many years of growth would be required in order to normalize valuations? The answer is ln(2.5)/ln(1.04) = over 23 years. Though prices would be unchanged, you’d also get a dividend yield of about 2% while you wait.
In my view, there will likely be very large changes in economic conditions and market psychology long before then, so my sense is that a major price collapse like 2000-2002 and 2007-2009 is the most likely way this bubble will be resolved. Meanwhile, it’s worth noting that it would not even take a decline to historically run-of-the-mill valuations to wipe out every bit of S&P 500 total return that the index has enjoyed since 2000.
While successfully engineering inflation seems like a tempting way to avoid major market losses, it’s important to remember again that the best equity valuation measures remain over 2.5 times their historical norms. Though higher inflation isn’t required for valuations to normalize, it would almost certainly accelerate that normalization. That’s another way of saying that the CPI would have to far more than double before the positive effects of inflation on nominal growth would begin to overcome the negative effects of inflation on market valuations.
In the Federal Reserve’s attempt to bring the U.S. out of the crisis of its own making, the Fed has produced conditions that make another collapse inevitable. Unfortunately, the scale of the present bubble is far grander, and the consequences are likely to be more severe.
Put simply, the extraordinary and experimental policies of quantitative easing and zero interest rates have not been “good” except in the myopic sense of encouraging a short-term burst of very bad choices and misallocations of capital. While it’s unfortunately necessary to tolerate cartoonish rants on CNBC about a potential Fed “policy error” as it normalizes interest rates, the fact is that the policy error is way, way behind us, and the Fed already made it.
The financial markets have already experienced years of aggressive yield-seeking speculation, record valuation extremes, and eager issuance of new “product” – in the form of covenant lite debt and leveraged loans – to satisfy the need of investors to “earn something greater than zero.” Now all we have is an unfortunate situation. With the total capitalization of U.S. corporate equities recently pushing $40 trillion, I continue to expect that $20 trillion or more of what investors count as “wealth” will vanish over the completion of this cycle.
Bubbles and hot potatoes
Over the completion of this cycle, you’re going to hear a lot of misinformation about monetary policy, along with a great deal of misplaced blame. The initial blame will be directed at whatever immediately accompanies the downturn. If a market collapse happens to fall on the same day that an organ grinder’s monkey throws a coconut at the bronze bull on Wall Street, they’re going to blame the crash on the monkey.
Additional rounds of blame will be directed at whatever advances the agenda of the person talking. Republicans will blame Democrats. Democrats will blame Republicans. Dogs will blame cats. Cats will blame mice. Everyone on financial TV will blame Jay Powell at the Fed for the “policy mistake” of even trying to normalize interest rates. But the true object deserving of blame will be the thing that made a financial collapse inevitable in the first place: the yield-seeking carnival of speculation engineered by the Bernanke-Yellen Fed.
Let’s walk through some of the mechanics of how monetary policy actually works, and how recent policies encouraged a bubble and collapse that is now baked-in-the-cake. The discussion will help to clear up some misconceptions (like the insufferable phrase “cash on the sidelines”), as well as some widely-believed cause-and-effect relationships that have no basis in fact.
by John P. Hussman, Ph.D., Hussman Investment Trust | Read more:
[ed. Do read the whole thing. In 2008, when the economic meltdown started to gain steam the S&P 500 was roughly around 1,400 and change. The Dow, 11,000. Now it's S&P: 2550 and Dow: 23,600 (not to mention the $1.5 trillion added to the national debt since then, courtesy of the GOP tax bill of 2017).]
