Bull markets tend to bring out movies about the world of finance. However, like the bullish Time magazine cover we have mentioned in recent months, they can be powerful contra-indicators. For instance, Wall Street came out in 1987 and Boiler Room arrived in 2000, marking critical turning points after significant market surges. This cycle has brought us a remake of The Great Gatsby (eery timing given our view that we are re-living the 1920’s in many ways) and more recently The Wolf of Wall Street. We have seen neither, but they reminds us how tightly scripted markets have become, as if the writers, directors, and producers somewhere have a story to tell us each trading day, and boy do they stick to the plot. Markets in cycles past have had a similar feel, but nothing like today. Perhaps it is because computer algorithms dominate trading completely and are quite adept at managing prices around the story line 24/7.
We call the current market movie “Mirage.” The script goes like this: the Fed is the heroic protagonist, dropping cash on Wall Street. The prime beneficiary of QE is the S&P 500. The Fed creates an illusion of well-being. Central bankers and policy makers in Europe and Japan wear the white hats too as they play up any signs of growth and promise to do anything they can to support markets. The private sector and the real economy do not even play “bit” parts. According to the script, the FOMC, in its infinite brilliance, will stop printing money at the exact perfect time in the distant future and equities will to continue to thrive as rates remain ultra-low. Villain bonds and precious metals are to be feared because QE might end today and the Fed might actually tighten policy tomorrow. Please pardon the disconnect between our last two statements because that’s what the markets do every day. It’s a gaping hole in the plot, we know.
The storyline includes no mention of the massive overbuilding in China, which helped corporate profitability in the U.S immensely, or any other factor that was outside of Fed control, like FASB easing mark-to-market rules for banks. The computers relentlessly trade all asset classes in a tight band around this storyline, as if the movie was completely nonfiction. Huge sums of money are placing identical bets as the herd grows larger, drawn into the engrossing plot. The intrinsic value of securities is not important, just listen to Bernanke. How the computers treat asset classes most days is the only thing that matters in this flick. Momentum rules the roost.
By our best measures, this “movie” has pushed equities to all-time high valuations. Yet apparently many participants feel compelled to buy stocks. Although some are skeptical of this year’s price move in equities and other risky assets like EU bonds, few seem willing to leave the party just yet. What strikes us as astounding is that just about every professional believes they can get out the door at just the right time and are even advising investors to do the same. That doorway will get mighty crowded at some point.
We think we know how the sequel goes. Tepid growth fades to recession because massive global debts simply cannot be overcome in spite of central banks’ liquidity binge. Consumers, businesses, and governments are already overly indebted in the U.S. and many other nations, but the powers-that-be attempt to create ever more debt to grow our way out of the chasm. However, both the desire to borrow and the desire to lend have passed their peaks and additional debt would be quite difficult to service. It is a “Catch 22” that central bank balance sheet expansion cannot defeat; the critical limit has been reached. According to this script, after a few painful years, only debt restructuring can clear the path for future growth. To avoid this pain, every country will continue debasing its currency in a “beggar thy neighbor” strategy to repay obligations with cheaper money, but this just leads to more asset bubbles and future crashes. The sequel will likely include an earnings collapse because of the slowing economy and the unsustainability of current record profit margins. Stocks should correct, but may just go mostly sideways for years. High quality bonds should do well in a flight to quality. Precious metals should rise in a flight to safety, as well as their relative scarcity versus the ever increasing supply of fiat currencies backed by nothing.
If we ever wondered about the long-term impact of QE, we think the cratering of mortgage applications to the lowest levels in twelve year answers the question. Inman News reported that Trulia’s Chief Economist recently tweeted that “increased mortgage rates — which jumped in the spring over worries that the Fed would dial back its stimulus program — have ‘whacked’ refinance applications, and the housing recovery has been too weak to fill the gap with purchase loans.” How real was any supposed housing recovery anyway? It was facilitated by a bunch of hedge funds buying properties and artificially driving up prices in major markets. For instance, the New York Times quoted a local broker who said “maybe 70 percent of the sales we were seeing were to hedge funds, investors and others taking advantage of what was happening in Brooklyn. Only about 30 percent were actual end users or first-time buyers.” This is going on all over the country to various degrees and that’s a problem. What a mirage! Have we learned nothing from the bubble of 2006-2007?
The views expressed on this blog are the opinions of the authors. This information is not intended as investment advice or to recommend the purchase or sale of securities. More information on Strategic Balance, LLC may be obtained by contacting investor relations.