Bubble 3.0: History's Biggest Financial Bubble
Who Blew It And How To Protect Yourself When It Blows Apart
Charts & Figures
This book features many charts. For the forthcoming hardcopy version, we replaced many of our first-round charts with homegrown Macrobond versions, but numerous others were sourced from external publications, websites and newsletters. The attributions are in some cases expanded or duplicated to ensure they are clear to the reader. As attribution details were elusive in some cases, we welcome any and all correction/clarification suggestions.
As many of our Substack subscribers know, we have been publishing individual chapters of Bubble 3.0 over the past couple of months (and not always in sequence). For those of you who have been following along, about half of the completed manuscript will look familiar. To all others, welcome to a bubble saga that continues to evolve, albeit with some serious signs of deflation.
This work is intentionally research-rich and draws from knowledge sources situated across the global financial landscape. Many of the charts, graphics, and figures appearing throughout the manuscript are products of Evergreen Gavekal research. Others are from outside sources whose particular areas of expertise were relevant (and often essential) to the Bubble 3.0 thesis. It’s been my privilege and good fortune to have built an extraordinary network of brilliant friends over my long – make that, very long – career. Their contribution to this project has been immense and I’ve tried to identify most of them in my list of Key Characters.
One benefit of our choosing Substack as the Bubble 3.0 publication medium is that we have been able to make updates along the way (while also correcting the occasional elusive mistake). For that reason, this version of the work will differ in some ways from the material thus far released. What has not changed is the overarching argument: the Fed’s culpability for this third and biggest bubble. My frustration with the Fed and its actions of the last twenty years prompted me to write this book. Most importantly, it compelled me to share my insights and warnings about the dangers of its policies with an extensive audience.
For those who heeded my warnings about the dangers of the Crazy Over Priced Stocks (COPS), conveyed in Chapter 10, you’ve avoided some losses. That was a chapter we pulled forward due to my concerns that the great stock market bubble of recent years was facing a series of pinpricks. With nearly half of the NASDAQ now down 50% or more, that fear has proven justified. We also released an advance publication of my chapter on the bubble in green energy and the risks of “greenflation” back in early October. This also provided a timely heads-up to the energy crisis in which we are now fully engaged.
The fact of the matter is, nearly every chapter you’ll read could easily have evolved into a book of its own. I’ve done my best to condense the most pertinent information on each chapter theme – naturally, highly focused on the long list of bubbles the Fed has enabled – into a manageable length. But, for those seeking an expedited read, you can home in on the bolded font.
Additionally, while my digital version of Bubble 3.0 will live exclusively on Substack for now, I have also decided to print a small run of hardcopies. Pre-order details will be sent out to all Substack subscribers later this month.
Lastly, this work concludes with a somewhat philosophical epilogue, one that in many ways builds off the advisory momentum which gathers in Chapter 17. In addition to that important closing chapter, I am also planning to post a separate follow-up to the book which I have titled the “Epi-Epilogue”. It is a more extensive text that branches out from the financial trunk of Bubble 3.0 to encompass a heartfelt plea for rational policy reforms, including, of course, from the Fed. That, too, will live here on Substack, and will likely be released in sections.
And now, we have a bubble – actually, a long and often intertwined series of them – to discuss.
- David Hay
Chapter 1 - Birth of a Bubble Nation
Chapter 2 - The Worst Kind of Bubble
Chapter 3 - A Brief History of Bubbles
Chapter 4 - The Bubble That Keeps on Punishing
Chapter 5 - The Anti-Bubble Years
Chapter 6 - The Ultimate Bubble Blower
Chapter 7 - What Price Bubblenomics
Chapter 8 - A Brewing Bubble in Inflation
Chapter 9 - Green Energy: A Bubble In Unrealistic Expectations
Chapter 10 - The Insanity Bubble
Chapter 11 - The Biggest Bubble Inside the Biggest Bubble Ever
Chapter 12 - Bye-Bye, Buyback Bubble?
Chapter 13 - I Hate To Burst Your Retirement Plan Bubble
Chapter 14 - Every Investor’s Favorite Bubble
Chapter 15 - Debts and Deficits: Essential Bubble Ingredients
Chapter 16 - Behind Every Great Bubble Stands… A Surprised Central Bank
Chapter 17 - How To Avoid Being Bubble Rubble
(Epi-Epilogue To Follow)
Bubble 3.0 is the result of yearslong generation, compilation, and literary evolution of research-dense newsletters, each of which was, in and of itself, a microcosm of the book completion process. Material drafted, revisions made, charts pulled, factoids verified, real-time data incorporated – over the past five years, it all slowly and (usually) deliberately coalesced into the now-published book in your possession. The coalescing was, you might have deduced, a team effort. A huge team effort, with skillsets of many kinds represented in that team. So, here are some words of acknowledgement in gratitude for the heaps of help we received along the way.
To my esteemed partner and bestie, Louis Gave, one of the financial firmament’s brightest stars.
To Evergreen Gavekal’s astute analyst and chart-procurer extraordinaire, Gherman Howell.
To our always-ready-to-help with back-up research tasks, Client Service Associate Christina Rondepierre.
Gavekal Research’s Fed and monetary expert Will Denyer and his colleague Kaixan Tan, the latter of whom also provided a number of critical charts.
Most of all, I’d like to profusely thank my creative wingman Mark Mongilutz. Without his relentless and skillful assistance, this book would never have made it to publication.
And this list would be incomplete if I failed to mention the foundational support of Evergreen Gavekal. It is the firm into which I’ve invested more of myself than I care to admit, especially as the age milestone of 70 rapidly approaches. In some ways Evergreen represents a second family to me, while also being a first family in a literal context. (That’s for you, Tyler, Adam, and Wyatt).
Evergreen has been a supportive presence as I’ve experimented with and set out on new ways to share my knowledge, concerns, and hopes with the nation and the world. And because a big part of that sharing means reaching larger audiences of people who might never fall within the Evergreen Gavekal client archetype, the firm’s backup has been all the more appreciated.
Last, but for sure not least, I’d like to thank Evergreen Gavekal’s longtime clients who have demonstrated exceptional loyalty over the decades. Without you, and your faith in me, my 43-year career in the investment industry would not have been possible.
How did it happen? How did the United States of America slide so far, so fast? Two decades is less than 10% of this nation’s history and yet in that comparatively short time the degeneration of America has been shocking. Whether regarding its finances, its social contract, its adherence to the rule of law, its respect for a two-party system, its reverence for free speech, its tolerance of dissenting views, its trust in its political leaders, its desire to reduce wealth inequality, or its perception of its own moral character, all have devolved to a degree that leaves most Americans depressed and deeply apprehensive.
Answering how this all happened requires a very complicated response. There have been numerous pernicious forces at work, some external and many internal. On the former score, 9/11/2001 was unquestionably a major pivot point. It not only destroyed our sense of security, it triggered two wars that added trillions of dollars to our national debt… and most of that back in the days when a trillion dollars seemed like a lot of money. Far worse, countless lives were lost or permanently impaired as a result of the conflicts in Afghanistan and Iraq, along with the spillover conflicts in countries like Syria and Libya. The merciless organization ISIS came into being almost certainly as a result of America’s Middle Eastern military interventions.
But the focus of this book is on the role that the U.S. Federal Reserve played in our painful national decline. It goes without saying, or writing, that the Fed, as it is popularly known, did not intentionally precipitate this unfortunate outcome. PROLOGUE 2 Nevertheless, it has repeatedly resorted to extreme monetary policies since the late 1990s tech bubble imploded. It has also consistently asserted that these radical measures were temporary. Yet, other than for brief periods, especially since 2008, it has maintained them, lending credence to the old saying by Milton Friedman (and Ronald Reagan) that there is nothing so permanent as a temporary government program.
The goal of this book isn’t to assign blame, though there is an abundance of that to go around. Rather, it’s my contention that objectively evaluating what the Fed has done — and the long-term ramifications of its actions — is essential in determining if it played a key role in America’s twenty-year deterioration. If so, a radical overhaul of the Fed is needed before it inflicts even more damage in terms of bubble inflations and social stratification.
Undoubtedly, many will question characterizations like decline and devolution but, in my opinion, most will not. It’s painfully obvious in early 2022 that the majority of Americans are scared and pessimistic. Certainly, the Covid pandemic that’s still raging as I write these words was another external shock and one that continues to plague us (literally). It has just as certainly been a huge factor in the national sense of despair. But pandemics all end, and we are much closer to the conclusion of this terrifying experience than the beginning (barring the apocalyptic scenario that variants develop a resistance to both vaccines and natural antibodies among the previously infected).
Once the virus crisis is largely in the past, however, its toxic impact on our country’s finances will remain. The virtual lockdown of the U.S. economy required deficit spending on a scale not seen since WWII. As a result, our federal debt-to-GDP ratio now stands at the highest ever, other than a year ago when it briefly hit 135%, above what it was even in 1945 after both Germany and Japan had surrendered. (The fact that it has now receded to 122% of GDP is a key part of this book and will be examined in detail in Chapter 17.)
The six trillion dollars of U.S. government deficit spending that has occurred over the last 21 months — from March of 2020, when Covid first went viral, until the start of 2022 — necessitated the Fed to do something called debt monetization. This is the technical term for a central bank buying up its own government’s bonds.
What makes it particularly alarming is that these purchases have been made with the Fed’s high-tech equivalent of the printing press: the creation of digital money, or reserves, simply fabricated from its very special computers. (Don’t we all wish we had one of those!) In my newsletters over the years, I have referred 3 to this as the Fed’s Magical Money Machine. And when it comes to asset prices like stocks, bonds, real estate and, even, cryptocurrencies, it has indeed worked magic. Perhaps the correlation shown below is a coincidence, but this book will contend the opposite.
The Fed has been joined in this debt monetization and money fabrication scheme by virtually every major Western central bank, so it is very much an international phenomenon. This process will be examined in more detail in subsequent chapters. (Please note the Glossary of Terms that accompanies this Prologue, as well as the Cast of Key Characters; you may want to print this out to have it easily accessible as you proceed. Many chapters also have an appendix where additional data or context is provided to avoid slowing down the pace of this book.)
The initial publication of this project actually involved my financial newsletter called the Evergreen Virtual Advisor (EVA) which I’ve written since 2005. It ran via roughly monthly installments from December of 2017 until May 1st, 2020.
What caused me to begin this effort in late 2017 was the speculative frenzy that engulfed Bitcoin and the other cryptocurrencies at the time. Even back then, Bitcoin had eclipsed every prior financial bubble (remarkably, unlike any other prior bubble in recorded history, it, and the other cryptos, have re-inflated to yet more astronomical levels; this extraordinary development will be a focus in Chapter 10). As with the dotcom craze of the late 1990s, Bitcoin in the second half of 2017 had captured the imagination of millions of Americans — along with billions of their investable dollars.
That first edition of the Bubble 3.0 series went out just as the incredible crypto mania hit its crescendo. Its peak almost perfectly coincided with the publication of the first chapter of this book in its on-line form, which is most uncharacteristic of me. Usually, my warnings are early – sometimes years early.
Chapter 1: Birth of a Bubble Nation
In attempting to identify a Bubble 3.0 starting point, it is only logical to reflect back on how we arrived at our present situation of unprecedented central bank involvement with financial markets. We must also consider the uniqueness—and latent danger—in the reality that most developed country governments have utterly trashed their balance sheets over the last dozen years. This was the case even before the pandemic panic struck; since then, sovereign indebtedness has hit end- of- WWII-like levels.
Prior to Covid, I had written in the real-time Bubble 3.0 (published in monthly installments via our EVAs) that the degradation of most developed countries’ balance sheets from 2009 through early 2020, left them with limited options for the next crisis. This erosion occurred despite a sputtering but long-lasting economic expansion. COVID was, of course, a disaster of nearly Biblical dimensions (this is no exaggeration; plagues played a starring role in the Old Testament!).
In Chapter 2, I will elaborate on how central banks coped with Covid. However, for now, let us zero-in on what central banks did in the decade between the Global Financial Crisis and the pandemic. (Ironically, “zero” is an apt word.)
If I had been so imprudent as to have speculated back in 2007 that, over the upcoming decade, the Fed would resort to four separate rounds of QE[i] my readers would have reasonably concluded I had lost it totally.
But Quantitative Easing (QE) was just the first loss of the Fed’s monetary virginity. Modern Monetary Theory, or MMT, has taken its fall from respectability to an entirely new, and far more dangerous, level. While QE and MMT are related, it is fair to think of the latter as burlesque while the former is a full-on striptease – sans G-strings – with all sense of propriety abandoned.
While the former created trillions of dollars of pseudo-money (what I sometimes refer to as “pseudough”), it was not effective at getting it into the economy itself, as opposed to allowing, even encouraging, it to leak into asset markets like stocks and real estate. But MMT involves the semi-direct financing of multi-trillion-dollar Federal government outlays to consumers and businesses. This is why, for the first time in U.S. history, household income rose during the short, but brutal, Covid-caused recession.
Basically, MMT is much more potent than QE and, in my opinion, much more inflationary. (As a side note, in 2008, when QE I was first launched — yes, they do sound like ocean liners — I argued with the many pundits who felt it would be highly inflationary.)
QE and MMT are such important topics that they richly deserve, and will get, their own chapters. Thus, for now, I’m putting an in-depth discussion of those on hold. Yet, they absolutely fall under the heading of things that would have been impossible to believe in 2007, prior to the explosive bursting of the late, not-so-great, housing bubble. As we shall soon see, that event changed everything… and for the much, much worse.
It was the massive mania in homes and, especially, mortgage lending that led to my writing our Evergreen Virtual Advisor (EVA) in 2005. Part of my motivation for doing so was to go on record with repeated (and, as it would turn out, repeatedly strident) warnings about the extreme dangers of that unprecedented inflation of home prices. I was even more adamant about the grave risks of the maniacal mortgage machine that was feeding it. This is what I think can reasonably be referred to as “Bubble 2.0”.
Candidly, I felt I had missed my chance to be more vocal about the first mass mania of the last quarter century: the intoxicating tech bubble of the late 1990s. In my view, there is little doubt this qualified as “Bubble 1.0” and it is generally considered to be the greatest stock mania in U.S. history. While I warned all my clients back then about its perils, I didn’t have a public platform through which to do so. The firm I was employed by at the time, Smith Barney, was also highly unlikely to let me take such a vehement and unpopular stand (telling investors they are about to get fleeced is never great PR for a large brokerage house). Accordingly, I will always feel like that was an opportunity lost.
However, as anyone who read our EVAs back then can attest, I didn’t pull any punches on Bubble 2.0. As continuous and shrill as my warnings were in those days, they actually weren’t equal to the calamity that was to engulf the world after Labor Day 2008. That September was the nightmarish month when Lehman Brothers, AIG, Washington Mutual, Freddie Mac and Fannie Mae all either literally collapsed or were prevented from doing so only by radical federal government intervention.
It still gives me a fleeting sense of panic to think back about how terrifying those times were and not just in the U.S.; it truly was a global financial pandemic. Perhaps it was a horrific sneak preview for the actual pandemic that was to strike the planet almost a dozen years later. In both cases, by the way, neither the Fed nor Wall Street saw what was coming, even as evidence mounted of the impending catastrophe.
With Covid, the window was very small for preventative measures and its ferocity was extremely hard to imagine for non-epidemiologists. But there were those of us who did get worried enough to hunker down early in the pandemic. In the case of the great housing bubble, though, there was plenty of time and abundant evidence of the escalating disaster. Consequently, free passes should be sparingly given. As another QE, Queen Elizabeth, asked her government’s best and brightest ex post crasho: “Didn’t anyone see this coming?”
Well, actually, many of us did, as brilliantly recounted in Michael Lewis’ mega-hit The Big Short. (Personally, I give copious credit to John Mauldin and David Rosenberg, both of whom played a huge part in alerting me to the impending disaster.) The problem was that most people, especially those in a position to do something about it, didn’t pay any attention to us.
Fed Chairman Alan Greenspan famously — make that, infamously — encouraged U.S. home buyers to use adjustable-rate mortgages… even as he was raising interest rates! His successor, Ben Bernanke, said more infamously yet that the unfolding fiasco in sub-prime mortgages, which had become obvious by the third quarter of 2007, would be “contained” within that dodgy part of the lending world. Citigroup CEO Chuck Prince covered himself in ignominy by declaring his bank would “keep dancing as long as the music was playing”, referring to his intent to keep funding the mania that was happening in nearly all forms of lending in the summer of 2007. Once proud Citigroup saw its stock price fall from the fifties to a mere dollar by early 2009, showing the extreme hazards of dancing too long during times of mass imprudence. As with most big U.S. banks, only gargantuan government support allowed it to survive.
This is a critical reason why Bubble 2.0 turned out to be so much more lethal than Bubble 1.0; namely, it involved the banking system. Banks were brimming with questionable loans by mid-2007. The toxicity not only infected the U.S. financial system, but had spread to most of the developed world. Once the dominos started tumbling, it looked for a time like they would never stop. There was a real risk of another Great Depression, as large banks all over the world were on the brink of failure. That’s why such credit-fueled manias are the very worst kind of bubble.
Bubble blind… again & again
How was it that such a multitude of people who should have known better, could have been so clueless about the escalating dangers? With the advantage of hindsight, it’s now clear that Bubble 2.0, and particularly its disastrous demise, would sow the seeds for Bubble 3.0. And though some no doubt would challenge the linkage – often those who continually deny the existence of bubbles in the first place – the evidence is strong that the speculative frenzy around tech stocks in the late 1990s initiated the chain reaction that would ultimately lead to the epic housing boom and bust.
With the passage of over 20 years’ time, memories are fading fast as to how traumatic the tech crash was in real-time. Arguably, the boom phase started with the initial public offering (IPO) of Netscape in 1995. The spectacular success of the search-engine pioneer’s public debut began what would become, over the ensuing five years, the most intoxicating run of new issues in financial market history.
The seemingly insatiable appetite for IPOs from 1996 until early 2000 (with a brief hiatus caused by the 1998 Asian Crisis), set off an extraordinary sequence. As Wall Street was increasingly bestowing breathtakingly lofty valuations upon companies that were going public — in some cases, with little more than a business plan — tech entrepreneurs and venture capital (VC) investors were incentivized to an unprecedented degree to create and fund start-ups. This allure, combined with the legitimate breakthrough nature of the internet, proved an irresistible temptation for investors. And, of course, Wall Street underwriters, always in search of big fees, were only too happy to satisfy their cravings.
As more companies went public and saw their prices rise vertiginously, VC investors were emboldened like never before. Private placement memorandums (PPMs) and executive summaries, the essential documents of raising capital for start-ups, began circulating in Silicon Valley and Seattle, the dual hotbeds of tech innovation, like illicit drugs at a Hollywood party.
Unquestionably, most of these failed without making it to the going-public stage and the bulk of those would eventually flame out during the great tech bust. But enough made it to the NASDAQ to pour napalm on the speculative flames of entrepreneurs and investors alike. The term “internet millionaire” — and, often, billionaire — entered the popular lexicon. (Of course, none of this wildly speculative behavior could happen again, right? No way. What happened in 2020 and 2021 with IPOs, SPACs, cryptocurrencies, NFTs, and meme stocks must have been just the latest manifestations of the efficient market theory.)
Before long, the most intense stock market boom in 70 years, since the giddiest years of the Roaring 20s, was working its way to a feverish crescendo. While the majority of the companies that would become associated with the tech bubble, such as Netscape, Cisco, VMware, and EMC, hailed from California’s Bay Area, the most dominant of all, as it would turn out, came from the greater Seattle area. That dominant tech-bubble precursor and omnipresent distributor of goods would be none other than Amazon.
(Note: It’s not entirely on-topic, and it runs a little too long for inclusion here, but in the Appendix I’ve included a personal story on my humiliation as a result of the internet mania — and my own obtuseness. Let’s just say, but for one small act of omission, I could have been a billionaire. As they say, it’s only money; I just wish it didn’t have to be that much money!)
As the 1990s wound down, the tech sector wound up to a dizzyingly frenetic pace. While Netscape and Amazon were in the vanguard, scores of other internet companies followed closely behind. Conditions had become feverish enough, as early as 1996, for then-Fed chairman Alan Greenspan to legendarily warn of “irrational exuberance” in the stock market.
As stock prices continued to rip higher over the next three years, the man known at the time as “The Maestro” for his deft handling of monetary policy and the economy, had his first major brush with fallibility. However, rather than maintaining the courage of his convictions and becoming increasingly vocal about the escalating mania, he began to equivocate.
Statements such as the following from his August 1999 speech in Jackson Hole, Wy., as the tech bubble was in full inflation mode, reflected his new-found ambivalence: “To anticipate a bubble about to burst requires the forecast of a plunge in the prices of assets previously set by the judgments of millions of investors, many of whom are highly knowledgeable about the prospects for the specific companies that make up our broad stock price indexes.” With those words, The Maestro made it clear he didn’t understand how the allure of overnight profits could distort the judgment of even professional – and allegedly knowledgeable – investors.
By the time the tech tide went out, institutional portfolios were bloated with internet and other “new economy” stocks. In fact, roughly half of the supposedly very diversified S&P 500 was in tech and telecom issues on the eve of the big meltdown, graphically illustrating that the “judgment of millions of investors” wasn’t so judicious.
Much more seriously, despite the growing obviousness that the behavior of the NASDAQ was becoming eerily similar to the market action leading up to the 1929 crash, Mr. Greenspan failed to do what prior Fed chairmen had done during earlier overheating markets. Individuals like William McChesney Martin, who coined the pitch-perfect adage that the Fed needed to remove the punch bowl just when the party was warming up, had proactively intervened to prevent past bull markets from morphing into bubbles by raising margin requirements. Yet, not once did the Greenspan Fed do so, even as the NASDAQ proceeded to nearly quadruple after The Maestro had warned of irrational exuberance.
In fairness, Mr. Greenspan, like many (including this author), was concerned about the potential for severely negative repercussions due to the Y2K computer conversion looming. This, combined with the late ‘90s Asian crisis, which slammed markets globally, and triggered a particularly deep correction in many tech stocks, caused the Fed to actually cut rates in the fall of 1998. It also flooded the system with money during 1999 due to Y2K concerns, despite a booming U.S. economy and a tech bubble that was distending to gargantuan proportions. By the end of 1998, the tremors of the late summer were long forgotten, with the NASDAQ roaring up almost 55% from the correction trough.
Yet, notwithstanding the Y2K issue, the Fed’s decision to relax monetary policy at a time of robust economic conditions and hyperventilating markets clearly injected rocket fuel into the financial system. Its actions during the Asian crisis also reinforced the belief by market participants that the Fed’s new unspoken third mandate[ii] (along with maintaining low inflation and high employment, two conflicting goals that were already challenging enough) was asymmetrical.
In English, this meant that investors now believed the Fed would step in during periods of market turbulence to support asset prices but would stand aside when they were rising, no matter how rapidly and excessively. Basically, with his 1999 Jackson Hole speech, Mr. Greenspan codified the Fed’s “see no bubble” policy. It was a mindset that would come back to haunt the Fed — and the global economy at large — fewer than 10 years later.
[i] Quantitative easing”, often referred to as QE, is the antiseptically technical term our central bank conjured up to obscure that it was, in fact, printing money. (For more details, please refer to the Glossary.) At least thus far, the major central banks have refrained from actually printing currency as Germany’s Weimar Republic infamously did in the 1920s; rather, they have created digital reserves out of nothing but their computers. Those reserves have then been transferred to the banking system, typically in return for government bonds.
[ii] Some would say the Fed of that era had three actual mandates, including maintaining moderate interest rates, though the latter was, and is, somewhat vague. Ironically, the deceased Lion of the Fed, Paul Volcker, felt two was one too many. The Fed of 2022 now also has to attempt to stop climate change and fight racial injustice. Why would anyone want to be its chairman these days?
Chapter 2: The Worst Kind of Bubble
Bubble 1:0 – In the beginning…
As the “Roaring ‘90s” reached their intoxicating end, and the calendar, as well as computers, flipped over into a new century and millennium, tech stocks displayed no evidence of suffering an early-year hangover. Y2K turned out to be a non-event and the NASDAQ kept rocketing. By early March of 2000, the “NAZ” was up another 24% (or at about a 208% annualized rate), bringing its surge from the lows of the 1998 Asian crisis trough to a mind-blowing 257%. Incredibly, this monster move occurred in less than a year and a half. Then, virtually overnight, the tech world shifted on its axis.
There are typically multiple pin thrusts that puncture a bubble as immense as the one created by the tech/internet mania. This explosive deflation was no exception. The first prick was, in hindsight, the failure of several new issues by dot.com entities. Even as early as April 2000, the 149 IPOs which had already occurred that year were down an average of 45% from their first-day close (though this was typically up, sometimes considerably, from the IPO price). Suddenly, the IPO market was no longer a gullible supplier of limitless funding, not to mention a fabulously lucrative exit strategy for early investors.
The shockwaves reverberated quickly through the start-up ecosystem. With the IPO market on its heels, venture capital-types became increasingly choosy about which business plans they would finance. The torrent of money that had been sloshing through Silicon Valley and Seattle stopped almost as if someone had closed the gates of a giant sluice. As always occurs when a boom goes bust, the losses came fast and furiously. By the summer of 2000, the NASDAQ was down an ulcer-inducing 35%.
Another factor behind the plunge, ironically, was good news about Y2K. The uneventful transition removed the Fed’s rationale for not hiking rates further. In January of 2000, the Fed hiked its overnight rate to 5.75%. (Yes, those were the days when holding cash wasn’t penalized; in fact, it was earning a net-of-inflation rate of 2%). The stock market, particularly tech stocks with nonsensical valuations and, usually, a complete absence of yield, had some serious competition for investors’ dollars.
This would prove to be the first of seven tightening moves the Fed initiated from mid-1999 through mid-2000. Despite the accelerating tech meltdown, the Fed hiked again in June 2000, pushing the Fed funds rate up to nearly 6.5%. With inflation running at 3 ½% that year, the real return on money market-type accounts rose to roughly 3%. Two decades ago, cash was definitely not trash and this obviously posed a competitive threat to the stock market, especially once the thrilling gains had turned into chilling losses.
As 2000 came to a close, and what would turn out to be the world-shaking year of 2001 began, hopes in “tech land” were high that the worst was over. This seemed a reasonable conclusion, given that the NASDAQ finished the year down a stunning 61.2%! Yet, unfortunately, for all those true believers in the glorious future for the internet and high technology, of which there were legions, the carnage in tech intensified.
Even prior to the horrific events on September 11th, 2001, the NASDAQ fell another 31.2%, leaving it down 66% from its March 2000 apex before a feeble rally occurred that summer. The inconceivable nightmare of the 9/11 terrorist attacks, which would reverberate around the planet for years to come (and still does), only intensified the tech devastation. From the peak of the summer bounce to the post-9/11 low, the NASDAQ melted by another 35%, before a vigorous year-end recovery erased most of the losses caused by the 9/11 panic. Regardless, for all of 2001 the NASDAQ had swooned an additional 20.8%, on top of the 61.2% shellacking in 2000.[i] Many assumed the worst was over. They were, once again, wrong. Even to my formerly tech-skeptical eye, it seemed as though further significant downside was unlikely.
Yet, notwithstanding some rousing rallies during the two-and-a-half-year bear market in almost all things tech, once the “NAZ” finally hit bottom in the fourth quarter of 2002, it had fallen from 5000 to 1100, a monstrous value annihilation of 78%. Not since the Great Depression, when thousands of banks failed and America looked to be on the brink of sheer economic collapse and/or a social revolution, had a major index declined by this magnitude.
The Fed’s earlier unwillingness to put out the raging speculative fire by raising margin requirements had come back to haunt it, and the world, as nearly all global stock markets were ferociously mauled. Alan Greenspan’s “Maestro” reputation was in serious jeopardy and his failure to follow through on his 1996 “irrational exuberance” message was widely criticized. The Greenspan-led Fed then proceeded to make a difficult situation much, much worse.
Another bubble to cure the crash
With almost hysterical pressure from high-profile sources, especially the New York Times’ Paul Krugman – who, in 2008, ironically, would win a Nobel Prize in Economic Sciences – the Fed kept cutting its overnight rate until it got down to the then unheard-of level of 1% by June 2003. Despite the U.S. economy having only endured a mild recession in 2001 — most remarkable given the twin shocks of the tech bust and September 11th — Mr. Krugman literally begged the Fed to create another bubble. Intentionally or not, Mr. Greenspan and his esteemed colleagues at the Federal Reserve Board, which included future Fed chairman Ben Bernanke, did exactly that.
Even as the U.S. bounced back from its technical recession (GDP actually rose 1% in 2001 and 1.8% in 2002, despite the tech crash and the terrorist attacks), the Fed left its overnight rate at 1% through May of 2004. This negligible cost of short-term money turned up the gas to high on an already simmering housing market. With adjustable-rate mortgages (ARMs) becoming all the rage, in order to fully exploit the collapse in short-term interest rates, the stage was set for lift-off into the “bubblesphere”.
Though mortgage debt more than doubled from 2000 to 2007 and housing prices rose by 80%, the Fed was oblivious to the rapidly rising dangers. Perhaps it drew comfort from the plunge by sub-prime mortgage defaults in those years but that was soon to prove itself the ultimate red herring — with massive amounts of red ink hitting the banking system as these spiked to nearly 14% by 2008.
It was during the boom years of 2003 through 2006 that both the mortgage industry and Wall Street formed the unholy alliance that would become immortalized in Michael Lewis’ blockbuster, The Big Short. Mortgage originators were lavishly incentivized through their cornucopia of fees to extend credit to nearly anyone who could fog a mirror. Unlike in bygone days when traditional banks and S&Ls would create loans and often hold them on their balance sheet, thereby ensuring a fair degree of prudence, the new breed of “originate and securitize” mortgage players had no residual skin in the game. By securitizing (i.e., bundling many mortgages into a package and selling them to Wall Street), the originator off-loaded the credit risk. Ergo, a tremendous moral hazard was created at ground zero, where the loan was initiated.
The next moral hazard was Wall Street (what a shock!). Its clients, both institutional and retail, were clamoring for yield. As usual, The Street was thrilled to comply… and supply. After all, it had only been a couple of years earlier when savers and investors were earning 6 ½% on cash while longer-term investment-grade corporate bonds and preferred stocks were yielding 8% to 9%.
In what was to be a sneak preview of the conditions that would last for the following decade – the era of Bubble 3.0, per this book’s title – Wall Street showed extraordinary ingenuity in creating vehicles to satisfy the ferocious appetite for yield. It began to manufacture CDOs by the droves, those securities more formally known as Collateralized Debt Obligations. These would be at the epicenter of the coming 9.0 planetary financial earthquake. Increasingly, these CDOs were populated by the subsequently notorious sub-prime mortgages. Why? Because of their lofty yields and, incredibly, as we will see in a moment, their perceived low risk.
To that point, and next up on the moral hazard list, were the rating agencies. Entities such as Moody’s and Standard & Poor’s, the Big Two (Fitch being a distant third), were compensated not by the buyers of the securities they rated but by the issuers, meaning the Wall Street underwriting machine. As Warren Buffett’s long-time partner, Charlie Munger, is famous for having declared, “Show me the incentive and I’ll show you the outcome.” In this case, the outcome was a steady stream of AAA-ratings on mortgage securitizations comprised totally of sub-prime loans. The logic, such as it was, for this seemingly absurd alchemy of turning junk into gilt-edged securities had to do with the supposed magic of “tranching”. (Please see the Appendix for an explanation of this remarkable process.) But that wasn’t to be the big surprise of this egregious example of mass greed.
One could make the argument that the rating agencies’ failure to do their job was the most indefensible. After all, the mortgage industry is in the business of making and selling as many loans as the markets and the regulators (more on them shortly) would allow. The same is true with Wall Street. But the rating agencies are supposed to be the adults in the room, warning professional and amateur investors if securities are high risk, or are vulnerable to adverse conditions.
Certainly, in the past, the assumption was that if a security was rated AAA, as so many of the sub-prime CDOs were, then it could withstand even a serious recession. In fact, it was common for very high-grade debt instruments to rise in value during tough times, the well-known flight-to-quality phenomenon. But, regardless, the belief was that they should at least hold their own during bust conditions, as they had during the 1930s. The crisis of 2008 shattered that precedent.
The operating assumption in bestowing a AAA-rating on sub-prime CDOs was that the home default experience would be similar to past down-cycles. Few, other than cranky renegades such as the stars of The Big Short, were connecting the dots between incredibly lax mortgage underwriting, home prices that were the furthest above their trend-line in history, and, as a result, affordability that was off-the-charts awful, as you can see in Figure 2 below.
In his after-the-crisis apologia, Alan Greenspan would concede that it shocked him how financial institutions could have been so imprudent – despite the fact that history is loaded with examples of exactly such reckless behavior on the part of banks and insurance companies. He had also assumed that securitization was a good thing, as the leveraged banking and lending system was offloading its credit risks to entities like mutual funds who typically were cash buyers. What he somehow missed was that the banks’ investment departments were as furiously accumulating these “securities” as their mortgage divisions were disposing of them.
Meanwhile, regulators like the SEC, the FDIC, and the Comptroller of the Currency, were in a deep-REM slumber. Nothing was done to slow down, much less stop, the craziness. It wasn’t like they couldn’t see what was happening with home values and mortgage debt. The numbers were hiding right there in plain sight, per Figure 2 above.
The New York Fed, given its proximity to Wall Street, should have been in its grill, pushing back vigorously on the blatant shenanigans. Instead, its president (and future Treasury Secretary) Timothy Geithner gave a speech in 2006, close to the top of mania, in which he said: “You are meeting at a time of significant confidence in the strength of the global economy and in the overall health of the financial system… the core of the U.S. financial system is stronger than it has been in some time.
Capital levels are higher and earnings stronger and more diversified… We have seen substantial improvements in risk management practice and in internal controls over the past decade.”
The fact that Mr. Geithner could be appointed Treasury Secretary after the crisis that he had no clue was brewing, and which had morphed into the worst financial panic since the 1930s, is certainly a testament to the inherent job security in working for the government. But it is stunning, and more than a bit terrifying as an American, to think that just two years later, everything he had spoken turned out to be complete nonsense. (In a later chapter, we will examine similar language voiced by senior Fed officials in recent years.)
Sadly, nearly all Wall Street strategists and money managers were oblivious or in total denial. (The smug portfolio manager portrayed in The Big Short, who completely blew-off the concerns of the housing bears, has an uncanny resemblance to Legg Mason’s former star Bill Miller.) However, there were a few brave and insightful exceptions. My good friend Danielle DiMartino Booth, who is cheering me on as I write this book, was one of them. Danielle is the author of the critically acclaimed book Fed Up and was a senior advisor to then Dallas Fed President, Richard Fisher. As such, she had a courtside seat to the inner workings of our country’s central bank during the lead up to the crash.
In her words, “In late 2006, after having written extensively on the potential for the housing bubble to unleash systemic risk across the global financial system, I arrived at the Fed just as home prices were beginning to crack. I was blown away by the calm and the blind acceptance of Alan Greenspan’s misguided creed that the economic benefits of homeownership, regardless of buyer qualification, outweighed the financial stability consequences precious few within the Fed saw coming.”
David Rosenberg, then chief North American economist at Merrill Lynch, and Pimco’s Paul McCulley were other lonely voices of caution. This author had the privilege of hearing them speak at John Mauldin’s Strategic Investment Conference in the years leading up to the housing crash. They provided me with critical data and other hard facts which influenced my decision to prepare my clients’ portfolios for a housing-driven bust.
The aforementioned lowest-rated slices (tranches) of sub-prime CDOs became the first, and worst, casualties of the housing bust. Most were wiped out during the early phase of the housing meltdown. But what was really shocking — and began to threaten the global banking system — was the utter collapse of the AAA-rated tranches.
By late 2008, a number of these were trading at around 30 cents on the dollar, meaning holders who typically had purchased them at or around par were sitting on losses of 70%. Since many of the owners of these instruments were banks with thin amounts of equity capital (especially in the pre-crisis days), losses like those were life-threatening. Moreover, because these were AAA-rated mortgage-backed securities (MBS) vs traditional home loans, banks were only required to have 1.6% in reserves set aside vs. 4% for traditional “whole” mortgage loans. Obviously, the 1.6% reserve was just a tad on the light side.
Source: Bloomberg, Evergreen Gavekal (as of June 7, 2018)
Greatly compounding this debacle was a formerly obscure accounting rule that had been enacted in 1993: Financial Accounting Standard 115. It required financial institutions to use “fair value accounting”, more popularly (or, by 2008, very unpopularly) known as “mark-to-market” accounting. In other words, banks and insurance companies were required to value their held assets at fair market value. From 1993 through 2007, this new rule didn’t pose any serious problems (the banking industry was not a significant holder of tech stocks). But once the bottom fell out of the housing market in 2008, it quickly became catastrophic.
It soon became clear that the financial system was loaded with sub-prime CDOs and other derivative securities whose values had collapsed. Even traditional investment-grade bonds and preferred stocks, from companies such as Nordstrom and Comcast, plunged 30% to 40% as the planet was essentially engulfed in a global margin call.
Source: Gavekal via Bloomberg
Source: Evergreen Gavekal via Bloomberg
With the new mark-to-market rule requiring financial institutions to value these formerly low-risk assets at fire-sales prices, it became apparent that nearly all U.S. banks and insurance companies were imperiled. Short sellers were circling even America’s strongest financial entities. The more the panic intensified, the lower stocks and bonds went. It was a classic doom loop.
This catastrophic chain reaction among financial institutions is why busts that involve the banking system are so horrific. Of course, you can’t have a terrible bust without an immense bubble, for which the housing/mortgage crisis unquestionably qualified. This thunderous implosion literally imperiled the entire planet’s financial ecosystem.
Opportunity (mostly) lost
In America, Lehman failed, as did Fannie Mae and Freddie Mac (both government-sponsored entities, or GSEs), along with the nation’s largest savings institution, Washington Mutual. Massive insurer AIG was saved only due to a government rescue that effectively wiped-out shareholders. It truly looked like no big bank or insurance company was safe.
During this bloodcurdling time, in the fall of 2008, my newsletter repeatedly urged the Fed and/or the U.S. treasury to borrow (note: not print) a huge sum — like $1 trillion — and then invest the proceeds in the open market in highly rated corporate bonds and mortgages. Because T-bill yields had plunged to almost nothing, this was virtually free money and the rates the government would be securing were in the high single digits, often above 10%.
As I argued at the time, the Fed would have made a killing, an opinion which future events proved out. It also would have almost certainly arrested the free-fall virtually overnight. (Please see the Appendix for an elaboration about this important topic.)
Instead, in 2008 and into 2009, crucial terror-wracked months went by as the government clumsily rolled out the TARP* (Troubled Asset Relief Program) which initially did very little to restore confidence. The Fed, for sure, introduced some effective calming moves like guaranteeing money market funds, which did lower the panic level. And it executed the trillion-dollar intervention I had pleaded for, but it resorted to the previously described QE. In other words, it created the funds from its computers – rather than borrowing in the bond market as it had always done in the past – initiating a series of these digital money fabrications that continue to this day. (De facto QE was bizarrely restarted in America in September of 2019, despite a sub-4% unemployment rate, even prior to Covid).
Further, instead of investing the trillion where it was most needed — into corporate debt-like securities with astounding yields and bombed-out prices — it invested that immense sum in the most overpriced debt securities on the planet: U.S. treasuries and government-guaranteed mortgages. Agonizingly, the Fed missed a chance to invest taxpayer money at credit spreads (the difference between the yield on government and corporate bonds) at the highest levels since the darkest days of the Great Depression.
Despite these splashy but clumsy efforts, it wasn’t until the mark-to-market provision was defanged in mid-March of 2009 that risk assets (like stocks) began their spectacular rise from the ashes. This included bonds such as Nordstrom’s issue shown above which, by July 2009, was back at face value, providing a 58.6% return to those who bought into the teeth of the panic. In fact, for several years after the turn, securities such as those matched or even exceeded the returns from stocks.
For investors with courage enough to buy the debt securities from AIG at 10 cents on the dollar, the return over the next four years was 754%. At the time, I was vehemently urging my readers to buy these types of corporate income securities. But, frankly, most were so paralyzed by fear that they missed this once-in-several-generations opportunity. (The AIG subordinated debt issue described above also paid a cash flow yield of roughly 80% to investors who bought it at a 90% discount to face value; remarkably, it never missed a payment, thanks to the tens of billions of government support which, by the way, was fully recouped.)
Even today, there are highly intelligent investment professionals who believe the government made a monstrous error by intervening. I do not count myself among them. Despite the ham-fisted way it was done, it worked, and I shudder to think what would have happened had they not resorted to measures that no one would have dreamed of mere months earlier. It was truly a near-death experience for the world’s financial system.
However, that does not exempt the Fed nor the government’s regulatory bodies from the primary responsibility for the disaster that still haunts us today. By allowing bubbles to expand to immense proportions without trying to cool down markets (such as by raising margin requirements, tightening lending standards, requiring more capital to be held by banks, preserving the separation of underwriting and banking, prohibiting rating agencies from being paid by the very companies they are supposed to scrutinize, to name a few), American policymakers blew it big time.
The multi-trillion-dollar questions are: 1) have they learned from their past disastrous misjudgments, and 2) should investors trust in their assurances that the financial system is now safe and sane? At the time I was creating this book through our newsletter’s monthly editions, I wrote that we would only know for certain during the next bear market and/or panic. Covid, of course, produced those conditions on an existential scale.
To its credit, the Fed resorted to even more extreme and creative rescue measures, particularly the intervention in the crashing corporate bond market, the move I had suggested during the Global Financial Crisis of 2008/2009. This was the vital lesson it had learned from the GFC that it deftly applied in March of 2020, as financial markets were in total pandemic panic mode. As I had postulated a dozen years ago, it only needed to acquire a small amount of high-grade and low-grade private sector debt to turn the market on a dime. Yet, as noted before, it was that announcement which killed the bear market and brought the latest romping bull market to life.
On the less clever side, America’s central bank now appears to be in a prison of its own design, as we will see in forthcoming chapters. Whether it can escape without severe damage to the U.S. economy and its credibility, will be perhaps the most important financial story of this decade.
[i] A brief explanation is in order of how compounding losses, especially of a sizable nature, impact a starting value. For example, if you start with $100,000 then lose 50% and another 50% after that, you aren’t down to zero. Rather you still have $25,000 left. That’s pretty much what happened to tech investors from 2000 to 2002.
Chapter 3: A Brief History of Bubbles
The “Fed Put” makes its debut
Readers of this quixotic book, one that attempts to fight back against the deeply embedded human emotion of greed, should be aware that I’ve had a long-running and contentious relationship with bubbles. And though we just made our way to the present, let’s take another brief look at market history and my own relationship with it.
My life in the financial industry began in 1979 when Jimmy Carter was president and inflation was the scourge du jour. For those readers old enough to remember, I’m not referring to the persistent double-digit price rises we have seen in almost all asset values in recent years, but rather of the CPI variety.
Back in the Carter era, it appeared as though the cost-of-living index was destined to continue rising at an accelerating rate, as it had done for most of the prior 15 years. That trend, coupled with the concomitant surge by interest rates to unprecedented levels (yields on short-term debt securities exceeded 20% in 1981 during the first year of Ronald Reagan’s presidency), proved to be a toxic combination for U.S. stocks. But those unparalleled rates, engineered by then-Fed chairman Paul Volcker, produced the intended effect. For the first time in a generation, inflation began to crack, and hard. By August of 1982, with the Dow Jones trading at seven times its trailing 12 months’ earnings (versus over 21 as I write this text), the stage was set for the greatest bull market of all-time.
But come the fall of 1987, the market’s price/earnings (P/E) ratio had tripled, and euphoria had replaced despondency among investors. Inflation was rising, as were interest rates. Yet, those threats did little to dispel the market’s incessant march higher, even as computerized trading and a supposedly risk-mitigating strategy called portfolio insurance came to dominate activity.
The infamous crash of 1987 hit in October of that year, bringing U.S. stock prices down 30% in just a few trading sessions. This was despite an economy growing at a rate three times as fast as the 2% snail’s pace that has characterized most of the past twelve years.
As rates on U.S. treasuries crashed in the wake of the 1987 panic and the economy remained robust, stocks quickly regained their lost ground despite widespread fears of a replay of the Great Depression. In short order, lofty valuations were restored… with a considerable assist from the Fed. Then chairman Alan Greenspan flooded Wall Street with enough liquidity to quell the panic. Thus, the legendary “Fed Put” was born. However, the real action was occurring halfway around the world from Wall Street, in the Land of the Rising Sun (and astronomically rising asset prices).
It was during the late 1980s that the ground under the Imperial Palace in Tokyo was supposedly worth more than all the real estate in California. The main Japanese stock index, the Nikkei, was trading at a P/E ratio of roughly 70. It was a bubble such as the world hadn’t seen since the late 1920s. The absurdity of the prices for Japanese stocks and property caused me, for the first time, to find myself in a bubble-busting state of mind.
Unfortunately, I had become convinced Japanese shares were ridiculously overpriced in 1988, when the Nikkei was trading at 20,000 (by the way, as recently as 2015, 27 years later, it was still trading at 20,000!). My belief caused me to urge my clients to sell their positions in some of Japan’s leading companies that I had bought for them in pre-euphoric times. Once this monstrous speculative frenzy climaxed, the Nikkei rose another 100%, topping out at roughly 40,000 and the aforementioned 70x earnings. Suffice to say, I sold somewhat prematurely, something for which I have a great knack.
The reason I rehash this 33-year-old episode, besides being my initial encounter with an unadulterated bubble, was that it proved to be the pattern of my bubble-opposing efforts: being painfully and embarrassingly early in my predictions of the ultimate reckoning. Little did I know at the time that the world, which had largely been bubble-free since the late ‘20s, with a few minor exceptions, was destined to be caught up in a series of these strange phenomena over the next three decades. And I was fated to repeatedly cast myself in the role of Dour Dave, Davie Downer, Doubting David, or any other derisive characterization of my unwillingness to play along with the prevailing giddiness — always at great cost to my psyche and reputation.
It now seems appropriate, in the early chapters of this book, to consider a basic question: What is a bubble, anyway? Some wags have suggested that a bull market is one in which an investor is a participant while a bubble is one in which he or she isn’t invested. Despite its whimsical tone, I think there is a lot of truth in this simple saying. Over the years, and through serial bubble events, I’ve repeatedly witnessed the extreme logic contortions supposed market gurus go to in order to rationalize nonsensical valuations. Why? Because rampaging bull markets are good, if not great, for business (and bonuses) as discussed below.
As prices on the Bitcoin, et al, went vertical in the fourth quarter of 2017, it was nearly impossible to read or watch any financial news story or show without being continually bombarded by articles or spots about Bitcoin and its less-famous clones. The steeper the slope of the ascent, the more the investing public and the media raved about this remarkable phenomenon. And phenomenal it was, as you can see from the following chart. (In Chapter 10, I will chronicle its even more phenomenal second act.)
The image above is crucial in answering the fundamental question about what constitutes a bubble. Based on over 40 years of market experience, and far too many personal battles with these extreme manifestations of humanity’s avarice, it’s my conviction that the chart needs to look at least somewhat like Bitcoin’s to truly qualify as a full-blown (pun intended) bubble. In other words, at some point in the latter stages of the bull move in whatever, the price-line needs to literally go vertical in order to apply the “B” word.
Despite the increasing frequency of these events over the last 20 years, there are many who don’t believe in bubbles, or at least are unconvinced that they can be identified in real-time. To that point, a U.S. Supreme Court justice once remarked that he couldn’t define pornography, but he could recognize it if he saw it. In my opinion, that’s exactly the situation with bubbles. They defy a precise definition but when you see one, you have to be truly bubble-oblivious to deny their existence.
The fact that so many do turn a blind (or least seriously impaired) eye to them has, in my view, much to do with the incentives. In this regard, please recall the earlier Charlie Munger quote about incentives and outcomes.
Bluntly, for far too many involved in the financial markets, the inducements to pump up asset bubbles are immense and irresistible. The amount of money that flows from the heart of Wall Street through all the veins and arteries of the financial system — banks, brokers, ETFs, mutual funds — is, inarguably, astronomical.
Like croupiers at the world’s biggest craps game, these intermediaries (of which, admittedly, I am one) skim off billions upon billions of riskless gains. After all, it’s not their capital on the line. Rather, it is the trillions in hard-earned money which, if you follow the trail far enough down, leads to ordinary folks, many of whom are retired or nearing retirement. In this era of central bank-eradicated interest rates, these individuals are among the most vulnerable to being lured into stocks by the TINA argument: “There Is No Alternative”, or by the even more primal motivation: FOMO, “Fear of Missing Out”. One of my biggest concerns is that when this monstrous bubble in almost everything implodes, it is going to create enormous hardship for millions of older investors who will have little chance of recouping their deep losses. But more on that in subsequent chapters…
For now, let’s go even further back a few hundred years to the first documented bubble. As almost everyone has heard or read, the Tulip bubble mania — or Tulpenmanie, in Dutch — that gripped Holland in the early 17th century was the first well-publicized bubble. This is perhaps because by then the printing press had been invented. (Ironically, the invention of digital printing presses by present-day central bankers has played a starring role in Bubble 3.0.) Thus, the dissemination of its spectacular rise, and just as spectacular collapse, was easily documented and preserved. (While I have no proof whatsoever, I suspect bubbles go back as far as humans have engaged in trading activity.)
But even with the existence of newspapers, price data from over 350 years ago is at least somewhat suspect. Putting that aspect aside, it is interesting, if not downright fascinating, to compare the purported price behavior of tulips back in 1636 and 1637 to that of Bitcoin in recent years.
Source: Convoy Investments
As you can see in the chart above, what we witnessed in 2017 with the cryptos was literally a once-in-a-three-and-a-half-century event. (Yet, as we will see in Chapter 10, the interval between spectacular speculative crazes has shrunk down to a mere three-and-a-half years.)
Unquestionably, there have been some whopper bubbles since Tulpenmanie, such as the U.S. stock market in the Roaring 20s, the aforementioned mania in Japanese stocks and real estate in the late 1980s, and, of course, the tech bubble in the late 1990s. Consequently, what happened with Bitcoin deserves considerable “credit” in the annals of speculative orgies. (As alluded to earlier, Bitcoin has also managed to do something no previous bubble object has ever achieved before: To crash by 80% and then rise again to even more vertiginous heights in just a few short years.)
Some have dismissed the crypto-craze, at least of 2017, as a niche development that involved only a few tech nerds, some Russian hackers, and a limited number of gullible trend-followers. The reality is that well over $1 trillion was invested in the cryptos themselves, as well as in stocks allegedly linked to them and to their far more reputable underlying technology: Blockchain.
In a precise repeat of the ‘90s dotcom insanity, companies that previously had nothing to do with either Bitcoin or Blockchain saw their stock prices explode by simply changing their name to include some reference to either B-word or announcing their business model now included something related to them (as in the case of the formerly bankrupt Eastman Kodak). The charts below give you a tangible idea of how this absurdity played out as 2017 ended (the most humorous might be the former Long Island Iced Tea, which tweaked its name to “Long Blockchain”).
But let’s go back in time again, though not quite as far as 380 years, courtesy of the incomparable Jim Grant. If you’ve never read one of his regular missives — Grant’s Interest Rate Observer — or heard him speak, you have missed one of the 21st century’s (and, for that matter, the 20th century’s) most accomplished financial wordsmiths. In his February 2018, issue, Jim wrote a captivating overview of a less well-known — and another long, long-ago — speculative frenzy: the Mississippi Bubble.
The primary architect of that initially intoxicating, but ultimately unhappy, affair was a Scotsman by the name of John Law. Mr. Law was born a few decades after the Tulip Bulb mania and his subsequent actions seemed to indicate he learned much from that episode. His hurried relocation to France was precipitated by being the winner of a lethal duel (presaging the fate of Aaron Burr a century later who had the same exile experience after fatally shooting the now resurgently popular Alexander Hamilton).
But Law is today notorious, at least among financial historians, for skills well beyond those of a steady-handed marksman or his other latent talent: gambling. Perhaps it was his tendency to turn a quick buck (or franc) that led him to devise his “System”, a means of solving the chronic debt problems of the French monarchy.
Just as U.S. president Richard Nixon would do some 250 years later, Law came up with a plan to ditch that barbarous relic known as gold and replace it with something much less restrictive: paper money; aka, fiat currency. (Please see the Appendix for more background on Nixon’s abandonment of the gold standard.) Unsurprisingly, this episode ended in disaster for both the French people and France’s aristocracy, not to mention Mr. Law himself. But we’ll get into this in more detail in Chapter 6 as we look at the updated version of his economic model, one that America is currently practicing.
Maybe we’ll get lucky, and more bubbles will collapse in on themselves, like the cryptos, without causing systemic damage. But since I believe we are in the midst of the Biggest Bubble Ever (BBE) across the major asset classes of stocks, bonds, and real estate, with evidence to back up that contention to be presented in future chapters, I’m taking the Cantillon approach.
Reportedly, Richard Cantillon made a fortune shorting Mississippi Company shares and loading up on gold. Since John Law’s company is no longer around to short, I’ll have to make do with U.S. small cap growth stocks instead. Since they trade at over 80x earnings, including the one-third of them that lose money, they’re not a bad substitute. And holding a generous amount of the barbarous relic (gold), along with other hard assets like energy securities, might save skeptically minded investors from the ravages of the latest central bank experimentations with printing press prosperity. But stay tuned – there’s much more to follow on the topic of asset preservation strategies in Chapter 17.
Chapter 4: The Bubble That Keeps On Punishing
The maiden voyage of QE I
Returning to the great housing speculation of the first decade of this millennium, it’s my contention that its impact cannot be overemphasized. In my mind, it’s the main reason Western countries are now following monetary and fiscal policies formerly associated with Banana Republics. Moreover, there is a profound difference between the monetary (the Fed) and fiscal (the federal government) responses today, as a result of the virus crisis than was the case after housing crashed 12 years ago, as we shall soon see.
The collapse of Bubble 2.0 started out innocuously enough. Just months before what would soon be known as the Global Financial Crisis, it appeared that problems in housing might merely cause a mild recession. As noted in Chapter 2, Fed Chairman Ben Bernanke had assured the public that the melt-down in the mortgage market would stay “contained” within sub-prime loans. Other high government officials, like Treasury Secretary Hank Paulson, assured investors in Fannie and Freddie that those two government-sponsored entities (GSEs) were safe and sound. Within months, however, both Mr. Bernanke’s and Mr. Paulson’s soothing words would be proven utterly unsound.
It was almost like what had happened in another September, seven years earlier, on 9/11/01. Americans woke up one day and the world they had known was forever changed. Fear had replaced complacency and the speed with which it happened made it feel like some kind of terrible dream. In reality, the 2008 crash was another national nightmare and one that continues to haunt us to this day, despite the seeming invincibility of the S&P 500 (at least as of this writing). Even prior to Covid, Western central banks continued to follow financial crisis policies such as binge money printing (the digital version) and ultra-low to negative interest rates. Both have had powerful and, in many cases, seriously negative impacts on society at large. This contention will be defended in more detail in upcoming chapters.
Remarkably, after over a decade of evidence that these radical monetary experiments have failed to produce prior economic growth rates—and have severely aggravated wealth inequalities—central banks are fiercely adhering to Einstein’s definition of insanity: Doing the same thing, over and over, and expecting different results.
As discussed in Chapter 2, a prime factor as to why financial conditions deteriorated so rapidly in the fall of 2008 was the Fed initially greatly underestimated the magnitude of the crisis. Once it finally grasped the severity, it flew into action with a series of bold moves. It guaranteed money market funds which had suddenly become suspect in the minds of investors, to forestall a mass panic-stricken run on these widely held vehicles that were once considered riskless. It provided foreign central banks with enormous sums of desperately needed dollars. And, perhaps most significantly, the Fed prepared to launch its first round of Quantitative Easing (QE) whereby it willed into existence $1 trillion of reserves with nothing more than a few computer keystrokes.
This money-from-nothing was, of course, unprecedented. Never had the central bank of a wealthy country resorted to such an extreme monetary policy. It was intended to instill confidence and stabilize the system, but it had an unintended consequence. Because we have become so numb to QEs over the past decade plus, most of us forget the chorus of supposedly expert voices warning that such overt money printing[i] would lead to inflation, possibly of the hyper variety.
One reason I vividly remember this aspect is that for at least the first few years after QE 1.0 was launched, with three more iterations[ii] to follow, I repeatedly found myself in the position of debating the subject with clients and other investment professionals. Many of them contended that inflation was inevitable and, moreover, that it was exactly what the U.S. government wanted as a way of inflating away its debt. (The Federal deficit was exploding in those days due to the Great Recession and the numerous bailouts that also included GM and Chrysler.)
My counter argument was that offsetting the stimulus from the trillion-dollar QE was something of which very few people were aware: the velocity of money. While the Fed was synthesizing its first trillion, money velocity was cratering at a rate unseen since the Great Depression. (For a more thorough explanation of money velocity, please see the Chapter 4 Appendix.)
Paralysis by faulty analysis
Yet, because most people had never heard of the velocity of money and were only focused on the sheer quantity of quantitative easings, they fell victim to the idea that yield securities were to be avoided. This was most unfortunate, and likely cost investors hundreds of billions, if not trillions, in lost income as well as capital gains. This is due to the fact that, as described in Chapter 2, high cash-flow investments like non-government guaranteed mortgages, corporate bonds, and preferred stocks were selling at prices unseen since the early 1930s. During the worst of the crisis, junk bonds were trading at yields of around 23%! (In early 2022, by contrast, they are roughly 5%.)
Additionally, other income vehicles, like master limited partnerships (MLPs) and real estate investment trusts (REITs), were mercilessly pummeled, with their prices often slashed by 60% or more. In some cases, cash-flow yields on MLPs were over 30% and, in almost all instances, their distributions held.
As a consequence of this meltdown, Americans were not only terrified, they were furious. They were livid with policymakers for having been blind to the mortgage fiasco that many, including this author, had warned about for years. They were incensed that their money was being used to “bail out Wall Street”.
It was in late 2008, during the worst of the panic, that Congress reluctantly passed the Troubled Asset Relief Program (TARP). This legislation provided for the U.S. Treasury to infuse capital into large banks and insurance companies in return for a high interest rate and, critically, an equity stake. Of course, with all financial equities having been crushed, the government was receiving de facto equity at ultra-distressed valuations. (Once again, please refer to the Appendix for more on this underappreciated, but vital, subject.)
This prompted me to write at the time that the Treasury would eventually earn windfall profits. To say this view generated widespread derision is putting it very mildly. Many people thought I had lost it, an opinion I often hear. Yet, as we now know, or should know, TARP became a monster moneymaker for taxpayers.
But, back then, the mantra was “Bail Out Nation” and the anger eventually led to the “Occupy Wall Street” movement (bet you forgot about that one!). For those of a less militant nature, which would be most investors, the mindset was not so much vitriolic as paralytic. They were too traumatized to buy anything, despite the yields mentioned above, even once it was clear the financial system would not implode.
Meanwhile, junk bond yields were tumbling from 23% to the mid-teens and then into the single digits, as millions missed the chance to make billions. Many MLPs were in the process of tripling or more. As noted earlier, even high-grade corporate bonds were producing 30%-type returns off their late-2008 lows, and preferred stocks in major financial institutions were posting total returns of 50% during the first year of the recovery (with many more years of double-digit returns still to come).
Part of the reason investors were so reluctant to reengage with financial markets was due to the dire warnings that continued to be issued by many of the experts who were among the few to warn of the mortgage mayhem. Despite a stock market that had been more than cut in half, predictions of much greater declines — like Dow 5000 — were commonplace. And because these individuals had considerable credibility based on their housing crisis calls, it was hard to dismiss their views. One of these experts, whom I personally respect very much, repeatedly predicted a second Great Depression well into the recovery.
Due to the pervasive pessimism in the early years of the rise from the abyss, valuations stayed attractive. As late as the summer of 2011, over two years into the new bull market (as a side note, the previous bull lasted only five years, from 2002 to 2007), the median P/E ratio on the Dow was just 12. (Those were the days! Today, as mentioned earlier, that number is over 21.)
The income realm was a different story, however. Double-digit yields were long gone. MLPs and REITs had continued their furious rally that started in November 2008 and March 2009, respectively. By mid-2012, investment-grade bond yields were a miserly 4% and the interest rate on junk bonds got down to 6% by summer’s end.
There were reasonable fears, though, that once the Fed quit creating money to buy government bonds, rates would rise dramatically. Yet, as with inflation, there was a surprise playing out. Treasury yields actually fell in anticipation of QEs I and II but then rose as the Fed began buying. Once the programs ended, rates declined again. (By the way, “OT” on the following chart refers to “Operation Twist”, another Fed tactic to bring down longer-term interest rates.)
Stability’s inherent instability
To the Fed’s great vexation, unemployment remained stubbornly high in the early years of the expansion, leading it to believe more monetary uppers were needed. In the fall of 2012, over three years into the economic up-cycle, it launched QE III. The third iteration would turn out to be the biggest of all, eventually totaling $1.6 trillion.
By the time it finally turned off its Magical Money Machine in October of 2014, the Fed’s balance sheet had exploded from around $700 billion pre-crisis to a Himalayan $4.5 trillion. There is little doubt much of this spilled over into asset prices, either directly or indirectly. (An indirect example is that by collapsing interest rates, the Fed encouraged publicly traded companies to leverage up to buy back their own shares, to the tune of about $5 trillion since 2010.)
In addition to fabricating almost $4 trillion, it also maintained interest rates at essentially zero until meekly hiking rates in December of 2015. In other words, the Fed kept the monetary pedal to the metal over five years into the recovery-cum-expansion. (Technically, a recovery is the post-recession phase that returns GDP back to its prior peak and the expansion is the GDP increase that occurs thereafter.) This was totally unprecedented in the annals of Fed monetary policy… but one that is eerily similar to what the Fed did again in 2020 and 2021.
Despite this unparalleled largess, and a near doubling of the national debt, not only was the jobless rate stubbornly high for many years, the expansion also turned out to be the weakest on record. (By the way, historically, the worse the recession, the stronger the recovery and expansion — and those prior vigorous rebounds were achieved without multi-trillion-dollar monetary stimulus.)
For example, in the 1980s recovery out of the deep Volcker-induced recession, real growth averaged 4.4% per year. Coming out of the S&L/real estate bust recession of 1990/1991, after-inflation growth came to 3.8% annually. But the expansion post the Global Financial Crisis (GFC) was a mere 1.8% per year in real terms. In other words, the economic return on the Fed’s three official QEs, plus the stealth one in 2019, was, with no exaggeration, pathetic.
As a result, it’s reasonable to question the efficacy of this epic experiment in flooding the system with liquidity and debt — at least as far as the economy is concerned. It was a completely different story for asset prices. Right before Covid struck, it was hard to find a major asset class that hadn’t been driven up to bubble-like prices, at least briefly. (One of the fascinating aspects of Bubble 3.0 has been its rolling nature, i.e., a particular asset class goes vertical, then crashes, as the cryptocurrencies did in 2018, while another one steps to center stage to become the latest moonshot — until it, too, plunges back to Earth.)
Another example, few would have foreseen, is that out of the smoking rubble of the real estate crash of 2008, prices would eventually exceed their 2007 peak. But that’s exactly what’s happened for both commercial and residential properties, even as early as 2018.
Yet more remarkable has been the post-Covid upside explosion in housing prices. As was the case a dozen years ago, the dark side of this has been an utter collapse in affordability.
This is perhaps where the Fed’s policies have most gone awry (though there is a lot of competition for that characterization). Its massive monetary manufacturing has made the rich even richer and the stinking rich even stinkier. [iii]
There’s scant doubt that the Fed’s asset inflation policies, so openly admitted to in the 2010 Washington Post Op-Ed by Ben Bernanke, have turbocharged financial and property markets. Since the rich own most of the assets, it’s axiomatic that such a ploy would disproportionately benefit the moneyed class. The synchronicity between the Fed’s monstrously expanded balance sheet, totally built up with its fabricated funds, and the stock market’s relentless ascent of the past twelve years is difficult to deny. Further, the vast expansion of wealth and its increasing concentration in the top percentile, and the top decile within that (i.e., top 1/10th of 1%), is simply a statement of fact. Please see Figure 4 for the visual evidence of this.[iv]
The stock market wealth concentration and extreme valuations are bad enough but housing being in the ionosphere presents more pressing societal concerns. The affordability, or lack thereof, highlighted above is why homeownership among millennials is unusually low. This is also a global phenomenon with some countries like Canada, New Zealand, and the Netherlands beset by even more outrageous home prices. In certain Scandinavian countries, some homebuyers surrealistically receive a monthly check from their bank for their negative yielding mortgages but, regardless, younger people often still can’t afford to get on the housing carousel. Presumably, they can’t handle the down payment and/or the ongoing costs of ownership, especially property taxes which inflate with home prices. Regardless, prices are far above the levels they hit during what has long been viewed as the greatest housing bubble of all time.
Per The Financial Times in a March 15th, 2021, article by Morgan Stanley Investment Management’s chief global strategist, Ruchir Sharma, 90% of 502 cities around the world are unaffordable, meaning prices are more than 3x median family income. In present-day Seoul, Korea, it takes 17 years of median yearly household income to purchase the average-priced home! (Source: Bloomberg Businessweek, 8/2/21)
Back in the U.S., it’s also hard to dismiss a linkage between the Fed’s multi-trillion balance sheet expansion and home purchase debt (i.e., mortgages). Is it sheer coincidence that this looks so much like the chart of the Fed’s balance sheet growth and the S&P 500’s monster rally of the past dozen years? I doubt it.
Source: Danielle DiMartino Booth/Quill Intelligence
Such extreme housing price inflation wasn’t always the case. From 1899 through 1999, U.S. home prices increased at roughly the inflation rate which, prior to the creation of the Fed in 1913, was essentially zero. Prices actually fell, adjusted for the CPI in the 1920s (surprisingly, considering those were boom years) and didn’t take off until the inflationary years after WWII. (In Chapter 16, we’ll look at the overall change in consumer prices since the Fed came into existence vs prior to 1913.)
Interestingly, even the semi-inflationary 1960s and the very inflationary 1970s didn’t see meaningful price rises, after adjusting for the CPI. Nevertheless, since 1963, the median sales prices have vaulted from $158,000 in today’s (rapidly depreciating) dollars to $350,000. Obviously, something changed around 2000. Could that something be Bubble 1.0? Or, more to the point, was it the bursting of Bubble 1.0 and the caving in by the Fed to calls for it to create another bubble, as Paul Krugman repeatedly did?
To reiterate one of this book’s main themes, it was the tech-wreck of that year which panicked the Fed into slashing rates down to levels unseen since the Great Depression. Then it left them there for years even as the economy began a steady, if unspectacular, recovery from the twin shocks of that market crash and the horrors of September 11th, 2001.
By the time the Fed began to raise rates, from a microscopic 1% in June 2004, the housing market was already ripping, as you can see from Figure 3 above. It then compounded its excessively easy money mistake by only glacially raising rates. Moreover, it did so in such a predictable way that neither the housing market nor the stock market were in the least bit rattled.
Senior Fed officials would subsequently admit that this predictability eventually led to extreme volatility. In this regard, it was the housing bubble and crash that focused tremendous academic and media attention on a deceased and formerly obscure economist, Hyman Minsky. It was Professor Minsky who articulated the basic premise that “stability breeds instability”.
The highly predictable and languid monetary tightening the Fed affected between 2004 and 2007 was a classic example of this phenomenon. It was this era that was the highwater mark of the so-called Great Moderation, an economic phase supposedly deftly orchestrated by the Fed’s former “Maestro” Alan Greenspan and then carried on by his hand-picked successor, Ben Bernanke. It was a blissful time of low inflation, long bull markets in stocks, and generally healthy economic conditions. Some have referred to it as a “Goldilocks” phase — neither too hot nor too cold. (Please see the Appendix for more on Mr. Greenspan and his de-deification.)
In hindsight, the Great Moderation was precisely the kind of long-lasting stability that Professor Minsky was warning about years earlier. Once the mortgage market came off the rails in the summer of 2007 – with the sudden collapse of two hedge funds that were leveraged investors in the sub-prime mortgage space — housing had its “Minsky Moment”, as Pimco’s then Vice-Chairman Paul McCulley presciently proclaimed at the time.
The reality is that long periods of stability and predictability, not to mention overly easy monetary policies, encourage consumers and institutions to get out over their skis on the risk spectrum. Leverage is increasingly used to goose returns. It rises to the point that any serious price correction has the potential to turn into a self-reinforcing chain reaction of selling and involuntary liquidation (like margin calls in the financial markets and bank foreclosures leading to distressed sales with real estate).
The detonation of the enormous housing bubble of the first decade of this millennium/century was indeed Professor Minsky’s moment. It shook the global financial system to its core and nearly created its Thelma & Louise, off-the-cliff ending. Without question, the Fed and the other leading central banks deserve plentiful praise for the emergency measures they took in avoiding an economic and financial apocalypse. But — and this is a huge “but” — their complacency as Bubble 1.0 and, especially, Bubble 2.0 engulfed most of the Western world was inexcusable.
And, certainly, their prior bubble-blindness was what necessitated their extraordinarily creative responses to the Global Financial Crisis. As the aforementioned financial commentator extraordinaire Jim Grant has often quipped, the Fed and its peers act as both “arsonists and fire brigade”. In my mind, that’s simply a pitch-perfect phrase.
The aftermath of the housing/mortgage crisis that began in the seemingly tranquil summer of 2007 still haunts us today. It is why the world continues to have some $10 trillion of negative-yielding bonds in existence. It’s also why central banks, including the Fed, can’t kick the habit of massive money manufacturing. The Boomer generation of retirees and near-retirees is particularly imperiled by the extermination of interest rates, as are the savings industries of the West such as pension funds, insurance companies and banks.
As many other pundits have pointed out, capitalism doesn’t work very well in the absence of interest rates, a sentiment with which I vigorously concur. For now, that reality is being obscured by mostly bubbly financial markets. But when artificially elevated asset prices revert to the mean, and quite possibly crash, the fragility of the situation will be revealed. When that day arrives, it will be a very mean reversion indeed.
[i] In reality, QE actually was the creation of digital reserves that the Fed used to buy treasury bonds from the banking system.
[ii] Although the Fed was reluctant to call its various money fabrication schemes QE, almost everyone else did; for some reason it prefers the term Large Scale Asset Purchases.
[iii] Roman emperor, Vespasian, once quipped, when he was criticized for taxing public toilets, “Pecunia Non Olet”, “Money doesn’t stink,” and I suspect all the newly minted centi-millionaires and billionaires would agree.
[iv] Covid has only accelerated this process. The total wealth of the planet’s billionaires increased from $5 trillion to $13 trillion from the March 2020 market bottom through March of 2021. This was the greatest asset spike ever recorded on the Forbes billionaire list. (Source: Grant Williams’ Things That Make You Go Hmmm, July 2021)
Chapter 5: The Anti-Bubble Years
A flashback to the disco decade
Back in the spring of 2021, as inflation was beginning to look increasingly non-transitory, I shocked my oldest son by telling him that I had been a bond bull almost continually over the past four decades. Because he’s now 40 himself, this means I have been an optimist about lower interest rates and, related to this, controlled inflation since before he was born. Due to the fact we’ve worked together at Evergreen Gavekal for almost 20 years, I was frankly surprised by his surprise. He then asked me why? What caused me to maintain a bullish stance on bonds for nearly all of the past 40 years? That also caught me off-guard; accordingly, I thought it might make an interesting story… and one relevant to Bubble 3.0, the third enormous speculative frenzy of the last quarter-century.
First, though, I’d like to discuss the concept of anti-bubbles. Bubbles themselves now get tremendous amounts of press. Their counterparts, however, don’t. In my 43 years of financial market experience, anti-bubbles are where immense amounts of wealth are made and bubbles are where they are lost.
Admittedly, the bond market does not leap to mind when you think about bubbles or their polar opposite — an asset class that has been in a long and/or ferocious bear market, what I and some others refer to as anti-bubbles. However, another central part of this book is that bonds today are arguably the biggest bubble of all-time. Realizing how much competition there is for that designation these days — such as from a crypto “currency” like Dogecoin — is why I wrote “arguably”.
But when you realize that interest rates are at a 5000-year low, I think it’s fair to say that bond prices are just a tad on the unusual side and have been for years. It’s also critical to be aware that when interest rates fall, bond prices rise. Thus, being at a multi-millennia low in rates means that bonds are also at a 5000-year peak in valuation. Now, I think that qualifies as a top contender for the biggest bubble ever! Because this is another mega-topic that deserves much more coverage, there’s a lot more to follow on bond market absurdities in Chapter 11.
Amazingly, though, this doesn’t preclude a long list of experts, many of whom I respect, from continuing to be bond bullish. To the point of this chapter, I was right there with them… at least until Covid struck. It was the Fed’s response to the pandemic that turned me — and turned me hard, as in, toward hard assets — and away from fixed-income. But, as usual, I’m getting ahead of myself. First, we need to go back, way back to when then-President Jimmy Carter made a crucial decision.
While inflation erupted under Jimmy Carter, it had been in a jagged but decidedly upward trend in the U.S. since the mid-1960s for a variety of reasons: the guns-and-butter policies of LBJ, increasing unionization, mounting political pressure on the Fed to let the economy run hot and, the ultimate coup de grâce, Richard Nixon’s removal of the Gold Standard in 1971 (as discussed in Chapter 3).
Once the latter occurred, the CPI was off to the races. Former President Nixon, the primary perpetrator of the inflation eruption, tried to get the inflation genie back into its now contents-under-pressure bottle. Against the vehement advice of expert economists like Milton Friedman, Nixon introduced a series of wage and price controls. These worked… briefly. As Dr. Friedman had predicted, once those were lifted, inflation raged again. Consumers and businesses quickly developed a strong distaste for these complex and ineffective intrusions into their lives and the economy. The controls were soon abandoned and by 1974, in the wake of the Watergate scandal, Mr. Nixon gained ex-president status two years ahead of schedule.
The twin energy crises of the 1970s only caused inflation to run all the wilder. As the 1970s came to a close, the U.S. CPI was screaming higher at a year-over-year rate of 13.3%. Shortly thereafter, it briefly receded due to draconian credit controls which were introduced in the winter of 1980, triggering a short but severe recession.
(This author entered the securities industry in early 1979, just in time to witness inflation and interest rates both going bonkers, to use a highly technical term. A slightly more momentous event happened that year than my employment by the former Wall Street firm of Dean Witter[i]: Jimmy Carter’s appointment of Paul Volcker as head of the Federal Reserve.)
In the presidential election year of 1980, the first-half recession was political suicide for Jimmy Carter. Predictably, even though inflation fleetingly crashed down near zero, as soon as the credit restrictions were lifted, the CPI was back in double-digits as the November election approached (in a flashback to the removal of Nixon’s wage and price controls nine years earlier). Also predictably, Ronald Reagan won in a landslide.
Mr. Reagan’s election did nothing to slow inflation initially. The CPI was still running at a double-digit rate early in 1981 and would stay above 10% for nearly the entire year. However, unlike the Fed chairmen who had preceded him for most of the 1970s, Mr. Volcker vowed to get ahead of the inflation curve. Previously, the Fed was constantly playing from behind, largely unable or unwilling to get its key interest-rate weapon, the fed funds rate, above the CPI. Therefore, for most of the ‘70s, short-term interest rates were negative, or minimally positive, in real terms, despite the fact they rose drastically over that decade.
By the end of 1980 and into 1981, it was a very different story. Mr. Volcker pushed the Fed funds rate over 20%. This in turn caused the prime rate (the key borrowing standard) to spike to the previously unimaginable level of 21% by June of 1981. Despite 12% inflation, the real Fed funds rate (the stated rate less the CPI) was roughly 9%. This was a real rate of return — or cost of money, depending on whether you were a lender or borrower — never remotely experienced in the U.S., with the exception of during the darkest days of the Great Depression, when consumer prices were crashing.
Long-term treasury bond yields were in the mid-teens. Even tax-free bonds were yielding 14% or more (I vividly remember this era because I was buying as many for my clients as they would allow). The period from 1966 to 1981 was without rival the worst bear market bonds had ever experienced. It was the ultimate anti-bubble in U.S. history for the normally tranquil and defensive world of debt instruments.
The dark side of these extraordinarily high real interest rates was the worst recession since the 1930s, with unemployment spiking into double digits. The upside was an inflation collapse. By the end of 1982, the CPI was sub-4%, a level not seen since the Nixon wage and price controls. Unlike then, when the inflation contraction was both artificial and brief, this one stuck.
The inflation implosion allowed the Fed to start drastically slashing interest rates. As 1982 came to a close, the Fed funds rate was down to 9%, the lowest it had been since 1979. But there was a huge difference in real terms: In 1979, inflation was also at 9% and rising sharply. Consequently, the real return was zero. This provided a strong incentive for businesses and consumers to keep borrowing and buying hard assets, like real estate and commodities, with the proceeds helping to stoke the inflationary fires.
However, by the end of 1982, the real rate was a still-very-stiff (or munificent, for lenders) 5%. Therefore, even though the after-inflation rate had come down from its most punitive levels (for borrowers) it remained extremely elevated. Regardless, the collapse in both nominal interest rates and inflation triggered one of the most dramatic financial events in the history of global stock markets. But a bit more market history is needed to fully appreciate what happened in August of 1982.
A bull is born
The Dow Jones Industrial Average had first essentially hit 1000 in 1966 (995). A sideways market then ensued into the early 1970s, with the Dow barely breaking above 1000 (1052) in 1973. This meant that, in after-inflation terms, the stock market had generated seven years of negative returns, at least before factoring in dividends. Even with dividends included, returns were meager net of inflation. (See the Appendix for the return details on this period when America was in the process of falling out of love with stocks.) Then things really got ugly.
The Arab Oil Embargo of October 1973 caused energy prices and inflation to do a moonshot. By the summer of 1974, oil prices had tripled, causing the CPI and the Fed Funds rate to both hit 12%. (Note that, once again, even an extremely high headline, or nominal, interest rate was actually zero relative to inflation.) The venerable Dow was basically cut in half by this twin gut-punch. Nixon’s aforementioned Watergate scandal that drove him from office in August of 1974 only added to the national nightmare, as incoming President Gerald Ford would soon call this period.
The Arab Oil Embargo ended in March of 1974, but stocks kept falling. Even once oil was flowing from the Mideast again, crude prices remained about four times higher than they had been in 1972. Surprisingly, the economy only contracted by 0.5% in 1974, in real terms, despite the oil shock, but that didn’t prevent the worst bear market since the 1930s.
When the market finally hit bottom in December of 1974, the price-earnings ratio on the Dow was down to a microscopic six, thus fully qualifying as a true anti-bubble (the inverse of the conditions prevailing in 2021). This meant the reciprocal of the P/E ratio, the earnings yield, on the Dow was basically 16%. This was the highest it had been since the aftermath of WWII, when many pundits believed the U.S. would enter another depression. [ii]
By 1975, inflation had come off the boil and stocks began a cyclical recovery. The Dow increased by 76% from the 1974 nadir to the early 1976 peak at 1015. With dividends included, the total return was 96%. However, the 1973 high of 1052 was not broken for many years to come. As a result, the late 1970s inflation surge would push stock investors’ real return even further into the red.
The next trough was hit in August of 1982 during the aforementioned severe recession induced by Paul Volcker’s do-or-die war on inflation. At that point, the inflation-adjusted total return (i.e., inclusive of dividends) on the Dow and S&P 500 since 1966 was a pathetic minus 45% and minus 29%, respectively, or minus 3.6% and minus 2.1% annually.
On a pure price basis, the Dow lost almost 214% relative to inflation while the S&P eroded 195%. The yawning gap between these real return numbers shows the power of dividends over an extended period. But that was when dividends averaged three times what they do today.
It was during this era that Business Week magazine, as it was called back then (now Bloomberg Businessweek), ran its infamous The Death of Equities cover story. With the passage of time, it has become roundly lampooned and frequently cited as a classic contrarian buy-signal. Forty years later, the magazine conceded it was still catching flak over its bearish message.
However, to be fair, it ran on August 19th, 1979, and it factually warned that inflation was greatly harming the stock market. So factual, in reality, that it was merely stating the obvious. And for the next three years, stocks continued to struggle. The total net-of-inflation return on the Dow from when the story ran until August of 1982 was a decidedly negative 20%, or about minus 6% annually. In other words, it was a pretty decent call, and certainly not deserving of such enduring historical derision. (Many far more poorly timed cover stories have cursed other big-name publications, especially The Economist.)
Moreover, the basic point of the article was spot-on: Inflation was enemy number one for stocks. (It was no coincidence that when the CPI became unanchored in the mid-1960s — and increasingly out-of-control all the way until the early 1980s — that the stock market performed so miserably.) Similarly, it wasn’t a fluke that stocks bottomed almost precisely three years after The Death Of Equities cover story, at a time when investors worldwide were waking up to the reality that a scourge they never thought would end was indeed being largely eradicated, or at least brought to heel.
The stock market lift-off in August of 1982 would go down in the history books for both its duration and its magnitude. Five years after its birth, the raging bull had surged from 776 to 2722 by August of 1987. It would arguably last until the spring of 2000, when the enormous bubble in tech stocks met its pinprick. The reason that it was arguable is what happened in October of 1987 when the market fell nearly 40% in a matter of weeks and almost 23% on Black Monday, October 19th, alone. (As an interesting sidenote, despite the late-year crash, the Dow finished plus 5.5% for all of 1987; it had been up a bodacious 44% for the year when it hit its August apex.)
Yet, as with the Covid crash in March of 2020, this dramatic interruption of the great bull market was so brief that it’s hard to classify as a true bear market. In hindsight, it was a fleeting panic which didn’t interrupt the long-term up-trend.
By March of 2000, when tech turned into a wreck, both the Dow and the S&P 500 had returned a spectacular 19 ½ % annually, including dividends, since the August 1982 trough. Even after inflation, returns were in the mid-teens. The NASDAQ, the object of the late 1990s bubble, had produced a 21.4% annual return, including returns of 85% and 101% in 1998 and 1999, respectively.
As usual, investors projected these returns into the new decade; instead, the first decade of this century/millennium saw a negative annual return of 1% on the S&P and 4.9% on the NASDAQ. On an inflation-adjusted basis, it was an even more depressing loss per year of 3.4% and 7.3%, respectively. (Interestingly, after the exceptional returns since 2009, despite sub-par economic growth and America’s stunning loss of stature, investors are once again projecting outstanding returns throughout this present decade.)
The birth of another bull
The epic bull run from 1982 to early 2000 was the biggest of all-time. But it wasn’t just stocks that were superstars. The bond market was, in its own way, even more spectacular. Thirty-year maturity treasury bonds bestowed upon the handful of intrepid investors who were willing to buy them at their yield peak in 1981, when they were derisively called “certificates of confiscation”, a per year return of 9.5%. On a risk-adjusted basis versus stocks, they actually beat the S&P 500 by 1.5% annually. (Bonds are less volatile, or risky, than stocks and, thus, are expected to have a lower return but with much milder fluctuations; this calculation makes that adjustment.)
There is no doubt the collapse in yields during the period from 1982 to 2000 turbo-charged the great equity bull market. This was despite the fact that long-term treasury bonds were still yielding around 6% in March of 2000 when the nearly 18-year bull run finally expired. This is in contrast to less than 2% on the 30-year treasury bond at year-end 2021.
Returning to the question of why, for nearly 40 years, I was almost always bullish to very bullish on bonds, it was in no small part due to the fact that interest rates were largely positive even after inflation. As you can see below, there were very few instances during this era, at least until the post-financial crisis timeframe, when real interest rates were not reasonably positive. Consequently, as a bondholder, you actually got paid to hold them, a refreshingly quaint, but also increasingly rare, notion.
Additionally, and similarly, inflation was under consistent downward pressure. There was a multitude of factors through this four-decade period that would keep it in check, if not push it even lower, and I was a believer in their sustainability.
This is a major topic, and it would take an entire book to do it justice, but I will try to summarize what I believe were among the major disinflationary forces. First up, was the decline of union power. It’s a statement of fact that the significant reduction in collective bargaining over the past half-century was behind the trends seen in the chart below. Union membership for the overall U.S. workforce fell from 29% in the 1970s to 11% today. It’s hard to argue this wasn’t behind a shift in the de facto profits split between businesses and labor.
Second, was the long-term erosion in the velocity of money. With its turnover rate in a persistent slide, it made a serious burst of inflation highly unlikely, at least of a lasting nature. It is worth noting that money velocity stopped falling for most of 2021 despite an enormous increase in the money supply; in my mind, this implies an important sea change may be underway. It may also be a key factor for why inflation has so totally wrong-footed the Fed. (For more on money velocity, see the Glossary and/or the Appendix for this chapter.)
Another exceedingly powerful factor in keeping the CPI muted was the ascent of China as a global export tour de force. The shift of production of almost everything to its shores, and the related emergence of what became known as “the China price”, resulted in actual deflation for many goods. This was heaven for U.S. consumers but often hell for U.S. producers. Entire industries were relocated from the American heartland to the Chinese mainland.
This was allowed by U.S. policymakers to unfold over decades, resulting in massive trade deficits and the loss of millions of high-paying jobs. But it certainly lowered consumer prices in the U.S. The ramifications of that laissez-faire attitude toward globalization, China-style, obviously came to a head under Donald Trump and are continuing with the Biden administration. There is little question that the model of having supply chains halfway around the world in ultra-low-cost venues is under siege. As others have noted, the world is moving from just-in-time to just-in-case inventories.
Demographics also played a starring role in the taming of the inflation saga. As tens of millions of Baby Boomers have aged, we’ve tended to spend less and save more (I’m smack dab in the middle of the Boomer generation, hence the “we”).
Two oil busts in the last decade also exerted downward pressure on the CPI. Based on how pervasive energy is throughout the global economy, this has been a significant disinflationary — and, at times, deflationary — force.
Admittedly, this is a very short and simplistic summation of an extremely complex subject, and they are all fairly mainstream views of the victory over high inflation that started under Paul Volcker. The exception on the obvious front might be money velocity, which is somewhat esoteric, but crucial in my view. (See the Appendix for Chapter 4 to brush up on this factor).
There was another more unique explanation for the subjugation of inflation that was perhaps the main reason I was for so many years a bond bull, with a few exceptions, mostly during the late innings of economic up-cycles. This has to do with the thermostatic effect of interest rates, at least when they were allowed to be set by market forces (i.e., totally unlike today).
This concept views interest rates/bond yields as the thermostat; when the economy got too hot, the bond market would fall in price[iii], raising the economy-wide cost of money. Such a reaction would depress borrowing, which had a cooling ripple effect. If the rate rise was severe enough, widespread bankruptcies often occurred, leading to recessions and, frequently, actual deflation in some goods and services.[iv]
Such a drastic cool-down, to the point of freezing portions of the economy, can have a pronounced, even terrifying, impact. For example, consider what happened to housing in 2007 and 2008 when mortgage rates soared, and home financing became nearly unavailable for a time. Financial ice storms such as this cause the Fed to heat things back up by cutting short-term interest rates. Longer-term, market-driven rates also plunge. Before long, the credit crunch eases and economic growth resumes. Inflation consistently falls, sometimes hard, during these glacial phases. Even in the inflationary 1970s, the 1974 recession cut inflation down by almost 60%.
There is yet another, much more cynical, explanation of why inflation has been in such a prolonged dormant phase. This focuses on the way the U.S. government measures the CPI. Starting in 1996, the official arbiter of inflation, the Bureau of Labor Statistics, changed its methodology to what is called chain-weighted.
What this non-descriptive term means in a practical sense is that consumers can switch to cheaper goods when prices for some consumer items increase. Thus, when the price of filet mignon is rising rapidly, consumers can switch to something cheaper, like pork. Another related example is that, in 2021, many were forced to shop at so-called “dollar stores” versus traditional grocery stores due to soaring food prices.
Most economists seem to have accepted the government’s contention that this is a more accurate way to measure inflation. However, others are much less certain. Perhaps a better name would be “the substitution effect”, or maybe “the trading down effect” but, regardless, when high prices cause consumers to make an inferior preference choice due to rising prices, that seems to me like a negative. And this leads to another way in which the government has controversially suppressed inflation — hedonics.
Hedonic adjustments attempt to take into account superior quality. Whether it’s airbags in cars or vastly improved computing power in cell phones, the idea is that if the price goes up but the quality improves more so, then the true cost has actually fallen. With technology, quality is often staggeringly greater while the cost of almost everything tech-related has crashed. Tech’s inherently deflationary nature has been another material, and totally legitimate, depressant on the overall CPI.
Clearly, hedonic adjustments are tricky and subjective. Further, they seem the opposite of chain-weighted, where there is arguably the need to create an adjustment for consumers moving down the quality chain. (There is a related stealth influence called “shrinkflation” of which we’ve all been the victim — same price but smaller number of items per package. I’m not sure government statisticians are on top of that ploy.)
One last critical inflation dampener has been housing, oddly enough — in fact, very oddly enough. As we all know, in most regions home prices have gone postal over the last 20 years, despite the 2008-2009 crash. This has, in turn, priced millions of young people out of the housing market. It has also pushed up rents in a big way. Based on these realities, one would think that housing should have been an upside driver of the CPI. But not according to our infallible central bank.
The Fed’s preferred inflation measure — the PCE, which stands for “Personal Consumption Expenditures” — attributes a much lower weighting to shelter costs than does the CPI. Moreover, it uses something it calls Owner’s Equivalent Rent (OER) which asks a sample set of homeowners how much they believe their home would rent for if they leased it out. If you think that sounds less than precise, I’m right there with you.
This methodology has almost certainly drastically understated housing cost inflation, particularly since 2000 when, as we saw in Chapter 4, home values began to far exceed the CPI. Since shelter costs are around 40% of the CPI, this is highly significant. Post-Covid, this approach created even more divergence versus reality, especially once rent abatements have begun to roll off. Rents were rising at a record clip in 2021, as you can see in the below chart, 17% above the prior lease rate overall.
In summary, most of the factors that have kept inflation subdued appear to be either weakening or outright reversing. This paradigm shift is increasingly looking much more enduring than the Fed believes… or wants the markets to believe. Yet, long-term treasury bonds are trading at the most negative yields since the 1970s, implying investors are buying into the Fed’s transitory inflation meme.
Source: Trahan Macro Research
As a result, even though bond yields soared from their 2020 lows (around 0.50% on the 10-year T-note), for the first time since 1981, I was not impressed. Even when the 10-year hit its recent peak of 1.75% in the spring of 2021, it was hard to muster any enthusiasm for that puny yield; however, it did rise sharply in price, lowering the yield to 1.25% by late August of 2021. Accordingly, it was, as they say, a tradeable rally. But I have a hard time playing that game, especially when there are myriad inflationary winds beginning to blow, even howl.
As recently as late 2018, when the Fed had been raising rates for several years, the 10-year T-note yield moved about 1.2% higher than inflation — 3% versus roughly 1.8% inflation. It was also possible to get close to a 5% yield on investment-grade corporate debt, generating an even more positive real return. (My team and I once again used this bond selloff to extend the maturities of our clients’ bond portfolios, something I have done in every bond bear market since the early 1980s. Now, however, I am beginning to wonder if I’ll ever get this opportunity again, based on current Fed policies.)
As 2019 unfolded, the yield curve (the difference between short-term and long-term rates) became inverted; in other words, short rates moved above longer rates. This is an unusual occurrence, but it does happen when the Fed has been tightening for an extended time and the bond market begins to sniff out a slowdown or, usually, a recession. In fact, an inverted yield curve is one of the best recession predictors around — far better than the Fed, which, once again, has failed to warn of a single economic contraction. (Since WWII, there have been nine yield curve inversions and eight of these were followed by recessions in relatively short order. Thus, the yield curve’s batting average has been .889 versus the Fed’s at .000)
This warning signal worked once again; in mid-2020, the National Bureau of Economic Research (NBER), the official recession arbiter, declared that a contraction had begun in March. This confirmed the recessions in corporate profits and industrial production that was already underway in 2019. (Of course, the Fed failed to anticipate its arrival in any of their press conferences and even in their internal meeting minutes, at least those that have been released thus far, on the usual delayed basis.)
Unquestionably, Covid turned what was likely a mild contraction into one of the deepest ever; however, the NBER has now determined it was also the shortest. According to its analysis, the Covid recession ended in April of last year (other sources opine that it lasted for three months; regardless, it was exceptionally short-lived). This coincided with the briefest bear market in stocks ever seen.
As mentioned in Chapter 2, it was the Fed’s announcement in late March of 2020 that it would buy corporate debt which triggered the furious bull market and ended the Covid recession, despite the on-going lockdowns. Again, this fulfilled one of my most far-fetched predictions: namely, that the Fed would bring down credit spreads during the next crisis (however, it also stated it would buy junk bonds, which I didn’t expect).
Ironically, and also as I speculated as far back as 2008, it actually didn’t need to purchase large quantities of corporate bonds to cause credit spreads to collapse. By the time the program was closed down by the Treasury Department at the end of 2020 — over the Fed’s objections — a mere $14 billion was actually acquired. This is in contrast to the $5 trillion the Fed has bought, via its Magical Money Machine, of U.S. treasuries and mortgage-backed securities since the pandemic hit. Just the idea that the Fed had the corporate bond market’s back was enough to produce the credit spread plunge seen below. (Falling corporate spreads mean that private-sector bond prices are rising relative to Treasuries; this process has an extremely powerful and beneficial impact on asset prices, as well as borrowing conditions.)
Consequently, as 2021 drew to a close, a bond investor was faced with a situation 180° removed from the time in 1981 when I first became a bull on bonds. Instead of a real rate of return far above inflation, investors were facing yields that lose money each and every year, even if the Fed’s 2% inflation target can be maintained. If I’m right, and we’re facing much higher consumer price increases than that, bonds will be “certificates of confiscation” to a degree they haven’t been since the 1970s.
Similarly, corporate spreads are down to levels that offer little compensation for default risk. This is particularly true with junk bonds which now, for the first time in history, also have negative real yields. (Obviously, junk bonds have far greater default risk than investment-grade debt but even the latter sometimes go belly-up.)
My love affair with the bond market has been a long and blissful one. There were times when I would briefly jilt it, such as late in an economic expansion as inflation was heating up and the Fed was just beginning to tighten. But this time is different — very, very different, in my view. Those are always dangerous words to utter in the financial markets. But, then again, when was there a time, outside of war, when the U.S. government was engaged in Modern Monetary Theory?
In Chapter 9, we will examine an inflationary force that, in my mind, has the potential — in fact, I’d say probability — of being the greatest of them all. Moreover, it’s one that very few pundits and financial narrative-spinners are discussing.
[i] This once proud firm was subsumed into Morgan Stanley many years later, as was my other longtime Wall Street employer, Smith Barney.
[ii] That apprehension was due to the belief that there would be mass unemployment as a result of millions of discharged servicemen; this was in addition to the ultimate “fiscal cliff”, as federal government spending collapsed with the cessation of hostilities.
[iii] Bond prices and yields are like a teeter-totter. When prices fall, yields rise and vice versa.
[iv] Oddly, when the Fed has been on long tightening campaigns and rates have risen considerably, most bond investors are typically reluctant to extend “duration”, a fancy way of saying buying longer maturity debt. This reluctance costs them dearly in terms of forfeiting the opportunity to lock in high yields for years to come.
Chapter 6: The Ultimate Bubble Blower
Unleash the trillions
Back in April of 2019, the Evergreen Virtual Advisor (EVA) newsletter series on Bubble 3.0 ran a chapter called Can An Acronym Save The World? That initialization represents the once obscure but now economically, and politically, dominant concept known as Modern Monetary Theory, or MMT for short.
At that point, less than three years ago, even our firm’s most astute clients were, to nearly a woman or man, totally unaware of this thesis. In the prior chapter that ran in March of 2019, called No Way Out, I had made enigmatic reference to a proposed solution to a problem some pundits have called secular stagnation. Among the most prominent proponents of that dilemma is former Treasury Secretary Larry Summers. His essential point is that America has long been in a low-growth phase caused by various factors. But in his view, and that of many other economists, the overarching growth impediments are a savings glut and an investment deficiency. Here is his explanation from an article he wrote for Foreign Affairs in 2016:
“The key to understanding this situation lies in the concept of secular stagnation , first put forward by the economist Alvin Hansen in the 1930s. The economies of the industrial world, in this view, suffer from an imbalance resulting from an increasing propensity to save and a decreasing propensity to invest. The result is that excessive saving acts as a drag on demand, reducing growth and inflation, and the imbalance between savings and investment pulls down real interest rates. When significant growth is achieved, meanwhile—as in the United States between 2003 and 2007—it comes from dangerous levels of borrowing that translate excess savings into unsustainable levels of investment (which in this case emerged as a housing bubble).” (Emphasis mine)
Mr. Summers has long believed that an intense blast of Federal deficit spending could pull the U.S. out of secular stagnation. His view was that radical monetary policies, such as zero or even negative interest rates, plus trillions upon trillions of central bank money fabrication, which had already been in place for seven years when his article ran, had clearly failed to break the secular stagnation cycle.
Fast-forwarding to the spring of 2019, that was still the case despite an initially promising growth spurt early in Donald Trump’s administration. For a time, the catchphrase “synchronized global recovery” had replaced “secular stagnation”. But unfortunately, U.S. trend growth soon returned to the flaccid 2% real GDP increases that had persisted in the post-Global Financial Crisis era. (By contrast in the 1980s and 1990s, U.S. GDP growth averaged over 3% per year, as noted earlier.) Europe and Japan fared even worse. Secular stagnation was once again in the limelight.
Accordingly, MMT was emerging from obscurity by April 2019 as a promising antidote to the growth deficiency disease. Stephanie Kelton, Bernie Sanders’ economic advisor during his 2016 surprisingly effective (for an avowed Socialist) presidential campaign, stood out as one of its leading advocates. In the early spring of 2019, MMT was still back page news, but that was about to change. In our April 5th EVA of that year, I opined that it would soon be on the frontpage. Frankly, I had no idea how soon.
Before going there, let’s examine the actual theory, because I suspect that even today many Americans are as perplexed by MMT as they are about Bitcoin. Similar to the cryptos, despite what most of us hear and read about it constantly, there is still a fog of uncertainty as to how it works and what it really is. (In my case, the more I study Bitcoin, the more I realize how clueless I am on that one.)
As briefly discussed in Chapter 1, the basic idea is that since the U.S. can issue debt in its own currency, which also happens to be the world’s reserve currency, it can deficit-spend to its heart’s delight. Per an Investors’ Business Daily article that ran in the spring of 2019, as MMT was zooming into the national economic debate, “it (the U.S. government) can simply print more money when it needs it to pay off its debts”.
If this falls under the too-good-to-be-true category in your mind, please bear with me. MMT advocates assert that, no worries, as long as the Fed keeps interest rates low, like below the increase in GDP (it seems to excel at that these days), AND lower than the growth of government debt (that one’s not so easy in this era of deficits gone wild), then it’s all good — and not too good to be true.
Perhaps you detect a hint of cynicism in my tone. If so, you are definitely not tone-deaf. But I need to give the in-favor-of argument a fair hearing.
It’s no exaggeration to say that MMT has both strident defenders and attackers. The former point out that the government should only employ MMT as long as it doesn’t create inflation. Back in 2019, inflation was melting right along with global interest rates. Accordingly, it seemed like a reasonable assurance. But more on that later because, to this author, inflation is this theory’s ultimate Achilles heel… and one that has already been exposed.
Let’s back up a bit to understand the genesis — but certainly not, in my view, the genius — of MMT. As one critic opined in the aforementioned IBD article, it’s “… sort of turbocharged Keynesianism”. My partner and all-around hero, Charles Gave, wrote on this topic which we ran in our March 14th, 2019, EVA.
For those who would like the Twitter version, Keynesian economic theory dates back to the Great Depression. It was the creation of Lord John Maynard Keynes, and its essence was, and still is, that during periods of a collapse in private demand due to a crisis – like the stock market crash of 1929 and subsequent bank failures – the government needs to spend far more than it takes in from taxes. In other words, deficit-spend as much as necessary to revive the economy. Ok, I know, that was a lot more than the max 140-character Tweet, but it’s still pretty concise.
Many Boomers, like me, who remember where they were when JFK was shot — and, an infinitely more pleasant memory, where they watched the Beatles first perform electrifyingly live on The Ed Sullivan Show a few months later (February 9th, 1964) — are also at least vaguely aware of Keynes’ brainchild. Moreover, many of us recall it was the dominant economic policy in the U.S., and most of the developed world, from after WWII until the late 1970s. (At that point it was superseded by supply-side economics which were a key aspect of the “Reagan Revolution”.)
Interestingly, and quite likely most relevantly, “Keynesonomics’” quasi-demise was triggered by inflation. Further, the rampant CPI rises of the mid ‘70s happened at a time when unemployment was soaring. According to the many disciples of Keynes, that was nigh on impossible. (In 1946, the Lord himself went to be with the Lord of lords — maybe — well before his dogma became viewed as the Bible of economics.) Keynesian theory held that a high jobless rate virtually guaranteed low inflation. But as Charles Gave wrote in his EVA on MMT, another great macro-econ thinker, Yogi Berra, once said: “In theory, there’s no difference between theory and practice. In practice, there is.” The growing legion of MMT fans out there might do well to remember those sage words.
However, a key difference between Keynesian economics and MMT is that the former assumed deficits generated during downturns would be financed by bonds. In turn, that debt would be repaid by surpluses during expansions. For a number of years, governments more or less adhered to that approach. (Accordingly, I would argue pure Keynesian economics has gotten a bum rap; if it was implemented as Keynes himself had suggested, it might have proven viable in his famous “long run” timeframe. But politicians have increasingly opted for all-deficits, all-the-time.)
For example, in the U.S. the massive debt incurred to win WWII was gradually paid down over the next three decades, at least as a percentage of GDP. (How it did so is fascinating and highly applicable to the debt fiasco America finds itself in today; the post-war experience of debt reduction, at least relative to the size of the economy, will be analyzed further in Chapter 15.)
Again, being old enough to remember the extreme angst of the 1970s, when it seemed like nearly all the economic news was bleak, it’s hard not to wistfully yearn for a time when the U.S. government was so lightly indebted. This was especially true compared to the swelling size of the economy during the polyester-&-bell-bottoms decade. As bad as things were in the ‘70s, at least the economy grew faster than government IOUs did in those days.
Ironically, it was the supply-side policies of Ronald Reagan that began the great debt lift-off. And, equally ironically, inflation and interest rates went down, pretty much the exact opposite of what was expected to happen as deficits under “The Gipper” blew out to unprecedented levels, at least in peacetime.
Basically, for many years Keynesian theory looked like a winner until it met its inflation Waterloo. That’s actually a relevant lead-in to the first dramatic example of MMT (which perhaps should stand for “Modern Monetary Terror”) in action. One of the main causes of Napoleon’s rise to power in the late 1700s was the French Revolution and its revolting Reign of Terror excesses.
But numerous historians believe the downfall of the French aristocracy was a function of the hyper-inflation that broke out decades earlier. This was, in turn, caused by the economic theories of the on-the-lam Brit, John Law – who apparently got sideways with the law back home – as briefly described in Chapter 3.
A blast from a bubble past
John Law’s plan, which he sold to the heavily indebted French monarchy, involved the idea that France could effectively borrow enormous sums by issuing shares in a company backed by its vast holdings in North America (what would eventually become the Louisiana Purchase).
As the gifted wordsmith Jim Grant retells it, the “System” was based on, in Law’s own words: “An abundance of money which would lower the interest rate to 2%... reducing the financing costs of the debts and public offices, etc, relieve the King.” Previously, the then-reigning majesty’s treasury was subject to the indignity of borrowing at 8%. Thus, a quartering of the interest cost could be theoretically realized.
Now, pay special attention to this part, again quoting Law himself: “It would enrich traders who would then be able to borrow at a lower interest rate and give employment to the people.” Does that sound familiar? Let’s compare Law’s words to the following excerpt from former Fed Chairman Ben Bernanke in his now legendary November 2010, Op-Ed article for the Washington Post in which he described the alleged benefits of his upcoming “System”, officially known as Quantitative Easing:
“The FOMC (Federal Open Market Committee) intends to buy an additional $600 billion of longer-term Treasury securities by mid-2011 and will continue to reinvest repayments of principal on its holdings of securities, as it has been doing since August.
This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate this additional action. Easier financial conditions will promote economic growth… Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”
Ah, enriching traders/investors and the virtuous circle. That’s exactly what Mr. Law promised the French monarchy and, for a time, in basketball parlance, he swished it. Law quickly became a hero of both aristocrats and the common folk. In the process he also became very, very rich — always a nifty side benefit. Per Jim Grant, as one of Mr. Law’s biographers noted with exquisite irony, he was a “twenty-first century banker in the eighteenth century”.
Essential to his “System” back in 1715 was setting up a bank. But not just any bank. It needed to be one with some serious gravitas, like having its notes or debt convertible into gold. It also needed a grand name — the Royal Bank. As Jim Grant observes, it became France’s first central bank.
If you are wondering what could go wrong with a bank whose obligations could be exchanged into gold, just wait a bit. Once the bank was officially the King’s own, it issued notes backed by… you guessed it: royal edict. In other words, it was fiat money. Accordingly, notes could be issued at will, at least by regal whim or inclination. And the King was very much inclined.
Once thus structured, the Royal Bank increased the supply of said notes somewhat — like by 400% in 18 months. Again, anticipating those to follow in his crafty footsteps, Law required the Royal Bank notes to be accepted for transactions. Then he made it illegal to hold gold and jewelry, beating President Franklin D. Roosevelt to the punch on the gold possession ban by over 200 years.
Yet Law’s ambitions went beyond the Royal Bank. He needed a narrative, a sexy story to get speculative juices really flowing. He got that with the Mississippi Company, which he established to acquire and possess the trading rights to France’s vast holdings in what would eventually be the United States, representing nearly half of the future superpower’s landmass. The Mississippi Company also secured a tobacco monopoly, trading monopolies, taxing power, and the royal mint. And you thought Google had a fantastic business model! Shortly thereafter, it managed to acquire all of France’s national debt, which he offered to refinance at just 3%. (Ironically, today that sounds like a lofty yield, at least for a government to pay.)
Law also issued shares in his Magical Money Machine, the first triple “M”, if you will (as it turned out centuries later, he had nothing on the U.S. Fed’s MMM). After initially trading sideways, the Mississippi Company stock price began a spectacular ascent in 1719, as shown in this chart (again, credit to Jim Grant).
Source: Hanke, Jim Grant
The Royal Bank offered loans at just 2% for those wanting to buy its shares, not unlike today’s Fed encouraging the use of what has been, for the bulk of the past dozen years, nearly free margin money (though, admittedly, to buy shares in the S&P, not in the Fed itself).
Law’s grand scheme predictably produced a raging bull market not only in France but throughout Europe. As Jim recounts, land prices quadrupled, and the Mississippi Company’s stock price soared to 50 times earnings (lofty indeed, though a far cry from some of today’s outlandish P/Es). The French economy boomed to a degree that puts the Obama and Trump expansions from 2008 through 2020 to shame.
However, one of Law’s former cronies, Richard Cantillon, suspected something was rotten, and not just in Denmark. Cantillon believed that eventually all the fake money would lead to cost-of-living inflation. By early 1720, it wasn’t just asset prices that were rapidly rising. Consumer prices were going — to use a 21st century colloquialism — postal, as well.
But there was another problem, per Jim, which today’s central bankers only seem to dimly perceive: “It was all very well for the bank to buy assets in a rising market. But to whom would it sell in a falling one?” Suffice to say what happened in France in 1720 was a debt crunch followed by uncontrolled inflation and a currency crisis. The Royal Bank printed money to frantically buy shares in the Mississippi Company, in a vain effort to support the share price. This caused the money supply to explode and the franc to implode. In short order, Mr. Law was out of a job.
Not long after, he was on the wrong side of the law once again. He fled into exile and, although formerly among the wealthiest men in Europe, he died (sorry) dead broke in Venice in 1729. As previously noted, the social malaise and cynicism toward the government that followed was believed to contribute to the eventual overthrow of the French monarchy. One could say that France’s aristocracy really lost their heads over this early version of MMT.
Of course, such events could never play out in the modern world. Not with central bankers, who so presciently saw the dangers of the tech and housing bubbles, in control of the situation, right? As Jim notes, despite all their computers and hundreds of on-staff PhDs, entities like the Fed may soon find out how tough it is to raise rates enough to combat mounting inflationary pressures without puncturing the series of asset bubbles they’ve blown over the last 12 years.
Undoubtedly, the many eloquent defenders of this “new and improved” economic theory (after all, it has “modern” in its name) will quickly point out the differences between what became known as the Mississippi Bubble and what they are proposing. As described above, Stephanie Kelton, the former economic adviser to Bernie Sanders, is among the most articulate. She is on record as being highly satisfied with the MMT policies the U.S. has followed as a result of the pandemic.
It’s exactly the right response, in her view, and it seems like Congress agrees with her. At least there has been little opposition to $6 trillion, and counting, of deficit spending, most of which has been financed by the Fed and its Magical (Fake) Money Machine. Ms. Kelton’s satisfaction with current fiscal and monetary policies would seem to be proof-positive that MMT is now the law of the land in America. John Law must be patting himself on the back somewhere (unlikely in the company of angels) for being so far ahead of the times.
Despite, or because of, the current ragingly bullish asset markets – stocks, bonds, real estate, cryptocurrencies, SPACs, IPOs, et al – there are haunting similarities to the ultimate undoing of John Law’s grand scheme. In particular, it is the apparent belief that creating enormous sums of new money, or money equivalents, can produce real wealth and lasting prosperity. As my good friend Will Denyer, one of Gavekal’s keenest analysts, wrote in a treatise on MMT: “At its core, (it) is a recognition that government spending is not constrained by how much the government can tax or borrow — not if the government has independent control of its own printing press and no obligation to maintain a fixed exchange rate (such as against gold or another fiat currency).” Because the U.S. qualifies under those terms, it is the perfect candidate to adopt MMT — at least based on this logic.
Covid’s financial variant: Mainstream Monetary Theory
A key reason MMT has become transcendent, in addition to the pandemic, is a growing awareness of how harmful it is to the banking systems in those countries that have exterminated interest rates. And when banks are under siege, they tend to be reluctant financiers of enterprises, especially of the smaller variety. They tend to prefer lending to big business, where the risks are lower, or simply to hold government bonds which have essentially zero reserve requirements.
As my various newsletters over the years have opined, it’s very dangerous to force interest rates down to levels that impair the planet’s lending apparatus and serve mostly to inflate asset prices. That view is becoming more accepted on almost a daily basis. Thus, there was a growing chorus, even pre-pandemic, particularly on the progressive end of the political spectrum, that fiscal stimulus needs to step up to the plate. Covid provided the ideal circumstance for MMT to go primetime.
One of the main arguments of those cheering on MMT is that most of the planet’s developed economies have been hamstrung by fiscal austerity. In other words, governments have been too worried about their debt levels and have not been bold enough in spending to revive growth.
This has been argued for years by those who feel if governments would only really cut loose with deficit spending, the world’s growth problems could be solved. But the rise of MMT has taken this debate to an entirely new level and it’s coinciding with another mega-trend my newsletters have been chronicling for several years: America’s “Leftward Lurch”.[i]
It’s increasingly clear that millennial Americans have, on balance, more affinity for socialism than capitalism. Moreover, the following words by Bernie Sanders, when he was running against Joe Biden for the Democratic nomination in 2020, are not just a campaign boast: “The ideas that we talked about when we came to New Hampshire four years ago, ideas that seemed so radical at the time — well, today virtually all of those ideas are supported by a majority of the American people.”
In this regard, it’s been startling to see that almost half of all Republicans support the onerous tax proposals by those once considered to be on the fringe left, such as Elizabeth Warren. You may have noticed that she’s no longer the most firebrand woman in Congress. That designation has now passed to Alexandria Ocasio-Cortez, also popularly known by the abbreviation AOC.
If you didn’t know this, AOC is a proud and self-avowed socialist, like Sen. Sanders. One of her top advisors went so far as to say that every billionaire is a policy mistake (apparently, these boo-boos include prominent Democrats such as Bill Gates and Jeff Bezos). AOC is also a proponent of the Green New Deal, estimated by some to cost as much as $90 trillion.
Unfortunately, even a tab half that high would be most inconvenient given that the U.S. budget shortfall hit nearly $3 trillion for the fiscal year ending on September 30th, 2021. The math problem becomes far worse when you look out at the next 10 years and consider the tsunami of entitlement spending the aging Baby Boomer generation represents. As previously mentioned, super investors, like the new King of Bonds, Jeffrey Gundlach, believe those total $150 trillion. Consequently, they contend the real annual federal budget deficit is far higher than officially reported (which is already horrifying enough).
To raise taxes to a level to pay for all the promised benefits and normal government operating expenses would almost certainly crash the economy. Thus, when AOC and others try to pay for the Green New Deal, it creates a situation that is utterly impossible. And that’s another key reason MMT looks so irresistible to those who feel like a blitz of government spending is the answer to secular stagnation, the pandemic, climate change, social injustice and a long list of other societal challenges. In their minds, it is not just a way out of this quandary, it is the only way.
Luke Gromen writes a niche newsletter called Forest for the Trees that is popular with a number of professional investors and financial scriveners, including this author. As MMT first began to attract national attention, appalling many mainstream economists like Larry Summers, Luke wrote these snappy words: “If we didn’t want to do MMT, we either need 75 million baby boomers to vanish by the end of next week or we need to get in an ’83 DeLorean with a flux capacitor and go back to 1937 and stop FDR from passing Social Security and then make a stop in 1968 and get LBJ not to pass Medicare and Medicaid… the bottom line is there are 75 million people who overspent and under-saved for 80 years because they were told the government would take care of them in the end. And the bill is due… The bottom line is if we didn’t want to get to MMT or something like it, that was a decision that should have been made 80 years ago, 50 years ago, 20 years ago with Medicare Part D. But it’s human nature. Politicians like to spend and people like free stuff that’s not going to show up until ‘someday’. It sort of stinks for the people who are there when ‘someday’ arrives.” (Emphasis mine)
Based on the policy decisions we’ve made in the U.S. (and, for that matter, most of the rich world), it’s hard to argue with the part about politicians liking to spend and people (voters) liking to get free stuff. As Luke wryly writes, it’s no worries… until “someday” arrives.
In my view, MMT is the ultimate “someday” deferral technique. It not only kicks the can down the road, it launches it at escape velocity nearly into the exosphere… but not quite out of gravity’s reach. Eventually, that can will start falling back to Earth as fast as it went up. But just like in 1700s France, MMT will likely work for a while. In fact, as we’ve seen since Covid, we’ve enjoyed an asset boom just like France in the early days of the John Law/Mississippi Company fake-money mania. In many ways, the speculative frenzy has been even more over-the-top. This is the fun phase, as I’ve been writing in my newsletters since the summer of 2020.
But not everyone is drinking the Kool-Aid. Larry Summers wrote in a 2019 Op-Ed: “Modern monetary theory… is the supply-side economics of our time. A valid idea… has been stretched by fringe economists into ludicrous claims that massive spending on job guarantees can be financed by central banks without any burden on the economy… (MMT) is fallacious on multiple levels.”
Then there’s Paul Krugman, who once again seems to have developed a convenient case of amnesia, as he did over his egging-on of the Fed to create the housing bubble nearly 20 years ago. Around the time Larry Summers wrote his MMT take-down, Mr. Krugman penned these words in his high-profile NY Times column, noting the ultra-inflationary implications of MMT: “When people expect inflation, they become reluctant to hold cash, which drives up prices and means that the government has to print more money… which means higher inflation, etc. Do the math and it becomes clear that any attempt to extract too much seigniorage (i.e., printing money) — more than a few percent of GDP, probably — leads to an infinite upward spiral in inflation. In effect, the currency is destroyed.” (Emphasis mine)
Incredibly, though, now that MMT is in full-swing, Mr. Krugman has had a road-to-Damascus-like conversion to the religion of MMT.[ii] He now ridicules those such as Mr. Summers who warn of its grave perils. He even cheered on Congress for its patently false financial assumptions, which he has conceded, that are part of the $1.2 trillion infrastructure bill passed in August of 2021. Perhaps this is because he was an advisor to the ill-fated and fraudulent firm of Enron right before it collapsed 20 years ago, which has largely gone unreported. Apparently, Mr. Krugman became a fan of deceptive accounting during his Enron stint.
Apolitical types like Jeff Gundlach, have summed up their MMT views in much briefer terms by simply stating: “It can’t work. You can’t drink yourself sober.” That’s one of those pithy soundbites he’s famous for but I’m afraid there are many, especially of the elected-official variety, who don’t believe — or won’t accept — the veracity of those words.
It’s safe to say that MMT has already become one acrimonious acronym – and the controversy surrounding it is almost certain to get more intense, particularly once its dark side is revealed. To appropriately and fairly blame both parties for our nation’s current MMT addiction, it started under Donald Trump in September 2019. That’s when the federal deficit was already blowing out — due to the enormous corporate tax cuts that were a cornerstone of Trumponomics — even during an economic expansion. For the fiscal year 2019, the deficit hit 5% of GDP, one trillion dollars, a level unheard of outside of the aftermath of the Great Recession and wars. (Of course, since Covid we’ve become desensitized to multi-trillion-dollar deficits.)
It was in the fall of 2019, six months before the pandemic, that the overnight bank repurchase market was in turmoil, clearly signaling there wasn’t enough natural demand to finance the Trump deficits, forcing the Fed to restart its Magical Money Machine, yet another triple “M”. In my view, MMT and MMM go together like heroin and a syringe.
Of course, once Covid hit, MMT went into hyperdrive. Yet, it has continued even as the U.S. economy has been in the midst of an explosive rebound from the Covid-intensified recession, notwithstanding a deceleration in the second half of 2021 largely due to the Delta variant and then Omicron. As I anticipated as long ago as August of 2020, when the economy was just beginning to heal, inflation is back and looking more and more like the 1970s version — despite the Fed’s many “it’s only transitory” assurances, which it dropped in late 2021. After all, that’s what history teaches us to expect from MMT. Did we really have the hubris to think we would somehow be miraculously exempt from the payback?
[i] Per my comment in Chapter 1 about the “Great Pushback”, there are growing signs of a trend reversal against ultra-progressive policies that are increasingly looking out-of-step with what most Americans support.
[ii] Here is what Mr. Krugman told Business Insider in May 2021: "MMTers, at least if they're consistent with their own doctrine, are substantially to the right of people like me…"
Chapter 7: What Price Bubblenomics?
As noted in the last chapter, Donald Trump was the first MMT-practicing president, albeit accidentally. Despite that, his administration failed to jolt the U.S. economy out of the desultory 2% growth trend in which it had been stuck since the Great Recession/Global Financial Crisis. Early on, however, that didn’t look to be the case.
His surprise victory on November 8th, 2016, radically changed conditions not just in America but internationally as well. This was contrary to intense fears leading up to the election in the unlikely event he should win (The Donald was a big underdog according to most polls). The 1000-point drop by the Dow during the overnight trading session, as the electoral votes tilted in his favor in the wee hours of November 9th, reflected that anxiety. It was also likely a function of overseas investors panicking since their perceptions of Donald Trump were nearly uniformly negative and their markets were trading many hours ahead of the U.S., as usual.
On the first day of post-election trading in America, however, the big losses reversed “yugely” as the U.S. stock market spiked, finishing up 1.8%. Markets around the world also rallied hard, completely counter to the pre-election expectations, with the MSCI Global index rising 0.35% on Wednesday, November 9th.
At first, the positive reaction was limited to investor, business, and consumer confidence. Soon, though, what had been a lethargic expansion, even in the U.S., and recurring recessions in many leading economies, evolved into what would be known by the end of 2017 as the “synchronized global expansion” referred to in Chapter 6. While nearly all Democrats, a lot of Republicans and most U.S. allies (especially in Europe), were loath to admit it, Donald Trump’s election ignited the global economy and financial markets.
In America, S&P 500 earnings, which had stagnated since 2013, began rising in 2017. As that year progressed, and especially as odds of an enormous corporate tax cut jumped, the stock market started discounting a 20% rise in profits by S&P companies in 2018, leading to 2017’s outstanding full-year return of 21.8%.
After years and years of anticipating robust earnings that never arrived, the market finally got it right in 2017. But, as is so often the case, the year of the actual earnings surge – 2018 – saw stocks initially sprint to the upside and then retreat. The usual culprit for this seemingly counterintuitive result was the Fed, which was belatedly taking away the proverbial punch bowl via its first ever double-tightening of raising rates and shrinking its balance sheet. (See Appendix).
Moreover, the synchronized expansion aspect quickly faded as one nation after another started reporting disappointing growth numbers. By the late summer of 2018, it was pretty much only the S&P and the U.S. economy that were still expanding to a meaningful degree. Even in the U.S., conditions began to fray, with housing prices in several key markets actually falling, leading to a brief bear market in home-building stocks. Then it became clear the U.S. auto industry was decelerating despite record-breaking incentives to move the metal.
Meanwhile, in the U.S. stock market, a sharp correction early in the year soon faded into investors’ memories as prices rebounded and the S&P hit a slight new high in late September 2018. Yet, below the surface, there was definite erosion occurring. Fewer and fewer stocks, mostly tech companies with valuations pushing $1 trillion, were leading the advance. This narrowness, along with an accumulation of eight prior Fed rate hikes and the gradual unwinding of three prior quantitative easings (QEs) — the aforementioned double-tightening — were classic warning signs the bull market might not make it a record-breaking 10 straight up years.
The proof is in the borrowing
As we now know, the coal mine canaries back in the fall of 2018 were falling off their perches for good reason. As that year had matured, many (besides this author) questioned the wisdom of the budget-busting, Trump-engineered, corporate tax cut. Some, such as the estimable Lacy Hunt, were pointing out that the red ink situation was even worse than it appeared on the surface — and that was bad enough. The official deficit for the fiscal year ended 9/30/18 was roughly $800 billion. That was 17% more than the prior year, despite an economy that increased 4.5%, inclusive of inflation (i.e., this is not the more commonly cited real GDP gain). However, according to Mr. Hunt, the true deficit was closer to $1.3 trillion. The difference was due to creative accounting by the Federal government as it considered about $500 billion of spending “off-budget”. Validating his view, the government sold approximately $1.3 trillion in debt to finance itself within the same year.
There are a couple of shocking aspects to this. First, deficits are supposed to fall — not run wild — during the latter stages of an economic up-cycle. Second, the leveraging-up of our national balance sheet left us extremely vulnerable to some kind of unexpected shock… like, say, a pandemic. Instead of reducing our debt relative to the size of the economy to have borrowing capacity in the next crisis – as Germany did, for example – Mr. Trump and an acquiescent GOP ran our debt-to-GDP to an all-time high in the post-WWII era. As I wrote earlier, there is plenty of bipartisan blame to go around for our current horrific national financial condition.
A key goal of the Trump corporate tax reduction was to encourage the repatriation of $4 trillion of profits sequestered overseas back into the U.S. However, the actual number for 2018 and 2019 was $1 trillion. That’s just a little bit of a shortfall, don’t you think?
The massive corporate tax cut was also supposed to cause companies to splurge on capital spending; as you can see, that didn’t happen, either. The National Association of Business Economics found in a 2019 survey of 116 companies that 81% hadn’t increased their capital investments as a result of the Trump tax cuts.
David Rosenberg was one of the precious few economists who recognized the housing bubble and also anticipated the economic disaster it would produce. Here’s what he wrote right before Christmas, 2018, on the erupting deficits caused by Trumponomics: “The fiscal recklessness from not ensuring the tax reform would be ‘revenue neutral’, and jeopardizing the quality of the national balance sheet in the process, will be viewed by historians as one of the greatest economic mistakes the US government has ever made.”
And yet it was this massive policy error that catalyzed the U.S. stock market to soar to valuations never seen before. By some measures, the S&P 500 exceeded those of what was the most extreme equity bubble of all-time, the late 1990s, right before Covid struck in early 2020, while Mr. Trump was still in the White House.
Admittedly, when I was writing this in real-time back in early 2019,[i] I expected that year would be challenging for stocks as they began to discount a recession. Instead, the bear market would viciously unfold in just two months in early 2020, with nearly all of the carnage occurring in March of that year.
As discussed in Chapter 5, it’s impossible to know whether a more standard recession and bear market would have occurred in the absence of Covid. Ironically, thanks to both the Fed’s commitment to buying corporate bonds (crashing credit spreads, which is always an exceedingly bullish development) and its fabrication of four trillion dollars from its Magical Money Machine, the stock market has likely risen more than it would have in the absence of one of Planet Earth’s worst disasters. (Even as I update this chapter, the Omicron variant is continuing to plague humanity — literally — and yet the S&P 500 continues to make a series of new highs, driving it up nearly 28% in 2021.)
David Rosenberg has also made the interesting point that the muscular earnings rebound by Corporate America coming out of the Covid recession has only brought profits to where they were projected to be back in early 2020 prior to the pandemic. In other words, as of 2021, earnings have merely attained the target set pre-Covid (the stock market discounts forward profits) and yet the S&P is up 40% since then!
Accordingly, in another irony, since the Fed went into its hyper-printing mode and the federal government into its equally hyper spending mode, the rich have gotten even richer. The wealth disparity has grown more extreme, even as the Democratic party has assumed full control. Of course, tax policy appears to be poised to become much more hostile to the highest earners and asset owners. While that may narrow the wealth gap a bit, I doubt it will be material. What would be a major needle-mover would be a reversion-to-valuation-mean for U.S. stocks and real estate. History has shown that the “great equalizers” are deep and lasting – not just flash crash – bear markets.
The problem is that drastic tax increases and truly grizzly bear markets crush the economy, especially the latter. On the former, Bill Clinton showed you can raise taxes somewhat and still have a strong economy. However, he did have a big tailwind with falling interest rates and inflation, plus the then-unprecedented internet bubble. And he left office just in time to avoid the damage from the tech-wreck, as well as the horrors of September 11, 2001, and the staggering costs of the war on terror.
As I observed in Chapter 6, the degree of tax increases needed to offset the amount of spending that already occurred due to Covid, the pending trillions of additional expenditures, and the looming years of reckoning for $100 trillion or more of unfunded Boomer entitlements, would clearly crush the economy. Thus, taxation to pay for this spending blitzkrieg, much less to meaningfully address wealth inequality, is almost certain to be much less than required to avoid ongoing trillion-dollar-plus deficits.
For those who believe that government deficit spending has a positive multiplier effect — basically, that it will pay for itself over time — a review of history might be in order. More likely, this is a classic case of the triumph of hope over experience. As my great friend and business partner Louis Gave likes to say, such an attitude has much in common with second marriages or, in my view, pretty much all Hollywood weddings.
The biting reality is that from 2007 through fiscal year 2020 (again, the Federal fiscal year runs from October to September), our nation’s sovereign debt compounded at an 8.75% rate. Meanwhile, the economy grew at roughly 4% (based on total, or nominal, GDP). Adding in the budget blow-out in fiscal year 2021, the wrong-way gap, or negative multiplier, is going to be even greater. Thus, our debt-to-GDP ratio looks like this these days, the highest it has been since the end of WWII.
Yet, as I write these words, this isn’t stopping a Democratic-controlled Congress from trying to ram through another multi-trillion spending program, spread over ten years (using reconciliation, a dirty budgetary trick the GOP employed for the aforementioned corporate tax cuts). Donald Trump opened the Pandora’s Box of outrageous budget deficits, monetized by the Fed, but the Democrats, who now control all three branches of government, are taking this to a staggering new level.[ii] All of us, as in U.S., Boomers should feel extremely sorry — and embarrassed — for the state of the country we are leaving to the younger generations.
Perma-bulls on Wall Street point to the Energizer Bunny of the U.S. stock market as a nearly fifty-trillion-dollar rebuttal – roughly the size of the aggregate market value of publicly-traded American shares – of our economic malaise. However, I would counter that counter with the question: What price prosperity?
What will be the ultimate cost to our long-term national wellbeing due to this monstrous equity bubble? Moreover, as I’ve described earlier, there are bubbles almost everywhere — and of the whopper variety, not the old Hawaiian crooner Don Ho’s Tiny Bubbles.
Throwing capitalism under the bus
Even pre-pandemic, Wall Street Journal editor Gerard Baker wrote, obviously representing a conservative publication (though not Fox News Network conservative), that “Faith in the American model of capitalism has been crumbling for a decade — and not just on the left.”
Baker’s article added this for good measure, referring to socialist Congresswoman AOC’s platform (which appears to have largely been adopted by the Democratic party in 2021): “The eye-catching proposals — the Green New Deal, universal free health care and education — seem like unfundable pipe dreams, and you don’t need a slide rule to know that a 70% top marginal tax rate really isn’t going to get you there. But if you think these messages — idealized symbols rather than developed policy proposals — don’t appeal to a rising generation of voters, for whom, opinion polling tells us, capitalism is a failure, then you need to get out more.”
What’s remarkable about when this populist trend first got rolling, both on the left and the right, was that economic times were still good, at least superficially. Ostensibly, Donald Trump’s election was a populist event. If so, he’s a very strange populist. Putting aside his immense wealth (though it’s probably not as immense as he likes to boast), some of his most important policy achievements were 180° removed from what most people would consider populism. A prime example of that was the monster corporate tax gift that began the accelerated trashing of our national balance sheet.
Thus, it’s no wonder that ordinary Americans are disaffected by this pseudo-prosperity produced by what I believe has been pseudo-capitalism. For most of the last 10 years, nearly the only policymakers pursuing the seemingly reasonable goal — emphasis on “seemingly” — of getting back to the pre-Great Recession economic growth rate has been the central banks. But, with the passage of time, it has become apparent both how futile and dangerous their radical remedies have been.
As governments around the world appeared confused and used conflicting approaches — some employing fiscal “austerity”, which was never actually austere, and others using aggressive deficit spending – their monetary branches, the Fed, the European Central Bank, et al, led the charge. They valiantly and mostly vainly sought to bring the so-called wealthy nations back to their former trendline GDP growth rate. This was despite a number of economic experts, usually outside of the central banks, who pointed out this was nearly impossible based on towering debt levels and aging workforces.
On the latter point, Gavekal’s Will Denyer noted to me in an email (after reviewing the original drafts of Chapters 6 and 7) that the U.S. labor force has been growing at just 1% annually since 2000. This is about half the prior growth rate. As a result, it is exceedingly challenging to maintain the prior rate of GDP increase. The only way to do it is via a surge in productivity. Yet, as we’ve seen, government debt binges actually impede the economy’s productive potential. No amount of central bank monetary magic can offset this reality. In fact, I’d argue it makes the situation worse by creating a dangerous degree of complacency due to the almost zero-cost borrowing.
The extreme indebtedness meant that additional debt brought little bang for the buck, per Figure 1 above showing the appalling deterioration in America’s federal government debt relative to the size of the economy.
Further, with the vast Baby Boomer generation heading into retirement, the labor force is destined to grow slowly for years to come. Basically, 2% GDP growth has become the new 4% but the monetary magicians have refused to face up to that fact. For sure, since the Global Financial Crisis/Great Recession, there have been a few spurts above 2% (or in Europe’s and Japan’s cases, up to it). Yet once whatever extraordinary stimulus wore off, like the Trump tax cuts, it was back down to that formerly paltry rate.
Essentially, in their maniacal pursuit of prosperity — or what they perceived prosperity to be — the central banks collectively decided the only viable approach was to pump up asset prices. In other words, they elected (not that they are; they’re appointed) to make the rich richer and, as we’ve seen, they succeeded spectacularly well.
As noted in Chapter 6, the Fed’s own studies showed minimal benefit from goosing asset values. A key part of the reason for this ineffectiveness is that since the rich own most of the assets, as clearly shown above, they were the main beneficiaries of this scheme. Yet, as all economists know, the propensity to save by the wealthy is far higher than the inclination to spend. Ergo, there was almost certain to be a negligible boost to Main Street, just as the Fed’s internal studies projected.
On the other hand, money-for-nothing policies were a lavish gift to Wall Street. But in the process, these too-clever-by-half (in Brit-speak) central bankers have birthed a bastardized form of capitalism. A tragic aspect of this is that during the Covid crisis, free markets have become materially less free, as have our daily lives. Government intervention in almost every aspect of life has dramatically increased—all in the name of protecting us, of course. (How effective that’s been is an entirely different story).
Central banks are so deeply involved in financial markets that prices no longer provide reliable signals, such as with interest rates that bear no relationship to the current level of inflation. Politicians on the far left have quickly seized control of the legislative process, with a “yuge” assist from Donald Trump. Consequently, capitalism is in even greater peril than it was pre-pandemic. Folks like AOC and Bernie Sanders have been ecstatic with the multi-trillions in additional Fed-monetized spending, though, naturally, they wanted to see much, much more. Yet, as 2021 ended, it was increasingly obvious that most Americans were not of like mind.
Tucker Carlson, in a scathing tirade against the current economic paradigm (on the Fox network, of all places!), fumed that: “Libertarians are certain to view any deviation from market fundamentalism as a form of socialism but that is a lie. Socialism is a disaster. It does not work. But socialism is exactly what we are going to get and very soon unless… responsible people in government reform the American economy in a way that protects normal people.” He ranted this in 2018 but his words have proven to be prophetic as MMT and socialist policies have gone viral in 2021.
To his point, 80% of Americans live paycheck to paycheck and only 39% are able to cover a $1,000 unexpected expense out of savings. Northwestern Mutual Insurance has reported that, overall, Americans have on average just $84,821 in retirement savings; 21% have nothing at all saved up for their “golden years”. Consequently, these individuals are easy prey for the siren-song of socialism, the poster child for what I call the “sounds good, works bad” school of economic theory (just ask any citizen of Venezuela, Cuba or North Korea).
Additionally, in the most economically vibrant cities, and even in some of the decaying ones, housing is usually prohibitively pricey for all but the most affluent first-time home buyers. This reality afflicts most “rich” countries where the housing wealth is highly concentrated in the hands of the older generations while the young are largely priced out. That’s not great for social tranquility, and the insanely low interest rates created by hyperactive central banks played a massive role in this triumph of inequity.
Money for nothing central bank policies have also had an enormous impact on companies buying back their own stock, especially in America. They’ve also caused severe distress for most retirement plans though that has, for now, been obscured by the heavily Fed-engineered never-ending bull market, once again, particularly in the U.S. (Both of these are important enough to receive full chapter treatment, which is coming up.)
Perhaps the average American, whomever he or she is, subliminally realizes how fragile conditions are despite the pseudo-boom caused by the central banks’ machinations. They may sense their 401(k)s are soon going to turn into 201(k)s, as they did in early 2009 – and almost did, briefly, in 2020 – due to the inflation of serial asset bubbles caused by reckless central bank policies. Maybe that’s why there is such an undercurrent of unease and even outright panic among so many in the developed world these days. They are losing faith in capitalism, but the irony is that what we’ve seen for most of the last 20 years or so has been a perverted form of it, not the real deal.
Repeated and extreme government interventions have distorted normal market mechanisms, creating a series of bubbles and busts, along with consistently disappointing economic growth. Frankly, I once had high hopes that current Fed chairman Jay Powell realized this sorry situation and was willing to move away from such meddlesome policies. But maybe he can’t. Perhaps it’s simply too late. Maybe the Fed is in too deep already, with its thumbprints all over the bubble-blowing machine and too afraid to be caught holding the pin that pricks the bubbles that haven’t yet popped—especially, large sections of the U.S. stock market.
In this regard, I was stunned at the time to read a quote from Jay Powell, in one of my friend Danielle DiMartino Booth’s newsletters from back in 2018. It was pithily titled The Powell Punt, a play on the “Fed Put” thesis. In it, she recounted that Mr. Powell, at a press conference with his two predecessors, apologetically said: “I was one who raised concerns when I first got to the Fed… they (his concerns) didn’t really kind of bear fruit… We didn’t see asset bubbles.”
Like me, Danielle thought Jay Powell would be a flashback to much stauncher Fed chairmen like William McChesney Martin and Paul Volcker. How any sentient human, much less a Fed chairman, could survey market conditions in 2021 and not see bubbles everywhere is simply astounding — and exceedingly disconcerting. Thanks to bubble-blindness like this, America’s central bank has morphed from indispensable under Paul Volcker, and most of Alan Greenspan’s tenure, to indefensible under the last three perma-easy money Fed-heads (Bernanke, Yellen and Powell).*
Until then, and particularly until something causes this all-encompassing bubble to blow apart, investors reading this book should be preparing for what will be a spectacular demise. While there could be multiple causes of the end of Bubble 3.0, my money — literally — is on what we’ll examine in Chapter 8.
*In Chapter 10, we’ll take a far more in-depth look at the depravity in today’s financial markets that these monetarily incontinent policies of the latter three have produced.
[i] This chapter was updated in late 2021.
[ii] Similarly, his obsession with the stock market, at least when it was rising, was another odd fit with a true populist politician. After all, who was really benefiting when the stock market rose by 15.4% over his four years in the Oval Office? The hard statistics are quite clear in that regard. Incredibly, 0.7% of the planet’s adults control 46% of the total wealth. Similarly, income has grown much faster for the top 1% than it has the rest of Americans. (To be fair, with government support payments included, the income gap isn’t nearly as wide.)
Chapter 8: A Brewing Bubble In Inflation?
Maybe “transitory” was the real transitory
Throughout 2021, there was likely no more pressing question for investors, and consumers, than this: “Was inflation truly transitory?” As described earlier, that’s certainly what the Fed wanted the world to believe.
It’s my view that high and rising inflation is the most likely factor that would terminate the Fed’s go-to reaction for nearly all threats: hitting Control + Alt + Print. This is because printing more trillions from its Magical Money Machine would only escalate inflation anxiety if it was thought to have become entrenched. Without the Fed downside protection mechanism (that now legendary Fed Put), both stocks and bonds would have to sink or swim based on actual fundamentals and free-market demand. For financial markets, this would be a most disruptive development. As you may have observed, these interrelated events are beginning to play out in early 2022.
So far in this book, I’ve just touched on inflation other than arguing that conditions are much different than in the past 40 years and, of course, in Chapter 6, that history is clear that Modern Monetary Theory-type policies are inherently inflationary. Now, though, let’s consider in detail the manifesting array of more conventional inflation forces. Far from trivial, you will see they are, in fact, paradigm shifting.
It’s sobering to consider the two images below, especially in the context of four decades of relatively benign inflation. Clearly, something big happened in the early 1970s and, as noted earlier, that was Richard Nixon pulling America off the gold standard.
Source: Grant Williams, TTMYGH
Source: John Goode, Morgan Stanley
Equally obviously, a game-changer also occurred right before WWI. If you’re not sure what that was, please allow me to remind you this was when the Federal Reserve was established. As you can see, basically from the founding of the Republic until the establishment of the Fed, the U.S. dollar held its own in purchasing power, except during the Civil War. Even that erosion was reversed in fairly short order due to a number of years of deflation. It’s important to point out that America enjoyed unprecedented growth in its economy during its first 130 years of existence, prior to the Fed’s creation, despite many boom-and-bust cycles.
Of course, since 1971 and the departure from the gold standard, the greenback’s decay has become even more pronounced. Yet, most Americans have felt comfortable with the Fed’s target of 2% per year purchasing power erosion despite that it means a 45% haircut over a 30-year period
Maybe that sanguine attitude was due to the fact that, as we’ve seen in earlier chapters, for most of the past 40 years it was possible to earn more than inflation with bonds and, often, federally insured certificates of deposit. But, as we all painfully know now, those days are long gone.
Frankly, that’s a big part of the inflation resurgence thesis of which I have become an ardent proponent. Millions of investors and savers are waking up to the reality that holding U.S. dollars, even including earned interest (such as it is), is a losing proposition. Thus, it’s much better to play the stock market or buy hard assets, like real estate, or not-so-hard assets, like cryptos, rather than stay in cash. When expectations become widespread that cash is trash, inflation can quickly become a societal problem.
By the fall of 2021, this had become a major consideration due to the fact that U.S. households were sitting on around $2.5 trillion of excess savings[i] and inflation was worsening, despite the Fed’s constant protests to the contrary. This massive savings cache had been accumulated since Covid blessed us with its presence and was a direct function of the federal government’s trillions of support payments. With Delta and then Omicron keeping things subdued in the second half of 2021, that money didn’t move much, other than into stocks, cryptos and other risky assets. However, given American consumers’ propensity to do what they do best — consume — I suspect this immense stash of cash won’t remain dormant. This is likely to be especially the case if Mr. and Mrs. America believe they better buy now because almost everything will cost more next year or, even, next month.
When Fed chair Jay Powell was getting grilled in Congress in July 2021 — as it was becoming obvious inflation was running much hotter than the Fed had anticipated – Senator Cynthia Lummins pointed out to him that U.S. households “… are sitting on deposits and close substitutes of equivalent to 79% of GDP” up from an average of 51%. “Is it really wise,” she went on to ask him, “to continue to have accommodative policy where there’s still trillions of household cash that will flow into the economy soon?” Mr. Powell looked at his watch as she was speaking and obfuscated as he has done so often in recent years – not to mention repeatedly contradicting himself, even in the same speech or reply. (Source: Grant’s Interest Rate Observer)
As far back as the summer of 2020, Wharton Professor Jeremy Siegel, well-known for his typically rosy view of the economy and the stock market, was picking up on the mounting inflation threat. Per Prof. Siegel, “The money created by the Fed is not going only into excess reserves of the banking system (as it did in the earlier QE rounds). It is going directly into the bank accounts of individuals and firms through the US Payroll Protection Plan, stimulus checks and grants to state and local governments”. He presciently predicted “… an extremely inflationary economy in 2021”, as early as mid-2020, per the above, when almost no one, including — make that, especially — the Fed, saw it that way.
The official inflation numbers during the second half of 2021 were certainly husky but it’s perhaps a stretch to call them “extremely inflationary”. However, Jeff Gundlach opined in his September 2021 webcast that if housing price increases were included, the CPI would be ripping at 12%, a number that certainly qualifies as extremely inflationary. This relates to my earlier examination of how the Fed’s OER (Owners’ Equivalent Rent) has understated the stunning increase in home prices this century/millennium.
Mr. Gundlach, the reigning King of Bonds, also believes the triple whammy of trillions of Federal red ink, financed by trillions of the Fed’s fantasy funds, and a hemorrhaging trade deficit, are going to be Kryptonite to the mighty U.S. dollar. Again, looking back over the last 40 years, the dollar has been strong against most major currencies. That has definitely helped keep inflation at bay.
The odds stack up against transitory
Should the buck fall hard, as Mr. Gundlach believes (in the summer of 2021 he referred to it as doomed, long-term), this will be another source of upward pressure on the CPI, as well as the PPI, the Producer Price Index. This is a function of the reality that a weaker dollar pushes up the price of imported goods.
Then there is the Fed itself and its changed and expanded mandates. It has been LCD clear that it will let the economy run hot to bring down unemployment. As a reminder, since 1978 its mission statement has been to keep inflation in-check and the jobless rate subdued. Now, the latter appears to be Job One and the former… well… not so much. This is despite the fact that, toward the end of 2021, Jay Powell began to pay lip service to controlling inflation — even as he maintained the easiest monetary policies in U.S. history, save for a few months earlier.
In my view, Powell & Co. would be well-advised to deeply reflect on this quote from former senior Fed official, William Poole: “The idea that we can let down our guard on inflation to increase employment is unwise in the long term because higher inflation eventually destroys rather than creates jobs.” (Emphasis mine) It’s a lesson that central bankers — and the planet — learned the hard way in the 1970s but, apparently, it has been unlearned in recent years.
Moreover, as I’ve also described in earlier chapters, the Fed is now under extreme political pressure to fight climate change and address racial economic inequities. On September 15th, 2021, a bill was introduced in Congress that would force the Fed to punish banks for lending to fossil fuel producers. (More on this in Chapter 9).
As far as narrowing the wage differential between whites and minorities, the Fed has made it clear it sees keeping the unemployment rate down as critical to this, even if it means more inflation. Perhaps that is admirable from a social justice standpoint, but it’s for sure another upward force on consumer prices. Moreover, there is the critical issue that the poor suffer the most from inflation surges. In his January 6, 2022, The Flow Show BofA’s Michael Harnett noted that “the price of basic human needs such as food, heat, shelter (are) soaring; global food price rose 27% year-over-year; US heating costs up 30% for natural gas, 43% for oil, 54% for propane; US rents up 12%, house prices up 18%.” Attempts to mitigate these hardships with wage and price controls, which might be poised to make a comeback in modern day America, are notoriously counterproductive. (Please see the Appendix for additional thoughts on this topic.)
Quoting my digital mate and fellow financial newsletter scribe, Sydney-based Gerard Minack: “The fact that the Fed has promised not to be pre-emptive in this cycle is the single most important reason to expect a second wave of inflation.” By “second wave”, he’s making the crucial point that during the first part of 2021, the CPI surge was due to commodities, like lumber, going vertical along with new and used cars. He correctly foresaw those pressures easing. This backing off caused many in the investment community to take it as validation of the Fed’s transitory thesis, at least for a while.
Yet, like me, Gerard sees this as a head-fake, hence the second wave part of his argument. He anticipates rent inflation to become a far more persistent inflationary impulse along the lines of a looming spike by the aforementioned OER.
Moreover, also simpatico with this author, Gerard thinks labor costs are heading in a decidedly northerly direction. As he wrote in his July 20th, 2020, Down Under Daily, (definitely not a “DUD” of a read, by the way): “For now, signs of a tight labor market are everywhere but in the wage statistics.”
Perhaps that’s because of the archaic way they are measured. Another financial newsletter compatriot is Ben Hunt of Epsilon Theory. He contends that the U.S. generated more wage inflation over the four quarters from March of 2020 to March of 2021 than at any time in the prior four decades. Ben believes the Bureau of Labor Statistics is understating wage inflation by using a century-old approach of tabulating hourly wages versus today’s far more prevalent salary-based compensation. The following Gavekal chart certainly indicates that Ben and Gerard are on the right scent.
François Trahan, voted the number one portfolio strategist on Wall Street for 8 of the 10 years from 2009 to 2018, pointed out in a September 2021 research missive that the supply of labor leads wage inflation by about a year. Wage inflation, in turn, leads core inflation by another year. Based on the extremely tight job market as the year progressed, with small business openings at a two-decade high (by far), there would appear to be considerable wage inflation in the pipeline, as the below chart clearly indicates. This will make a significant CPI cool-down even less likely in 2022.
Source: Goldman Sachs, 11/18/21
My close friend Vincent Deluard, Director of Global Macro at International Stone X, believes the Fed is overlooking a critical change in the overall employment situation. In cliff note form, he is convinced it is missing the millions who are now employed in the “gig” economy, such as folks working for Uber. These individuals typically don’t have income tax withheld and, in many cases, might not report their income at all if it is paid in cash.
Yet, millions must be reporting their earnings because, per Vincent, in the first half of 2021, the Treasury collected $308 billion in non-withheld personal income taxes, up 110% from 2019! Another shocker is that this number was materially larger than the $230 billion the U.S. treasury brought in from corporate taxes in the first half of 2021. As he concedes, not all non-withheld personal income tax is from gig workers but the fact that this number exploded as the gig economy took off certainly indicates it’s been a big factor.
Vincent further observes, “Yet, the statistics the Fed uses to model the economy ignore this massive and soaring portion of the economy… The Fed’s lack of data on the… gig economy will likely lead it to overestimate the slack in the labor market.” If he’s right, and his logic is persuasive, the Fed has been making a prodigious mistake by continuing to print $120 billion a month throughout almost all of 2021 in its attempt to force down the unemployment rate when the labor market is already speedo-on-a-Sumo-wrestler tight. This has significant inflationary implications.
To put more color on just how robust the U.S. employment picture was in the fall of 2021, job openings were nearly 1 million above new hires, a record spread. Additionally, the Quit Rate, which measures those workers voluntarily leaving their current employers, presumably for higher pay in most cases, has been in a powerful uptrend.
Source: Danielle DiMartino Booth/Quill Intelligence
Then, of course, the federal government has been paying generous unemployment benefits, creating a disincentive to return to work. The support payments were essential during the worst of the lockdowns. However, even early in 2021 there were countless businesses — large, small and in-between — desperate for workers, causing this policy to become exceedingly counterproductive. Unquestionably, it is yet another factor contributing to a severe shortage of employable individuals.
There was another force lurking in America’s labor market at the time, one that threatened to make conditions even more nightmarish for businesses, including hospitals, to retain their workforces. It’s a trend that pundits like Luke Gromen began referring to as “The Great Resignation”.
This referenced the swelling wave of American workers refusing to be vaccinated and choosing to retire or, I suspect, in millions of instances, opt to work in the aforementioned gig economy. The latter might not be quite as deleterious as the former because theoretically jobs are still being filled even if they aren’t part of the official economy. By the time you are reading these pages, we’ll know how great — or un-great — this resignation movement became but I would venture to say it will be another blow to keeping wage inflation in check. As I write these words, it’s hard to find a company that isn’t desperate for workers. In reality, they were often so hard-up they were forced to shut down, or, for those with the means, to dramatically raise compensation.
The remarkably lucrative settlement John Deere workers agreed to in late November 2021 is a graphic, and most telling, example of the latter. Its union was able to secure for its members an upfront 10% raise, an $8500 signing bonus, further 5% pay bumps in the third and fifth years of the six-year contract and 3% hikes in the second, fourth and sixth years.
Yet, the biggest eye-opener, at least to me, was that this deal reinstituted a cost-of-living adjustment, also known as a “COLA”. These were a hallmark of the inflation-riddled 1970s, but they had largely faded away since the 1980s. The fact that these are making a comeback is extremely ominous from the standpoint of avoiding the dreaded wage-price spiral. Even in Europe, where chronically high unemployment has kept a tight lid on labor costs, COLAs are reappearing.[ii]
Of course, that’s what the Fed wants: higher pay for the rank and file. The problem is that, as many began to notice during the early fourth quarter of 2021, inflation was eating up all or more of the wage gains. Rising compensation only helps workers if it outpaces the CPI which, for all the reasons we’ve seen, has become a steep hill to climb.
Further complicating this situation was a supply chain that was snarled beyond anything seen before, at least in peacetime. Rather than getting better, as it was supposed to, by the fall of 2021, it further seized up. Shipping behemoth UPS announced as the third quarter drew to a close that the logistics industry expected 2022 to be as challenged as 2021. As one wag noted around this time: “How can inflation be transitory if supply chain disruptions are here to stay?”
Further putting lasting upward pressure on prices was the passage of the contentious Infrastructure Bill that finally was signed into law in November 2021. Undoubtedly, America needs a big-time refresh of its roads, bridges and airports but the timing of this legislation is problematic. With almost all resources in tight supply and the acute shortage of workers, this legislation is highly likely to shovel more fuel into the inflation blast furnace.
On top of that, there was the even more controversial spending package — the now notorious Build Back Better (BBB) — which was first proposed by Bernie Sanders with an initial $6 trillion price tag. Moderates in Congress whittled that down to a still jaw-dropping $3 trillion. Fortunately, at least for the struggle against even higher inflation, the BBB push stalled at the end of 2021. However, the effort to pass it will likely resume in 2022. Accordingly, the jury is still out as I write this chapter as to whether this will be yet another inflation impetus.
There is little doubt that the various spending packages amounted to a massive overstimulation of the economy, generating a tsunami of additional demand in an already supply-challenged economy. It’s my prediction that the impact of this will persist not only into 2022 but for years to come.
Essentially what we did by practicing de facto MMT was to replace the normal tax-and-spend cycle that Democrats typically resorted to when they were in power — and the GOP wasn’t much, if any, more restrained – with a new model of spend-and-print. Once again, this started under Donald Trump, but Covid gave the perfect cover for it to be taken to an almost incomprehensible level. As Ben Franklin warned 250 years ago, “When the people begin to think they can vote themselves money, it will herald the end of the Republic.” Mr. Franklin didn’t know about MMT, at least by name, back then, but he was fully aware of what happened in France a few decades earlier thanks to the French monarchy’s dalliance with John Law’s version, as described in Chapter 6.
This unprecedented overstimulation of the economy revealed itself in the U.S. money supply as it inflated by 33% in less than 18 months, the greatest surge in 150 years, going all the way back to the Civil War era. Even when compared to Japan’s desperate attempt to print its way out of deflation in the early part of this century, what the U.S. money supply did was stunning. Further, there was no effort to remove that money from the system, meaning it will linger there for years to come, with all its inflationary potential.
As we’ve seen earlier in this book, negative real rates, such as prevailed through 2021 and are almost certain to persist in 2022, are also inherently inflationary. As Charles Gave has often pointed out, a prime reason they stoke inflation is that they encourage the leveraged purchase of existing assets (like stocks or cryptos bought on margin and, of course, debt-financed real estate) at the expense of making long-term, productivity-enhancing investments such as new plants. Perhaps that’s why capital spending has been deficient for many years per Chapter 7.
Are you getting the sense yet that the Fed’s transitory story might just have a few holes in it? Well, there’s more — even before we get to the hurricane-force inflation-driver in Chapter 9. Louis Gave has pointed out that China’s One Child policy is coming home to roost. As previously discussed, China and its rock-bottom labor costs, were a significant and structural deflationary factor for at least 20 years. This was in no small part due to the fact that its labor force was growing by 10 to 15 million workers every year.
Now, though, thanks to its looming population shrinkage due to One Child, it is set to contract by 5 to 10 million annually. As Louis notes, this is a classic example of a government intervention that has gone awry, at least if you want to believe the transitory inflation narrative. With big government on the rise pretty much everywhere in the world these days, that’s yet another inflationary force. (To access excerpts from Louis Gave’s essay on how China’s demographic challenges will influence global labor costs, please see the Appendix.)
From delight to fright
It’s a similar story with the all-important semiconductor supply situation. The China trade war that started under Donald Trump, which denied Chinese tech companies access to critical American components such as semis, caused its government to launch a frantic effort to build its own semiconductor industry. One reason being floated for why China might invade Taiwan is to secure control over the most valuable and cutting-edge integrated circuit company in the world, Taiwan Semiconductor. As you can see, Taiwan Semi’s market value now greatly exceeds Intel’s, reflecting the former’s increasing dominance.
In turn, the U.S. is pressuring companies like Intel and Taiwan Semi to build new plants in the U.S. to ensure access to this basic building block of nearly all things tech related. Accordingly, supply chains are being shortened, by bringing production closer to end markets. However, this has the effect of making products, including semis, more expensive. Illustrating this was Taiwan Semi’s 2021 price hike, so unusual in the tech world where, historically, prices have typically consistently gone down.
A wide range of Asian tech players are raising prices, a previously unheard-of development. Moreover, there was an acute shortage of semiconductor substrate in the autumn of 2021. Our excellent tech analyst, Arnaud Legland, sees an extremely tight market for another critical semi component, wafers, starting in 2022 with little hope of new supply coming on-line anytime soon. (Arnaud does see a number of semi products becoming oversupplied as 2022 matures.)
As Pimco’s former CEO Mohamed El-Erian wrote in the Financial Times in September 2021, “The dominant structural theme post the financial crisis — that of deficient aggregate demand — has given way to frustrating supply rigidities. They are not going away soon.” (Emphasis mine) If he’s proven right over time, as I clearly think he will be, this is highly likely to be a concussing shock to most investors who, as I’ve conveyed, remain convinced the Fed has the inflation situation under control. This is true even as Jay Powell reluctantly conceded in December 2021 that the term “transitory” needed to be “retired”. However, it’s those kinds of unpleasant epiphanies — when the majority of investors realize they’ve been betting on the wrong horse, like inflation coming down to around 2% by the end of 2022 — that create market convulsions.
This pervasive faith in the Fed has long puzzled me. As The Wall Street Journal pointed out in a July 29th, 2021, opinion piece: “The Federal Reserve employs hundreds of economists whose job is assessing the American economy. So it is remarkable that the Fed is so wrong so often in its economic forecasts. The latest big miss has been its failure to anticipate this year’s surge in consumer prices.”
Unlike the Fed, I did believe inflation was coming our way soon. Here’s what I wrote in the Evergreen Virtual Advisor (EVA) newsletter as far back as late October of 2020, when inflation was still MIA: “With Modern Monetary Theory (MMT) giving US politicians from both parties the greenlight to spend like they never have before, at least in peacetime, financed by the Fed’s MMM[iii], it’s just a matter of time, in my opinion, before we have both a weaker dollar and higher inflation. Policymakers might be delighted at first with inflation moving above 2% but when and if (I think it’s when, not if) it hits 4% or even 5%, that delight is going to turn into fright very quickly.”
It was a good, but not perfect, call: While inflation did move into the 4% to 5% range — actually, nearly 6% based on the Social Security hike — the U.S. dollar performed remarkably well in 2021. This is almost certainly due to the fact that most major Western countries pursued similarly incontinent fiscal and monetary policies. However, China and Russia — our, once, present, and future geopolitical rivals — have not been; thus, it’s interesting that the Renminbi rose slightly vs the USD in 2021 while the Ruble was essentially flat. Against most other currencies, the dollar rose throughout 2021.
Also, while it’s true a number of influential individuals began to publicly express concerns about inflation, the Fed was able to convince most politicians, and certainly the markets, that it’s a fleeting phenomenon, despite the trash-canning of “transitory”. However, former Treasury Secretary Larry Summers was not one of them. In the summer of 2021, he warned, “The Fed has had almost no success in bringing down prices once the economy has overheated.”
Regardless, the Fed has repeatedly and vehemently told the world it has all the tools it needs to bring inflation back down should it prove sticky. To which I say, “No way, Jay!” It has been my view that the Fed lacks the fortitude to take the type of extreme tightening needed to rein in truly virulent and persistent inflation. In fact, I believe Jay Powell has become the anti-Volcker.
Moreover, at this juncture, I have begun to suspect the Fed wants much more inflation than it has admitted — as long as it convinces the rest of the world of the opposite. The aforementioned Luke Gromen wrote extensively on this even before Covid hit. His basic view, in short form, is that the only way the U.S. government can cope with its nearly $30 trillion of official debt, and the off-balance sheet $100+ trillion (note the plus sign) of entitlements, is to do what America did after WWII.
Essentially, the U.S. kept interest rates low (as was the case in 2021, the Fed bought bonds to keep rates suppressed) while the economy boomed and inflation soared. The CPI rose by 20% at times in the late 1940s but interest rates were held in the 2% to 3% range. The economy grew by an average of 7.2% from 1946 to 1952 on a nominal (i.e., including inflation) basis. As a result, the debt-to-GDP ratio fell from about 115% to roughly 70%. In other words, the strategy worked, and a debt crisis was avoided. Of course, bond investors were the sacrificial lambs, as inflation destroyed the purchasing power of their holdings.
Per Luke Gromen: “When the US government borrows from its own domestic investors at negative real rates, the US government is actually stealing real wealth from its own citizens (effectively a sort of tax increase on a real basis).” He also wryly, but rightly, observes that: “Importantly, a key part of inflating away one’s debts is convincing one’s creditors that one is not inflating away one’s debts.”
To that last sentence I would add: like convincing them that the current high inflation rate is abnormal, even if no longer transitory. In Chapter 9, I’ll finally address the intense inflationary force that I believe ranks right up there with MMT in undercutting the Fed’s “we’ve got this” storyline.
[i] In other words, U.S. consumer savings has increased by around $2.5 trillion since pandemic began.
[ii] Vincent Deluard is one of the few pundits I know making the important point that COLA adjustments on Social Security payments are creating a much broader wage-price spiral than is generally understood. Even though these benefits are not technically wages, the inflation impact is the same. With tens of millions of now retired Boomers, and another nine million Americans disabled, thus collecting benefits, this equates to around 40% of America’s labor force. Accordingly, COLAs have quickly become extremely pervasive… and inflationary.
[iii] Its Magical Money Machine, as described earlier.
Chapter 9: Green Energy - A Bubble In Unrealistic Expectations
Green Energy: A Bubble In Unrealistic Expectations
Europe’s shocking energy crisis
As I wrote previously, it amazes me how little of the inflation debate in 2021 centered on the inflationary implications of the Great Green Energy Transition (GGET). Perhaps that’s because there is a built-in assumption that using more renewables should lower energy costs since the sun and the wind provide “free” power.
However, we will soon see that’s not the case; in fact, it’s my contention that it’s the opposite, and I’ve got some powerful company. BlackRock CEO Larry Fink, a very pro-ESG[i] firm, is one of the few members of Wall Street’s elite who admitted this in the summer of 2021. The story, however, received minimal press coverage and was quickly forgotten (though, obviously, not by me!).
This chapter will outline myriad reasons why I think Mr. Fink was telling it like it is… despite the political heat that could bring down upon him. First, though, I will avoid any discussion of whether humanity is the leading cause of global warming. For purposes of this analysis, let’s make the high-odds assumption that for now the green energy transition will continue to occur. (For those who would like a well-researched and clearly articulated overview of the climate debate, I highly recommend Unsettled by a former top energy expert and scientist from the Obama administration, Dr. Jeffrey Koonin.)
The reason for the italicized “for now” is that I think it’s extremely probable that voters in many Western countries are going to become highly retaliatory toward energy policies that are already creating extreme hardship. Even though it’s only early autumn as I write these words, energy prices are experiencing unprecedented increases in Europe. Because it’s “over there”, most Americans were only vaguely aware of the severity of the situation. But the facts were shocking…
It was a perfect storm on the Continent as the fall of 2021 turned into the winter of 2022. Or perhaps it was the perfect non-storm as a major culprit in Europe’s current energy crisis has been a general lack of wind, becalming its myriad windmills. It’s also been unusually cloudy which is saying something, especially for Northern Europe, inhibiting solar power output. Further, temperatures have been somewhat colder than normal, though not nearly to the degree — or very low degrees — which China is facing. This has left natural gas storage levels critically low. (Fortunately for the Continent, thus far the actual winter has been relatively mild.)
Consequently, “nat gas” prices went truly postal at the end of last year reaching roughly $170 per MegaWattHour (MWH) in late December, the highest ever. Now get ready for this one: that’s eight times what it was a year earlier. This has driven electricity prices to the equivalent of $250 per barrel in oil terms! Obviously, the term “crisis” isn’t hyperbole “over there”. In fact, I’d suggest it has truly become a mega-crisis. (As of early February 2022, they have been cut in half, thanks in part to a 40% surge in U.S. liquified natural gas shipments to Europe; yet, they are still four times their year-ago level.)
Per best-selling author Bjorn Lomborg, 50 to 80 million Europeans were suffering from severe energy poverty even prior to the estimated $400 billion power cost surge in 2022. Additionally, six million UK households may not be able to pay their energy bills this winter. In fact, because of this unprecedented energy cost explosion, the British populace is facing the most severe drop in living standards on record. Widespread social upheaval in Europe is a distinct risk considering that gas pump hikes of just 12 cents per gallon in France produced widespread unrest. Lending credence to this concern, the bloody riots in Kazakhstan in early January 2022, which caused Russia to send in paratroopers, were primarily attributed to surging energy costs.
Besides the escalating human suffering, which threatens to be truly catastrophic should the last month of winter 2022 turn out frigid, it’s also producing a boom in coal power. The Continent’s coal plants are running full out and lignite, the dirtiest of coal sources, is dominating the fuel mix. Therefore, Europe’s energy agony is also aggravating environmental degradation. As we should all know, using coal as an electricity feedstock is far more polluting than oil and, especially, natural gas.
Aggravating the growing humanitarian crisis, serious food shortages were developing after the exorbitant natural gas price surges forced most of England’s commercial production of CO2 to shut down. Per the London-based Financial Times during the fall of 2021: “Soaring gas prices have forced the closure of two large UK fertiliser plants, sparking warnings of a looming shortage of ammonium nitrate that could hit food supplies as record energy prices start to reverberate through the global economy.”
Please check out this chart from the super-savvy team at Doomberg that shows the literally vertical move in North American fertilizer prices. Moreover, the U.S. and Canada have a tremendous cost advantage due to far cheaper natural gas which is a critical fertilizer in-put.
Source: Doomberg, Doomberg
In Spain, consumers were paying 40% more for electricity compared to the prior year. The Spanish government began resorting to price controls to soften the impact of these rapidly escalating costs. (But we all now know about how “well” those work, right?). Naturally, they hit the poorest hardest, which is typical of inflation, whether it is of the energy variety or of generalized price increases.
Normally, I’d say the cure for such extreme prices, was extreme prices, to slightly paraphrase the old axiom. But these days, I’m not so sure; in fact, I’m downright dubious. After all, the enormously influential International Energy Agency has recommended no new fossil fuel development after 2021 – “no new”, as in zero.
It’s because of pressure such as this that even though U.S. natural gas prices doubled in the fall of 2021 and were still up around 75% over 2020 as the year ended, the natural gas drilling count stayed flat. The last time prices were this high there were three times as many rigs working.
It was the same story with oil production. Most Americans don’t seem to realize it, but the U.S. has provided 90% of the planet’s crude output growth over the past decade. In other words, without America’s extraordinary shale oil production boom — which raised total oil output from around 5 million barrels per day in 2008 to 13 million barrels per day in 2019 — the world long ago would have had an acute shortage. (Excluding the Covid wracked year of 2020, oil demand grows every year — strictly as a function of the developing world, by the way.)
Unquestionably, U.S. oil companies could substantially increase output, particularly in the Permian Basin, arguably (but not much) the most prolific oil-producing region in the world. However, with the Fed being pressured by Congress to punish banks that lend to any fossil fuel operator, and the overall extreme hostility toward domestic energy producers, why would they?
There is also tremendous pressure from Wall Street on these companies to be ESG compliant. This means reducing their carbon footprint. That’s tough to do while expanding the output of oil and gas. Further, investors, whether on Wall Street or on London’s equivalent, Lombard Street, or pretty much any Western financial center, are against U.S. energy companies increasing production. They would much rather see them buy back stock and pay out lush dividends. The companies are embracing that message. A leading CEO publicly mused to the effect that buying back his own shares at the prevailing extremely depressed valuations was a much better use of capital than drilling for oil.
One U.S. institutional broker reported that of his 400 clients, only one would consider investing in an energy company! Consequently, the fact that the industry is so detested means its shares are stunningly undervalued. How stunningly? Myriad U.S. oil and gas producers are trading at free cash flow yields of 10% to 15% and, in some cases, as high as 25%. (In early 2022, there seems to be a sentiment shift underway. The plethora of pundits who deemed energy “uninvestable” in 2021 are suddenly removing the “un”; it’s amazing what oil prices nearing $100, caused by crashing supplies, does to investor attitudes.)
In Europe, where the same pressures apply, one of its biggest energy companies is generating a 16% free cash flow yield. Moreover, that is based upon an estimate of $60 per barrel of oil, not the prevailing price of nearly $95, as I apply the final edits to this chapter.
Besides how vital the U.S. shale industry has been to global supplies, another much overlooked fact about shale production is its rapid decline nature. Most oil wells see their production taper off at just 4% or 5% per year. But with shale, that decline rate is 80% after just two years. (Because of the collapse in exploration activities in 2020 due to Covid, there are significantly fewer new wells coming online; thus, the production base is made up of older wells with slower decline rates, but it is still a far steeper cliff than with traditional wells.)
As a result, the globe’s most important swing producer has to come up with about 1.5 million barrels per day (bpd) of new output just to stay even (this was formerly about a 3 million bpd number due to both the factor mentioned above and the 1.5 million bpd drop in total U.S. oil production, from 13 million bpd to around 11.5 million bpd in 2021). Please realize that total U.S. oil production in 2008 was only around 5 million bpd. Thus, 1.5 million barrels per day is a lot of oil and requires considerable drilling and exploration activities. Again, this is merely to stay steady-state, much less grow.
The foregoing is why I wrote on multiple occasions in my newsletter during 2020, when the futures price for oil went below zero, that crude would have a spectacular price recovery later that year, and especially in 2021. Even as it rallied hard throughout most of last year, I continued to opine it had more upside. My repeated 2021 forecast in numerous of our EVAs was that with supply extremely challenged for the above reasons, and demand marching back, I felt we could see $100 crude in 2022, possibly even higher. With it knocking on the triple-digit door in February of this year, that prediction has nearly come to fruition.
Frankly, I believe many in the corridors of power would like to see oil trade that high as it will help catalyze the shift to renewable energy. But consumers are likely to have a much different reaction — potentially, a violently different reaction.
You thought 2021’s gas prices were high?
Mike Rothman of Cornerstone Analytics has one of the best oil price forecasting records on Wall Street. Like me, he was vehemently bullish on oil after the Covid crash in the spring of 2020 (admittedly, his well-reasoned optimism was a key factor in my upbeat outlook). Here’s what he wrote in the late summer of 2021: “Our forecast for ’22 looks to see global oil production capacity exhausted late in the year and our balance suggests OPEC (and OPEC + participants) will face pressures to completely remove any quotas.” My expectation is that global supply will likely max out sometime in 2022, barring a powerful negative growth shock, such as a Covid variant even more vaccine-resistant than Delta or Omicron turning out much more virulent than it looks to be in early 2022. A significant supply deficit looks inevitable as global demand recovers and exceeds its pre-Covid level.
This is a view also shared by Goldman Sachs and Raymond James, among others; hence, my forecast of triple-digit prices next year. Raymond James pointed out that in June of 2021, the oil market was undersupplied by 2.5 mill bpd. Meanwhile, global petroleum demand was rapidly rising with expectations of nearly pre-Covid consumption by year-end. Mike Rothman ran this chart in a webcast on 9/10/2021 revealing how far below the seven-year average oil inventories had fallen. This supply deficit is very likely to become more acute in 2022. (For more on this topic, see the Appendix.)
In fact, despite oil prices having already moved over $70 in the early second half of 2021, total U.S. crude volumes were projected to actually decline. This is an unprecedented development. However, as the very pro-renewables Financial Times (the UK’s equivalent of The Wall Street Journal) explained in an August 11th, 2021, article: “Energy companies are in a bind. The old solution would be to invest more in raising gas production. But with most developed countries adopting plans to be ‘net zero’ on carbon emissions by 2050 or earlier, the appetite for throwing billions at long-term gas projects is diminished.”
The author, David Sheppard, went on to opine: “In the oil industry there are those who think a period of plus $100-a-barrel oil is on the horizon, as companies scale back investments in future supplies, while demand is expected to keep rising for most of this decade at a minimum.” (Emphasis mine) To which I say, precisely!
Thus, if he’s right about rising demand, as I believe he is, there is quite a collision looming between that reality and the high probability of long-term constrained supplies. One of the most relevant and fascinating Wall Street research reports I read as I was researching the topic of what I think can be referred to as “Greenflation” was from Morgan Stanley. Its title asked the provocative question: “With 64% of New Cars Now Electric, Why is Norway Still Using so Much Oil?”
While almost two-thirds of Norway’s new vehicle sales are EVs, a remarkable market share gain in just over a decade, in the U.S. the number is an ultra-modest 2%. Yet, per the Morgan Stanley piece, despite this extraordinary push into EVs, oil consumption in Norway has been stubbornly stable.
Coincidentally, that’s been the experience of the overall developed world over the past 10 years, as well: petroleum consumption largely flatlined. Where it hasn’t done an imitation of the EKG of a corpse is in the developing world, which includes China. As you can see from the following Cornerstone Analytics chart, China’s oil demand has vaulted by about 6 million barrels per day (bpd) since 2010 while its domestic crude output has, if anything, slightly contracted.
Another coincidence is that this 6 million bpd surge in China’s appetite for oil almost exactly matched the increase in U.S. oil production over the past 12 years. Once again, think where oil prices would be today without America’s shale oil boom.
China’s thirst for oil, as well as the rest of Asia’s, is unlikely to change over the next decade. By 2031, there are an estimated one billion Asian consumers moving up into the middle class. History is clear that higher incomes mean more energy consumption. Unquestionably, renewables will provide much of it, but oil and natural gas are just as unquestionably going to play a critical role. Underscoring that point, despite the exponential growth of renewables over the last 10 years, every fossil fuel category has seen increased usage globally, again, mostly a function of the developing world.
Thus, even if China gets up to Norway’s 64% EV market share of new car sales over the next decade, its oil usage is likely to continue to swell. As you may know, China has become the world’s largest market for EVs — by far. Despite that, the above chart vividly displays an immense increase in oil demand.
Here's a similar factoid that I ran in our December 4th, 2020, EVA, Totally Toxic “(There was) a study by the UN and the US government based on the Model for the Assessment of Greenhouse Gasses Induced Climate Change (MAGICC). It predicted that ‘the complete elimination of all fossil fuels in the US immediately would only restrict any increase in world temperature by less than one-tenth of one degree Celsius by 2050, and by less than one-fifth of one degree Celsius by 2100’. My apologies for asking a politically incorrect question, but if the world’s biggest carbon emitter on a per capita basis causes minimal improvement by going cold turkey on fossil fuels, are we making the right moves by allocating tens of trillions of dollars, that we don’t have, toward the currently in-vogue green energy transition?” Moreover, based on China’s recent no-show at the planet’s main climate change conference (COP 26) in Glasgow in 2021, it seems as though its fondness for fossil fuels isn’t likely to diminish.
Another reason to expect China’s oil and gas needs to rise in the years ahead is its current heavy reliance on coal. In fact, 70% of China’s electricity is coal generated. Since EVs are charged off a grid that is primarily coal powered, carbon emissions actually rise as the number of such vehicles proliferate. As you can see in the following charts from Reuters’ crack energy expert John Kemp, Asia’s coal-fired generation has risen drastically in the last 20 year, even as it has receded in the rest of the world. (The flattening recently is almost certainly due to Covid, with a sharp upward resumption nearly a given.)
The worst part is that burning coal not only releases CO2 — which is not a pollutant and is essential for life — it also releases vast quantities of nitrous oxide (N20), especially on the scale of coal usage seen in Asia today. N20 is unquestionably a pollutant and a greenhouse gas hundreds of times more potent than CO2. (An interesting footnote is that over the last 550 million years, there have been very few times when the CO2 level has been as low, or lower, than it is today.)
Some scientists believe one reason for the shrinkage of Arctic Sea ice in recent decades is the prevailing winds blowing black carbon soot over from Asia. This is a separate issue from N20, which is a colorless gas. As the black soot covers the snow and ice fields in Northern Canada, they become more absorbent of the sun’s radiation thus causing more melting. (Source: Weathering Climate Change by Hugh Ross)
Due to exploding energy needs in China in 2021, coal prices have experienced an unprecedented surge. Despite this stunning rise, Chinese authorities have instructed its power providers to obtain coal and other baseload energy sources, such as liquified natural gas (LNG), regardless of cost. Notwithstanding how pricey coal has become, its usage in China was up 15% in the first half of 2021 versus first half 2019 which was, obviously, pre-Covid. Figure 5
Despite the polluting impact of heavy coal utilization, China is unlikely to turn away from it due to its high energy density (unlike renewables), its low cost and its abundance within its own borders. As we saw in Figure 3 above, it must heavily rely on oil imports to satisfy its 15 million bpd needs (about 15% of total global demand).
In yet another irony, China has a preference for U.S. oil because of its light and easy-to-refine nature, despite the current Cold War between the two superpowers. China’s refineries tend to be low-grade and unable to efficiently process heavier grades of crude, unlike the U.S. refining complex, which is highly sophisticated and prefers heavy oil such as from Canada and Venezuela — back when the latter actually produced oil.
Thus, China likes EVs because they can be de facto coal powered, lessening its dangerous reliance on imported oil. It also has an affinity for them due to the fact it controls 80% of the lithium-ion battery supply and 60% of the planet’s rare earth minerals both of which are essential to EV manufacturing.
However, even for China, mining and processing enough lithium, cobalt, nickel, copper, aluminum, and the other essential minerals/metals to meet the ambitious goals of largely electrifying new vehicle volumes, is going to be extremely daunting. Then there is its goal of mass wind farm construction and enormously expanded solar panel manufacturing
As energy expert par excellence Daniel Yergin writes: “With the move to electric cars, demand for critical minerals will skyrocket (lithium up 4300%, cobalt and nickel up 2500%), with an electric vehicle using 6 times more minerals than a conventional car and a wind turbine using 9 times more minerals than a gas-fueled power plant. The resources needed for the ‘mineral-intensive energy system’ of the future are also highly concentrated in relatively few countries. Whereas the top 3 oil producers in the world are responsible for about 30 percent of total liquids production, the top 3 lithium producers control more than 80% of supply. China controls 60% of rare earths output needed for wind towers; the Democratic Republic of the Congo, 70% of the cobalt required for EV batteries.”
As many have noted, the environmental impact of needing to immensely ramp up the mining of these materials is undoubtedly going to be severe. Michael Shellenberger, a lifelong environmental activist, has been particularly vociferous in his condemnation of the dominant view that only renewables can solve the planet’s energy needs. He’s especially critical of how his fellow environmentalists resorted to repetitive deceptions, in his view, to undercut nuclear power in past decades. By leaving nuclear energy out of the solution set, he foresees a disastrous impact on the planet due to the massive scale (he’d opine, impossibly massive) of resource mining that needs to occur. (His book, Apocalypse Never, is also one I highly recommend; like Dr. Koonin, he hails from the left end of the political spectrum.)
Putting aside the environmental ravages of developing rare earth minerals, when you have such high and rapidly rising demand colliding with limited supply, prices are likely to go vertical. This will be another inflationary “forcing”, a favorite term of climate scientists, caused by the Great Green Energy Transition. Per Pickering Energy Partners: “The capital intensity of the Energy Transition is unlike anything that we have seen. Relative to 2020 investment rates, spending needs to increase about 10x and hold steady for the next three decades.”
Moreover, EVs are very semiconductor intensive. With semis already in serious short supply, as we saw in Chapter 8, this is going to make a gnarly situation even gnarlier. It’s logical to expect there will be recurring shortages of chips over the next decade for this reason alone, not to mention the acute need for semis as the “internet of things” moves into primetime.
In several of the newsletters I’ve written in recent years, I’ve pointed out the present vulnerability of the U.S. electric grid. Yet, it will be essential not just to keep it from breaking down under its current load; it must be drastically enhanced, a herculean task. For one thing, it is excruciatingly hard to install new power lines. As J.P. Morgan’s Michael Cembalest has written: “Grid expansion can be a hornet’s nest of cost, complexity and NIMBYism, particularly in the US.” The grid’s frailty, even under today’s demands (i.e., much less than what lies ahead as tens of millions of new EVs plug into it) is particularly obvious in California. However, severe winter weather in 2021 exposed the grid weakness even in energy-rich Texas, which also has a generally welcoming attitude toward infrastructure upgrading and expansion.
Yet it’s the Golden State, home to 40 million Americans, and the fifth largest economy in the world if it was its own country – which it occasionally acts like it wants to be – that is leading the charge to EVs and seeking to eliminate internal combustion engines (ICEs) as quickly as possible. Even now, blackouts and brownouts are becoming increasingly common. Seemingly convinced it must be a role model for the planet, it’s trying desperately to reduce its emissions, which are less than 1% of the global total, at the expense of rendering its energy system more similar to a developing country. In addition to very high electricity costs per kilowatt hour (its mild climate helps offset those), it also has gasoline prices that are 77% above the national average.
Voters in the reliably blue state of California may become extremely restive, particularly as they look to Asia and see new coal plants being built at a fever pitch. The data will become clear that as America keeps decarbonizing — as it has done for 30 years mostly due to the displacement of coal by gas in the U.S. electrical system — Asia will continue to go the other way. (By the way, electricity represents the largest share of CO2 emission at roughly 25%.)
California has always seemed to lead social trends in this country, as it is doing again with the GGET. The objective is noble, though extremely ambitious, especially the timeline. As it brings its power paradigm to the rest of America, especially its vulnerable grid, it will be interesting to see how voters react in other states as the cost of power leaps higher and its dependability heads lower. It’s reasonable to speculate we may be on the verge of witnessing the Californication of the U.S. energy system.
In case you think I’m being hyperbolic, the IEA has estimated it will cost the planet $5 trillion per year to achieve net zero emissions. This is compared to global GDP of roughly $85 trillion. Frankly, based on the history of gigantic cost overruns on most government-sponsored major infrastructure projects, I’m inclined to take the over — way over — on the $5 trillion estimate.
Moreover, energy consulting firm T2 and Associates, has guesstimated electrifying the U.S. to the extent necessary to eliminate the direct consumption of fuel (i.e., gasoline, natural gas, coal, etc.) would cost between $18 trillion and $29 trillion. Again, taking into account how these ambitious efforts have played out in the past, I suspect $29 trillion is light. Regardless, even $18 trillion is a stunner, despite the reality we have all gotten numb to numbers with trillions attached to them. For perspective, the total towering level of U.S. federal debt is around $30 trillion (unfunded entitlements may sum to as much as $150 trillion, per pundits such as Jeff Gundlach).[ii]
Regardless, as noted at the start of this chapter, the probabilities of the Great Green Energy Transition happening are extremely high. Similarly, I believe the likelihood of the Great Greenflation is right up there with them. While it would be unfair to blame the Fed for this particular inflation forcing, per earlier comments it is now being instructed to become involved in fighting climate change. This includes mounting pressure on it to penalize banks that invest in fossil fuel projects. If anyone at the Fed believes this poses extreme economic risks, their silence is deafening.
As Gavekal’s Didier Darcet wrote in mid-August of 2021: “Nowadays, and this is a great first in history, governments will commit considerable financial resources they do not have in the extraction of very weakly concentrated energy.” (my note: i.e., less efficient) “The bet is very risky, and if it fails, what next? The modern economy would not withstand expensive energy, or worse, lack of energy.”
While I agree this an historical first, it’s definitely not great (with apologies for all the “greats”). This is particularly not great for keeping inflation subdued, as well as for attempting to break out of the growth quagmire the Western World has been in for the last two decades.
In my view, as I’ve written in my newsletters, we are entering the third energy crisis of the last 50 years. If I’m right, it will be characterized by recurring bouts of triple-digit oil prices in the years to come. Along with Richard Nixon taking the U.S. off the gold standard in 1971, as discussed in Chapter 5, the high inflation of the 1970s was caused by the first two energy crises (the 1973 Arab Oil Embargo and the 1979 Iranian Revolution). If I’m correct about this being the third, it’s coming at a most inopportune time with the U.S. in hyper-MMT mode (per Chapter 7).
The sharp and politically uncomfortable rise in U.S. gas pump prices in the summer of 2021 caused the Biden administration to plead with OPEC to lift its volume quotas. The ironic implication of that exhortation was glaringly obvious, as was the inefficiency and pollution consequences of shipping oil thousands of miles across the Atlantic. (Oil tankers are a significant source of emissions.) This was as opposed to utilizing domestic oil output, as well as crude from Canada (which we know is better suited to the U.S. refining complex). Beyond the pollution aspect, imported oil obviously worsens America’s massive trade deficit – which would be far more massive without the 11.5 million barrels per day of domestic oil volumes – and would cost our nation high-paying jobs.
Surely, there are better ways of coping with the harmful aspects of fossil fuel-based energy than the scorched earth policies of some activists. (Literally, in the case of one Swedish professor who has written a book on blowing up oil and gas pipelines; he was inexcusably given a platform by the venerable The New Yorker.) Less violent, but seriously harmful, anti-energy policies include blocking new pipeline builds, shutting existing ones, and efforts to seriously restrict U.S. energy production. In America’s case the result will be forcing us to unnecessarily and increasingly rely on overseas imports. (For example, per The Wall Street Journal, drilling permits on federal land have crashed to 171 in August from 671 in April of 2021 despite rapidly rising oil prices.)
More rational solutions include fast-tracking small, modular nuclear reactors, encouraging the further switch from burning coal to natural gas (a trend that is, unfortunately, going the other way now, as noted above), utilizing and enhancing carbon and methane capture at the point of emission, including improving tailpipe effluent reduction technology; enhancing pipeline integrity to inhibit methane leaks; among many other mitigation techniques. The essential consideration is to recognize the reality that the global economy will be reliant on fossil fuels for many years, if not decades, to come.
If the climate change movement fails to acknowledge the indispensable nature of fossil fuels, it will almost certainly trigger a popular backlash undermining the positive change it is trying to achieve. This is similar to what it did via its relentless assault on nuclear power in the 1970s, which produced a frenzy of coal plant construction in the 1980s and 1990s. On this point, it’s interesting to see how quickly Europe is reembracing coal power to alleviate the energy poverty and rationing occurring over there in late 2021 and early 2022. It has also now categorized natural gas and nuclear power as green energy sources, infuriating the extreme faction of the environmental movement. However, in my view, that was a big step toward political pragmatism. When the choice is between supporting climate change initiatives on the one hand and being able to heat your home and provide for your family on the other, is there really any doubt about which option the majority of voters will select?
Moreover, one of my other big fears is that the West is engaging in unilateral energy disarmament. Russia and China are likely the major beneficiaries of this dangerous scenario. (Please see the Appendix for an elaboration on this point.)
In 2011, the Nord Stream system of pipelines running under the Baltic Sea from northern Russia began delivering gas west to the German coastal city of Greifswald. For years, the Russians sought to build a parallel system with the inventive name of Nord Stream 2. The U.S. government fought its approval on security grounds, but the Biden administration has dropped its opposition. It appears Nord Stream 2 will happen, leaving Europe even more exposed to Russian coercion.
A closing thought for this chapter: Is it possible the Russian government and the Chinese Communist Party have been secretly and aggressively supporting the anti-fossil fuel movements in America? In my mind, it seems not only possible but probable. After all, wouldn’t it be in both of their geopolitical interests to see the U.S. once again caught in a cycle of debilitating inflation, ensnared by the twin traps of MMT and the third energy crisis?
[i] I.E., per the Glossary, supporting Environmental, Societal, Governance acceptable standards.
[ii] Further driving home the probability of a multi-trillion-dollar annual price tag, at the 2021 COP 26 in Glasgow, India demanded $1 trillion from the OECD (i.e., developed countries) to fund its decarbonization efforts. Thus, it may be a situation where greenflation intersects with greenmail.
Chapter 10: The Insanity Bubble
The bubble to end all bubbles
In my admittedly totally biased opinion, I believe this is one of the most important chapters of this book, if not THE most important. That’s because it pulls together an abundance of evidence on the sheer lunacy that commandeered America’s investing mindset in 2020 and 2021. If you were to suggest friends and family read just one chapter in this book, I’d recommend it for that purpose.
Harking back to Chapter 5 on Modern Monetary Theory (MMT), if America was truly practicing that controversial economic system in the early part of the 2020s, one would expect the nearly limitless liquidity MMT provides to show up in wildly speculative investor behavior. Was there any tangible evidence of that as 2021 was winding down? Maybe just a little…
Perhaps a reasonable way to start this chapter is to reflect on words uttered by former Fed chairman Alan Greenspan way back in late summer of 2002, when he was still venerated as “The Maestro” and the erstwhile tech bubble had blown itself to bits. To wit: “Bubbles are often precipitated by perceptions of real improvements in the productivity and underlying profitability of the corporate economy. But as history attests, investors then too often exaggerate the extent of the improvement in economic fundamentals. Human psychology being what it is, bubbles tend to feed on themselves, and booms in their later stages are often supported by implausible projections of potential demand. Stock prices and equity premiums are then driven to unsustainable levels. Certainly, a bubble cannot persist indefinitely.” (Emphasis mine)
Speaking of “certainly”, it certainly would have been more helpful to millions of investors if he had delivered these cautionary words three years earlier when the internet and dotcom mania of that era was still raging. Regardless, the wisdom of his utterances was well worth reflecting upon in the early years of the roaring 2020s because, in my opinion, the degree of speculation since Covid struck has, ironically, exceeded what was seen in the late 1990s. In Chapter 14, I will focus on the overall U.S. stock market, but for now let’s examine what is going on within some of the most casino-like realms of asset markets (using the word “asset” very loosely). These are where the quaint notions that Mr. Greenspan was referring to like “productivity”, “profitability” and “economic fundamentals” are total non-issues.
The below April 2021 cover from New York Magazine succinctly captures the prevailing zeitgeist of this era, the “new world of money”, as it refers to it, that I will chronicle below. It’s definitely a very brave new world... if not an utterly reckless one.
One of the most salient examples of the lack of economic factors is in the chaotic world of crypto currencies. Of course, there are no earnings, dividends, or profits (other than by trading them) that underlie the cryptos. This is not to disparage Bitcoin and Ethereum, which do have unique attributes in terms of growing acceptance by businesses and institutional investors alike. They also offer scarcity due to a limited amount of future supply. Further, there’s little doubt the blockchain technology that authenticates and facilitates transactions in them is here to stay.
However, the scarcity appeal of Bitcoin (which has a hard cap of 21 million units to be “mined” or created) doesn’t extend to the crypto space in general. As of early 2022, there are roughly 6000 different cryptos with more being created on a regular basis. Undoubtedly, there is a plethora of examples of the prevailing insanity in cryptos presently, but there is one in particular that, to me, perfectly captures the mood of the moment.
While there has been a lot of shameless promoting of various cryptos by their creators and paid floggers — often with the express intent of the insiders selling into the buying frenzy they whip up — that accusation cannot be leveled at Billy Markus, the co-founder of Dogecoin. In early 2021, Mr. Markus told The Wall Street Journal that: “The idea of Dogecoin being worth 8 cents is the same as GameStop being worth $325.” (We’ll get to that one later in this chapter.) “It doesn’t make sense. It’s super absurd. The coin design was absurd.” Perhaps what Mr. Markus was missing with his candid observations is that an exhaustive list of markets has become theaters of the absurd. But the theatrics of Dogecoin are definitely hard to top.
Though it was already up from half a penny per coin at the end of 2020 to the aforementioned 8 cents, amounting to a market value of $10 billion when he expressed his incredulity, it was ultimately heading to 64 cents for an $80 billion market cap (capitalization, i.e., the number of coins outstanding times market price) by May of 2021. This for something that, per its creator, was not just absurd, but super-absurd. As the Journal ironically noted, referring to Mr. Markus: “He set out to create a coin so ridiculous it could never be taken seriously.” Incredibly, there were blue chip companies with strong franchises, healthy dividends and growing profits that were trading for less than $80 billion during 2021. This was despite the fact that the U.S. stock market was trading at one of its priciest levels ever by multiple metrics. (Again, more on that topic in Chapter 14.)
One reason why Mr. Markus argued against his own brainchild’s worth was that he intentionally designed it to have unlimited supply, in contrast to Bitcoin, with its 21-million maximum. Why would rational investors pay as much as $80 billion for an alleged asset that could be produced in limitless quantities? (If you’re similarly wondering why people around the world value U.S. dollars so highly when the Fed is fabricating them in seemingly infinite amounts, you won’t get an argument from me.)
Despite its inherent worthlessness, Dogecoin’s extraordinary market success has brought about the sincerest form of flattery. By 2021’s third quarter, there were nearly 100 cryptocurrency tokens that included “doge” in their name.[i]
Beyond dodgy Dogecoin and the thousands of likely value-free cryptos floating around, there is also the issue of the so-called “stable” coins. (In my mind, due to their questionable long-term viability and fiction of stability a better name might be “fable” coins.) Tether is the dominant stable coin and is used for most crypto transactions, including Bitcoin. Thanks to my great friend and fellow newsletter author extraordinaire, Grant Williams, I came to believe in the summer of 2021 that Tether is a fraud. That’s a strong word, and it deserves some serious backing up… which is exactly what I’ll now do.
In case you don’t know, a stable coin is supposed to be backed one-to-one with something like U.S. treasuries or other ultra-safe assets. For years, Tether insisted that was true in its case. Unfortunately for the planet’s leading stable coin, New York State Attorney General, Letitia James, begged to diﬀer.
Moreover, it’s my strong suspicion that either the U.S. Department of Justice, or the SEC (or both) are on the verge of untethering it once and for all. In fact, not long after I ran some of my Tether text in our July 23rd, 2021, EVA, Bloomberg announced that criminal indictments against its senior management were being prepared. (However, as I write these words, no actual indictment has occurred.)
Despite Tether’s protestations of its innocence, the New York Attorney General’s oﬃce secured an $18-million-dollar ﬁne against it as well as its incestuously related ﬁrm, Bitﬁnex. Further, it banned both from conducting business in the state of New York. Sadly, that leaves the other 49 states, and millions of gullible crypto investors in them, at the mercy of this demonic duo, not to mention the rest of the world.
As you can see in the following chart, there was a remarkable correlation between the rise in the number of Tethers outstanding and the 900% moonshot by Bitcoin from the summer of 2020 until the spring of 2021. This pushed the world’s leading crypto to a mind-bending $1 trillion. Further, once the quantity of Tethers flatlined, Bitcoin entered a nasty correction, before another frenzied rally ensued, followed by a 40% faceplant from November 2021 to early January 2022 (as of late January, its decline was approaching 50%).
Even a casual observer might wonder if there wasn’t a causal relationship. In my mind, Tether going from around $12 billion worth of coins outstanding (remember, these are supposed to be backed one-to-one by real assets) to $64 billion is closely linked to Bitcoin ripping by 450% at the same time.
Skeptics about this linkage would point out that even Bitcoin’s starting value last fall of roughly $150 billion would be tough to move — certainly, all the way to $1 trillion — with just $60 billion of Tether (not all of which went into Bitcoin, by the way). However, this ignores two things: ﬁrst, only about 20% of Bitcoin is estimated, on the high side, to actually trade; second, prices are set by the marginal transaction which is, even for U.S. large cap stocks, usually just a tiny fraction of the total market value.
Thus, $60 billion of fresh “capital” coming in can have a huge impact, particularly if there is a lot of leverage involved which, in the case of Tether and Bitcoin, is a given. (For a summary of an eye-opening, jaw-dropping and head-shaking podcast Grant did with two forensic investigators on the Tether situation in the summer of 2021, see the Chapter 10 Appendix)
Many crypto fans concede that Tether smells bad. But their common rationalization is that it really doesn’t matter to Bitcoin and the other digital “currencies”. Some even think Bitcoin would go up as money ﬂows from Tether into Bitcoin directly, should the leading fable-, sorry, stable-coin implode.
They might be right but, again, I don’t think that’s what the odds favor. Because so much funding of cryptos has been via Tether and other “stable coins”, anything causing millions of investors to question their backing would seem to me to be a cataclysmic event in crypto space.
The crypto exchanges like Coinbase also would almost certainly come under intense pressure due to any broad crisis of conﬁdence. Even some ardent crypto fans are advising investors to extract coins from the crypto exchanges to avoid what could essentially be a run on them.
If I’m right about this, there could be an exceptional buying opportunity in Bitcoin and possibly Ethereum as they should ultimately benefit from the collapse of the plethora of shitcoins. (Sorry for the vulgarity but it’s just so appropriate!)
Here’s one fascinating factoid to end this section on: during the Covid crisis, the market value of all cryptos was $154 billion. By March of 2021, it was $1.75 trillion. Astounding, yes, but not the ultimate shocker — four months later that number was $3 trillion. And yet our precious central bank is still afraid to utter the “B” word!
Moving on from cryptos, let’s examine another one of the truly bizarre manifestations of Bubble 3.0 and the tens of trillions of global central bank funny money – NFTs. For my more “mature” (and conservative) readers, this stands for Non-Fungible Tokens. That helps a lot, right?
Maybe a peak into the art world might help convey (sort of) what these things are. To quote Barron’s on those that are art-related: “NFTs are unique digital works encrypted with an artist’s signature that prove authenticity and ownership.” The artist Beeple discovered the joys of NFTs in March 2021 when a digital collage of his creations, “Everydays: The First 5000 Days”, sold for $69 million. It had been minted as a digital token and stored on blockchain (the previously mentioned cyber-ledger widely used for crypto trading).
While Beeple’s NFT was certainly the blockbuster, it wasn’t a fluke. There was subsequently a string of million-dollar-plus NFT transactions. One involved Twitter founder Jack Dorsey’s first tweet, which fetched nearly $3 million in March of 2021. Showing how mainstream NFTs had gone by 2021, Barron’s ran this cover story on them in their Penta special supplement, oriented toward the high-net-worth set.
Consider these illuminating comments by Evan Beard, national art services director at BofA’s Private Bank in Barron’s Penta. First, he noted the advantages, and then just a bit of a problem. “Art gives you utility and NFTs have been lacking in the utility delivered to the client—in the aesthetic value, the pleasure, the status.” Then, the not-so-hot news: “We believe 99.9% of NFTs being minted right now will go to zero.” That seems a bit extreme to me but in the approximate disastrous neighborhood (and reminiscent of what is probably in store for almost all those 6000 or so cryptocurrencies).
On a much more mundane, but quite humorous, level, Charmin, (yes, the maker of the cotton-ball soft TP), auctioned rolls of its signature product accompanied by some artistic designs. It immediately received a bid for $2100. Personally, I’d rather buy mine at Costco and they can keep the art.
In another crypto echo, NFT artists can generate one design and then replicate it 10,000 times. Call me old-fashioned but I don’t think that has the makings of a scarce investment. The venerable bubble-buster Jim Grant cited the example of an NFT series by some outfit called EtherRocks. With eerie resemblance to Dogecoin, one fan referred to its NFT collection accordingly: “It’s so stupid that it’s perfect.” Forrest Gump might have quipped about how: “Stupid is as stupid does.” And someone did something incredibly stupid, at least in my mind, with another NFT called the Bored Ape Yacht Club. Per Mr. Grant, a pair of their tokens, along with a warrant (like an option) to create new ape variants, went for a cool $26.2 million at a Sotheby’s auction in September 2021. The buyer clearly went ape… sorry, I won’t use another four-letter word.
Again, quoting Grant’s Interest Rate Observer (IRO), one of my favorite research reads, “Some vendors offer images to which they have no rightful claim.” That seems like a problem, but maybe I’m being picky.
EtherRocks’ website, once more courtesy of Grant’s IRO, also channels Dogecoin’s Markus by advising that its assets: “…serve NO PURPOSE beyond being able to be brought (sic) and sold.” Maybe it wasn’t a sloppy typo; perhaps it meant bring it and we’ll sell it — no questions asked. Somehow, I strongly suspect EtherRocks takes a cut of the transactions it processes.
EtherRocks also managed to pay homage to its name by cleverly resuscitating the 1970s pet rock rage. Several of these sold for $100,000, or more, in the summer of 2021. The first half of 2021 turned out to be a golden age for NFTs with $2.5 billion in transaction volume (realizing this pales in comparison to cryptos).
But the much bigger NFT money involves CryptoPunks (if you’ve heard of it, I’m impressed; or worried about where you spend your spare time… and investment dollars). According to Wikipedia, each one has been algorithmically produced via computer code. Allegedly, no two images are precisely alike, but some have more unusual characteristics than others. They were originally free and could be acquired by anyone with an Ethereum wallet.
Like Bitcoin, they have a hard issuance cap. In this case, it is far lower at 10,000. 1000 of those existing images are shown below. Apparently, most of these images are of humans but there is also a smattering of Zombies, Apes (it seems as though the NFT world is “Planet of the Apes”) and Aliens. It’s nice to know humanity keeps such good company.
But don’t laugh — a CryptoPunk that was purchased for $443 in 2018 sold for almost $4.4 million, at least in Ethereum (which is theoretically convertible into U.S. dollars). And all of you crypto traders reading this thought you were crushing it with Bitcoin!
The craziness doesn’t end with NFTs, of course. There is another acronym that is in some ways yet more outrageous, if nothing else for the large sums involved. This initialism is SPAC and it stands for Special Purpose Acquisition Company. SPACs are basically so-called “blank check” entities. They are funded by investors who are willing to trust that the SPAC will make wise investments with the capital they raise. Typically, the actual investment is unknown at the time of funding, hence the blank check nomenclature.
SPACs became enormously popular in 2021 despite their opacity. In the first quarter alone, SPACs represented $170 billion in mergers and acquisitions, commonly known as M&A, amounting to roughly 25% of all M&A activity.
SPACs themselves raised nearly $80 billion in fresh capital in 2021’s first three months, slightly more than for all of 2020, almost totally on U.S. exchanges (befitting America’s status as the world’s most overvalued and wildly speculative investment venue). This early year hyper-popularity caused me to warn in my January 1st, 2021 EVA that SPACs were due for a serious spanking. Since that time, the SPAC ETF (of course, there’s an ETF for them!) swooned by 35%, even though the S&P 500 has vaulted roughly 20%.
Trusting in SPAC sponsors to intelligently and carefully deploy capital in an environment where almost everything has been driven up to ridiculous valuations by trillions of central bank liquidity creation is another remarkable leap of faith. The SPAC insiders have a great deal: If they get lucky and their SPAC explodes higher — as many have done, often before imploding — they make a killing; if it flops, they still make good returns due to their rewards for establishing the SPAC. Thus, their incentive is to launch these deals and hope they find a solid investment… or, more likely, a sexy story that they can spin to push up the market price. This allows them to sell at least a portion of their ownership interest that they typically received at no cost.
Starwood CEO Barry Sternlicht had this to say about SPACs during the heady days of their amazing craze: “You can’t compete against stupidity. It’s a little out of control. No, it’s a lot out of control. Don’t expect Wall Street to regulate the launch of SPACs. They’re making too much money. If you can walk, you can do a SPAC.” As the old Wall Street idiom goes: When the ducks are quacking, feed them.
90-year-old Sandy Robertson built his investment career as a stockbroker helping Warren Buffett accumulate a 5% stake in American Express in the early 1960s, when that iconic U.S. company’s stock had been pummeled. (For an interesting nugget of Buffettology, please refer to the Appendix.) Sandy went on to become one of Silicon Valley’s earliest and most renowned dealmakers, helping to co-found two of the Valley’s leading investment firms: the eponymous Robertson Stephens and Montgomery Securities. Thus, he’s seen his share of bubbles and busts.
When SPAC mania was still raging in the first half of 2021, he told The Financial Times: “This SPAC thing is very indicative of the later stages of a cycle.” (He could have also said “bubble” instead of “cycle”.) “There are some that are pretty good, but at the bottom there is a lot of junk.” (He could have also used another four-letter word that would be much stronger than “junk”.)
After noting that there were far too many buyers chasing after a limited amount of worthwhile takeover targets, he went on to say: “The seller has the advantage on the price. They (the SPACs) are going to pay too much. It’s the proliferation of them that I’m worried about.” He was alluding to the fact that SPACs have a limited time to make their play; otherwise, they need to return the uncommitted funds back to investors, a most unlucrative outcome for the sponsors. Thus, they are in a hurry to find targets and rushing is a recipe for making imprudent investments. Based on how hard these have been hit since their early 2021 apex, Mr. Robertson’s warnings were well founded.
Before moving ahead to the next example of 2021’s casino conditions, I’ll end this section with one of the most incredible case studies in SPAC absurdity. A SPAC by the name of Hometown International managed to raise $2.5 million, including from the universities of Duke and Vanderbilt. Perhaps that sounds like a modest amount, but its market value was anything but in May of 2021 when it hit $100 million. What was truly modest was the SPAC’s lone asset (other than its rapidly depleting cash): a delicatessen in Paulsboro, New Jersey. This was not exactly the second coming of Carnegie Deli; its total sales in 2020 were $13,976. That’s right — no zeroes after the number.
Hometown International’s CEO also serves as the wrestling coach at the local high school. He grandly told The Financial Times that: “We will not restrict our potential candidate target companies to any specific business, industry, or geographical location.” Perhaps a wrestling coach’s skills are exactly what’s needed for a tiny deli to do a takedown of a much larger entity… which would be just about any company.
As Columbia law professor and takeover expert John Coffee told the FT, referring to Hometown International, sounding a lot like Sandy Robertson: “(It) is a self-parody of a SPAC. And that’s what I would expect at the end of a bubble.” Hedge fund legend David Einhorn, marveling at this monstrous disconnect between true value and market value — even by 2021’s outrageous standards — quipped: “The pastrami must be amazing.”
This chapter wouldn’t be complete without exploring the memorable meme stock experience seen early in the year. “Meme” refers to those stocks such as AMC Entertainment and GameStop, among others, that appreciated by thousands of percentage points, almost overnight, gravely wounding at least two well-known, and formerly successful, hedge funds.
As most are aware, meme stocks became the playthings of the Robinhood and Reddit investor cohort which numbered in the tens of millions by January 2021. Robinhood, the stock trading platform, not the hero of Sherwood Forest, had 13 million account holders at that point. In the spirit of helping take from the rich to give to the poor, this “Robin Hood” allows free trading to its customers. However, it did receive almost $700 million for selling its “order flow”; i.e., routing its clients’ trades to market-makers such as Citadel Securities, controlled by billionaire Ken Griffin.
In December 2020, Robinhood’s less than altruistic motives were revealed when it was fined $65 million by the SEC for misleading its customers about how much money it made by trafficking in their order flow. This included admitting that it wasn’t diligent about attaining “Best Ex”, or best execution prices. Some experts logically wonder if savvy and opportunistic firms like Citadel are exploiting the knowledge they gain of what amateur investors are buying and selling in order to trade against them and their often irrational moves.
For a time, though, as AMC and GameStop both went vertical — putting to shame even Bitcoin’s 900% rise from its summer of 2020 trough to its spring 2021 high — it looked like the newbies were besting the pros. Actually, it looked more like a beasting than a besting.
Figures 5 - 7
This extraordinary blow off stunned the investing world. Iconoclastic billionaires such as Elon Musk and Mark Cuban egged on the mania, tweeting out such messages: “GameStonk!” (“Stonk” is Robinhood trader slang for stocks, per the earlier New York Magazine cover, particularly the ones its community is embracing.) They were not alone. On January 28th, 2021, The Seattle Times ran the headline “Who’s the ‘dumb money’ now? Day traders lift GameStop to new high.”[ii]
New highs indeed — GameStop (symbol: GME) hit $483 on January 27th, up from $5 in the summer of 2020. The problem was that the role reversal didn’t last long — like 24 hours. On the same day that edition of The Seattle Times landed on the doorstep of the precious few who still receive hard copy papers, GME’s market price was nearly cut in half. By mid-February, it was down to $40. Consequently, all those Robinhooders frantically buying GME as it went postal were nursing horrendous losses. The dumb money once again lived down to its name. (My newsletter did warn about the extreme dangers in meme stocks at the time.)
Speaking of dumb money, passive investing ETFs and index funds, such as those run by BlackRock and Vanguard, were forced to mechanically buy more of these stocks as they went parabolic (or, more accurately, in math jargon, vertically asymptotic — that’s my fancy phrase for this chapter). This is due to the fact that investment vehicles tracking specific indices are required to precisely match something like the Russell 2000 small cap index.
Due to their stunning ascents, GME and AMC became two of the Russell 2000’s largest holdings, regardless of their fundamentally unjustifiable valuations. (When AMC was trading in the 40s in the summer of 2021, the average analyst price target was $5.40, with a high of $16 and a low of $1!) Thus, BlackRock and Vanguard, with their constant inflows of billions upon billions, became two of the largest holders of GME and AMC in 2021. So much for the efficient market theory in action! And perhaps that’s why, by late January 2022, the Russell 2000 Growth Index was approaching a 30% smackdown from its early 2021 peak even as the S&P 500 was still not even in actual correction mode.
Critical to the exponential increases by the meme stocks were “influencers”. Per an August 28, 2021, Wall Street Journal article, the three cardinal rules of influencers were: 1. Be relatable; 2. Sell the dream; 3. All bulls, no bears. Ah, there you have it. As the article’s sub-headline read: “Always be bullish.”
It was an internet influencer by the name of Keith Gill who was the primary instigator behind the GameStop moonshot, and he totally got the always-be-bullish part. In the summer of 2019, a young and obscure Mr. Gill began buying GameStop stock and options. He also started touting his bull case in cyberspace.
Because most millennials were aware that GameStop’s business model was dated and eroding, with online gaming and downloads being where the action was, his bullishness initially drew skepticism from his handful of online followers.
By late 2020, though, GameStop’s price was moving higher, and Mr. Gill began to establish a reputation as a stock market “influencer” on Reddit’s WallStreetBets social media forum. (One of the more popular posts on that is “Buy High, Sell Never”, a meme that is certain to be eventually thoroughly discredited, if it hasn’t been already.)
Outside of this forum, Mr. Gill was largely unknown, until January 2021. From early August 2020 through year-end, GameStop (ticker: GME) rose 500%. But that was just the warm-up act. After rising another 75% in the first two weeks of 2021, to $35, GME began one of the most breathtaking ascents in the history of the financial markets, as shown in Figure 6 above.
By Thursday, January 28th, 2021, when it nearly hit $500, it represented a market capitalization of roughly $32 billion. All for a company that has been profit-free on a cumulative GAAP basis since 2015. (Of course, it never did get as nuts as Dogecoin did; like I said, that one was epic.)
As the first month of 2021 came to a close, GME became the financial market sensation of the young year. It attracted scrutiny from key members of Congress, along with causing tremendous stress for Robinhood’s trading platform upon which much of the GME buying frenzy occurred. To cope with the regulatory capital requirements of the spectacular volume explosion, it was forced to raise $3 billion almost overnight. Briefly, Robinhood, TD Ameritrade, and Charles Schwab suspended transactions of GME, attracting considerable criticism, with Robinhood taking the brunt of the blowback.
Supposedly, there were more GME shares sold short than were outstanding, a remarkable development that begs the question of how regulators allowed that to happen. Curiously, the SEC was largely missing in action as the GME phenomenon unfolded (other than a terse message in late January 2021 that markets should be allowed to function). Similarly, the Fed did nothing to intervene, such as to raise margin requirements. Years back, when the Fed sought to interdict bubbles — rather than enable them — it frequently increased the amount of capital investors needed to put up to buy stocks when conditions became highly speculative and/or volatile.
In case you’re bemused as to how a rag-tag informal army of online traders like Mr. Gill — whose rallying cry is YOLO (You Only Live Once) — can overwhelm multi-billion-dollar hedge funds, it is due to a confluence of factors. First, many, if not most, of these players (and for many of them it truly is a game) use margin debt, often combined with options. Thus, they can control far more market value than they actually put up in cash.
To maximize their option leverage, they often purchase far-out-of-the-money calls (meaning, the right-to-buy, or exercise, price is way above the current stock price; thus, they can be bought for chump change with lottery-like payoffs in the case of a GME-type move). As the swarm of call options (bullish bets on the underlying stock) swells, option market-makers are forced to buy the underlying shares to hedge their de facto short option positions.
This buying naturally further reinforces the shares’ upward trajectory which, in turn, creates even more of a feeding frenzy among buyers — particularly when they smell short sellers’ blood in the water. One pundit appropriately referred to this as the “weaponization” of call options.
Second, the “Reddit Rebels” often move in concert, egging each other on with frequently obscene and boastful verbiage. Screenshots of their brokerage accounts show multi-million-dollar gains, inciting intense greed and FOMO (Fear Of Missing Out.) Influencers like Mr. Gill are shrewd enough to target stocks such as GME with high short positions. As the shorts take huge hits, often triggering margin calls, the share price typically goes straight up. Any connection to true intrinsic value is severed and, for a time anyway, becomes totally meaningless.
Third, social media platforms like Facebook, Twitter and YouTube use algorithms and, as we should all know, these select the most compelling content based on past user activity. These “algos” then push fresh material along similar lines to countless other interested parties. As a result, a powerful digital amplification process occurs, accentuating the hysteria in the case of short squeezes. The Wall Street Journal’s Christopher Mims wrote about this phenomenon during the height of meme madness: “Ample research has described the addictive potential of social media and apps like Robinhood, which make trading stocks feel like gambling… drop them into a stew of sensation-seeking young people with limited entertainment options during a pandemic, and it’s hardly surprising that all of this has come to pass.”
In such situations, short sellers, like the unfortunate hedge funds I mentioned earlier, become trapped by wave upon wave of leveraged, self-reinforcing buying. They learn the hard way about the old market adage that: “He who sells what isn’t hissen’, buys it back or goes to prison.” These days, it’s either put up (as in cash to meet the margin calls) or get sold out.
As I was writing these words in the fall of 2021, GME and AMC, the signature meme stocks, have gone through multiple cycles of breathtaking run-ups and nauseating bungee dives. However, the Himalayan heights they hit in January and June 2021, respectively, have not been retaken. At this point, they appear to be in a long, jagged return to terra firma and their legions of FOMO/YOLO traders seem to have increasingly lost interest in them. As numerous media reports indicated, many (most?) of them have lost considerable sums of money, too.
Of course, the influencers, like Mr. Gill, likely made a killing. When he reportedly liquidated his position in GME, he was alleged to have accrued $20 million in gains on it. Who said “pump and dump” was illegal? (For a compilation of other absurdities, please see the Appendix.)
Because cryptos, SPACs, NFTs, and meme stocks were extreme, and ironic, beneficiaries of the pandemic investing environment, they have been the ultimate examples of what I believe is the greatest wealth destroyer known to woman or man: the moonshot move, i.e., an asset or asset class, like cryptos, that goes parabolic. As I discuss in other parts of this book — but this chapter is most relevant to the topic — a major contributor to the problem is the intense media attention these straight-up spikes receive.
The media frenzy stokes a nearly irresistible allure of seemingly instant and easy money. Essentially, these lottery-like payoffs, that seemed to be happening continually in 2021, aroused one of our worst human emotions: unadulterated greed. (Please see the end of the Appendix for this chapter to read a short recap of one of the highest profile examples of this phenomenon.)
These manias are in a way metaphors for the new American meme, to borrow that term, which has, in many ways, replaced the old American Dream: The idea that money, success, prosperity, fame, early retirement, to be another Kevin Gill and have all of the above, whatever is your ultimate dream scenario, can be attained nearly overnight and without the typical extreme effort, like Gladwell’s oft-cited 10,000-Hour Rule.
Maybe today it’s the Fed’s ten-trillion (almost) rule. If it can magically whip up trillions of fake money, why try to succeed the old-fashioned way? We’ve moved to the polar opposite direction of those ancient John Houseman Smith Barney ads: “They earn it!” Rather these days, it seems as though with outfits such as Robinhood it's more like “We churn it!” It wins — and Citadel wins even more — but the millions of social media market warriors who trade through them and fell for the get-rich-quick siren song, end up wiped out and even angrier than they were before they were infected with meme madness.
It’s the “something for nothing” mindset and I believe the Fed has enabled that attitude. The eight trillion it has generated literally just from its computer banks has reverberated and been amplified not only through financial markets but through much of American society. We’ve been led to believe, particularly through MMT — which, in my mind, unquestionably produced the insanity bubble — that fake money can produce real and lasting prosperity. Again, to me, nothing could be further from the truth. This has been a massive fake-out and millions have fallen for it.
To end this chapter on the modern-day madness of crowds, I thought this anecdote was an ideal capstone: Someone very lucky, or very smart, bought $8000 of a Dogecoin knockoff known as Shiba Inu (SHIB) in August of 2020. It was worth $5.7 billion 13 months later! Somehow, being a billionaire just isn’t quite as exclusive as it used to be. In my mind, the eventual post-mortem of this biggest bubble ever is almost certain to conclude along the lines of: “How could so many have been so stupid?” Except, of course, for those rare individuals savvy enough to sell into the insanity.
[i] Dogecoin was originally intended to be a satire of the cryptocurrency world. Apparently, it was designed in mere hours and its name is a play on a 2013 “meme” that went viral about a mythical spelling-challenged Shiba Inu — hence the “Doge” instead of “Dog”. Obviously, that pedigree makes it worth the $30 billion it was still valued at in late 2021. Obviously!
[ii] Around this time, one of the highest profile influencers, Dave (Davey Day Trader) Portnoy tweeted: “I’m sure Warren Buffett is a great guy but when it comes to stocks he’s washed up. I’m the captain now.” Increasingly, it’s looking like Captain Davey is going down with his ship and his crew of similarly hubristic day traders. Meanwhile, Mr. Buffett’s Berkshire Hathaway stock recently hit an all-time high.
Chapter 11: The Biggest Bubble Inside The Biggest Bubble Ever
Picking the low-hanging fruit
Are U.S. stocks more overvalued than at any time other than 1929 or 1999? Or are they even more expensive? Or are they reasonably priced, as so many media commentators and Wall Street strategists contend? (Please see the Appendix for a listing of some of the more popular valuation techniques.)
The answer somewhat reminds me of the old story of various people applying to be hired as an accountant at a certain firm. The owner asks each applicant what two plus two equals. The first dozen or so give the obvious reply and the boss politely but quickly dismisses them. Finally, one cagey interviewee (who clearly shows the mindset to be the CFO of a publicly traded corporation) answers: “Whatever you want it to be.” Of course, this person was hired.
Depending on which methodology you use, you can come up with whatever answer you want. Debating this with true believers, using whatever is their preferred metric, is nearly akin to arguing the articles of faith with an ardent Jew, Christian, Muslim or Buddhist. (Wait a second, do Buddhists argue?)
In this chapter, I’m going to tread on much safer ground. Instead of tackling the great stock-valuation debate, my focus is on a market that, frankly, most investors ignore – the one that is made up of those sleepy instruments known as bonds. (In Chapter 14, I will wade into those hazardous stock valuation waters.)
However, bonds being off the radar of the majority of market participants doesn’t mean they aren’t important. The fact alone that central banks have pumped nearly all of the $11 trillion they’ve digitally fabricated, since Covid struck, into fixed-income securities is proof-positive of their importance. Or, looking at it a bit differently, while not many people care about bonds per se, almost everyone cares a lot about interest rates, especially when they are paying or receiving them, as nearly all of us do at some point.
Fixed Income 101 tells us bond prices and interest rates move inversely, as discussed in Chapter 5. As a refresher, when a bond’s market value increases, its yield decreases. When yields fall in a big way, the returns can be surprisingly equity-like.
For example, the bond shown below issued by mid-stream-energy titan Enterprise Products produced a 20% per year return if purchased close to its early 2016 trough and held for the next 30 months. It happened again during the Covid-induced panic in the spring of 2020, as you can also see.
Source: Bloomberg Finance
After crashing 37.5% almost overnight, this thrashing raised its current yield to 6.2% (roughly four full percentage points, or 400 basis points, over long-term treasuries). It then screamed back up 55% by the summer of 2021, providing those who summoned the courage to buy it during the worst of the virus crisis with a total return (i.e., including the aforementioned 6.2% yield) of nearly 65%! Rather punchy, don’t you think, for a low-risk security?
Similarly, I doubt most gung-ho stock investors (isn’t that almost everyone these days?) are aware of the below total return comparison between the 30-year zero-coupon treasury bond and the S&P since the dawn of this century/millennium.
Let the protests begin!
The sound of all the equity cultists vociferously objecting is already ringing in my ears. Of course, they say, what do you expect? Central banks have ridiculously and massively distorted almost all major bond markets. And you know what? They’re absolutely right – $11 trillion of binge printing by the planet’s monetary mandarins couldn’t help but have an impact.
In fact, even though interest rates have been rising around the world as 2021 faded into the history books, there were still nearly $14 trillion of bonds that “produced” negative yields (production like that is reminiscent of the old Soviet Union). This is despite the fact that rates had been erratically rising during the year. Incredibly, more than a dozen years past the Global Financial Crisis (GFC), the world remains heavily populated with bonds in which investors pay the borrower for the “privilege” of investing.[i] There are even banks in Portugal and Denmark that pay homeowners interest on their mortgages. Almost certainly, future generations will look back in bewilderment about this strange and nonsensical phenomenon, not to mention countless others that are equally bizarre.
Even in the U.S., which has among the highest yields of any developed (G7) country, interest rates were at levels that in pre-crisis days would have been considered deep recession, almost depression, level. In fact, long-term treasury bond yields are lower in early 2022 than they were in the 1930s. Moreover, this is despite the current roughly 6% inflation rate. As a result, it’s hard to argue that bonds haven’t been, and basically still are, caught up in the biggest bubble in recorded human history. The only time they’ve been lower was briefly in the months following Covid going viral (literally). (Please see the Appendix for an eye-opening meeting Charles Gave had with a client of GaveKal’s on this topic back in 2019.)
The extraordinary power of interest rates
Unquestionably, Covid played a big part in forcing interest rates down somewhat further, but the reality is bond yields were extraordinarily depressed even before the pandemic. In most developed countries, near-zero and negative interest rates have been as persistent as sluggish growth and enormous government deficits. Could there be a connection?
It’s simply a fact, not an opinion, that the recovery by the U.S. economy from the Great Recession of 2009 was the weakest of the post-WWII era. You can go all the way back to the early 1920s and observe that reality.
Source: Gavekal, EHA
Most overseas advanced economies fared even worse from 2009 through 2019, despite the fact that deep recessions, which the financial crisis unquestionably produced, typically lead to powerful recoveries. You can observe that in the chart above looking at the Great Depression-racked 1930s. Pre-pandemic there was only one G7 country that did not resort to the quantitative easing (QE) “remedy” (post-pandemic, it did). That would be our good neighbor to the north.
Despite remaining QE-free during the post-Great Recession years, Canada’s economy grew at essentially the same rate as did the U.S. Accordingly, it’s not unreasonable to wonder if the Fed’s many trillions of bogus bucks were worth putting itself in the quandary it is in today. It’s a lot easier to fabricate and inject money on a massive scale than it is to withdraw once the economy and market participants have become addicted to the monetary amphetamines. Perhaps that’s why Canada was able to immediately halt its brief dalliance with QE while the Fed continued to whip up another $500 billion or so of pseudo-money despite raging inflation.
A prime factor in why zero and, especially, negative interest rate policies have failed to bring home the economic bacon was their effect on the banking system. As the top-notch bond guru Jim Bianco has cogently noted: “…the fractional reserve banking system is leveraged to interest rates. This works when rates are positive. Loans are made and securities bought because they will generate income for the bank. In a negative rate environment, the bank must pay to hold loans and securities. In other words, banks would be punished for providing credit, which is the lifeblood of an economy.” His take seems pretty rational about fractional, as in banking, don’t you think? Of course, that assumes stoking healthy economic growth was the main objective.
Or was this extraordinary, unprecedented, monetary manipulation intended to raise inflation to the 2% level with which central bankers today are so obsessed? Putting aside the question as to why it is desirable to erode a currency’s purchasing power by 45% over 30 years — which is what 2% inflation produces in that length of time — is it worth expending trillions to move the CPI up by, say, ½%?
Alternatively, was it the goal of central banks to drive asset prices to extreme (some would say insane) levels in order to create a wealth effect, thereby turbocharging economic growth? If so – and former Fed head Ben Bernanke plainly stated years ago that was the goal – have they succeeded? Per the above image about the reality of how deficient this expansion has been, it’s hard to argue that the Fed succeeded on economic grounds.
But when it comes to asset prices, the tsunami of trillions, and the related collapse in interest rates, has swamped all those, like me, who dared to question the wisdom of incessant QEs which have now morphed into MMT, particularly in the U.S. When the original version of this chapter ran in our September 2018 EVA, we published an article by Reuters columnist Edward Chancellor titled The Mother of All Speculative Bubbles, obviously, a most relevant piece for the main thesis of this book.
In the opening section, he gets right to the heart of the matter — or mania – by quoting the father of economics, Adam Smith, on the impact of interest rates on property prices a few years ago — like back in the 1700s! In 1776, English man of letters Horace Walpole observed a “rage of building everywhere”. At the time, the yield on English government bonds, known as “Consols”, had fallen sharply and mortgages could be had at 3.5 percent. These days, mortgage rates at that level would be considered usurious in Europe!
In The Wealth of Nations, published the yearAmerica’s War of Independence from England began, Adam Smith observed that the recent decline in interest rates had pushed up land prices: “When interest was at ten percent, land was commonly sold for ten or twelve years’ purchase. As the interest rate sunk to six, five and four percent, the purchase of land rose to twenty, five-and-twenty, and thirty years’ purchase.” [I.E., the yield on land ownership fell from 10 percent to 3.3 percent; he’s essentially describing a falling “cap rate” to use current real estate vernacular]. Smith explains why: “the ordinary price of land ... depends everywhere upon the ordinary market rate of interest.” That’s because the interest rate discounts, and places a capital value, on future income. Undoubtedly, were Mr. Smith still on this side of the grass, he would be dumbfounded and horrified by the specter of negative interest rates. Equally surely, he would assert they lead to myriad distortions and excesses.[ii]
Among the latter, of course, would be real estate valuations soaring to outrageous heights, which is exactly what has happened. This creates assorted societal ills including, as mentioned in earlier chapters, unaffordable housing and exaggerated wealth disparities between those who own and those who rent.
All the great past speculative bubbles – from the tulip mania of the 1630s up to the global credit bonanza of the first decade of this millennium – have occurred at times when interest rates were abnormally low. The basic point is that as interest rates plunge to ultra-depressed levels, buyers are willing to pay higher and higher prices for income-producing real estate. (When Adam Smith used the term “purchase” he was referring to annual cash flow.) Admittedly, that’s not a brilliant insight for real estate-savvy individuals, but I suspect most of them have been amazed by how long de minimis interest rates have persisted during this cycle.
Consequently, this has led to the longest bull market in property prices on record, one that has become a bona fide super-cycle, notwithstanding a brief hiccup during the worst of the Covid lockdowns. Stories of astounding transaction prices in late 2021 are as common as bad policy decisions in Washington, D.C.
If one accepts the reality (and not to is denying same) that recent years have seen the lowest interest rates in 5000 years, as we saw in Chapter 5, then how could we not be at least going through a massive bubble, if not, as I’ve contended, the Biggest Bubble In Recorded Human History or BBIRHH.
Source: Source: BofA
Will they EVER learn?
While acknowledging Sweden isn’t the most systemically critical country on the planet, it is nonetheless an interesting (sorry) case study in what insanely low interest rates can cause. First, for those of you who don’t waste your life studying these things like I do, Sweden had a monstrous housing bubble in the early 1990s. And like ALL bubbles ultimately do, it popped — big time. The implosion was so cataclysmic that it wiped out the staid nation’s banking system. Additionally, as is nearly always the case, it triggered a severe recession. (For more on this crisis and its parallels with our own housing bubble of 15 years ago, please see the Appendix.)
One might think that such an experience would cause Swedish policymakers to do everything in their power to prevent a repeat performance. But, then again, one would also think the brainiacs at America’s Federal Reserve would be extremely bubble-averse after what happened from 2000 to 2002 and then again in 2008. In both cases, one would have been wrong — like dead wrong.[iii]
In Sweden’s case, it was the world’s fastest growing developed country in 2015, with real growth cresting at 5%. Yet, in its central bank’s infinite wisdom, its official interest rate was MINUS 0.5%. And, as predictably as the Fed continuing to make erroneous economic forecasts, including totally missing 2021’s inflation spike, Swedish home prices did a moonshot.
As you can see below, Sweden made the top ten of riskiest housing markets with an estimated 165% overvaluation. This list also gives you the sense of the global nature of the latest housing bubble. The U.S. didn’t even make the top ten despite the outrageous pricing in cities like Seattle, San Francisco, LA, New York and Washington, D.C. As we know, since this table was published in 2017 prices have levitated higher yet. Figure 6
As with the stock market, Covid has had a perverse impact on home valuations, sending them much higher despite all of the economic distress the pandemic produced. There’s scant question that central banks drenching the planet with trillions of their quasi-counterfeit money was behind this odd development.
Pre-pandemic, housing prices were beginning to crack in many global markets. But, as noted, Covid changed the calculus, demonstrating that even a worldwide pandemic is no match for the power of the collective central banks’ Magical Money Machines. Even in cities like Seattle, where thousands of residents were, and still are, decamping in droves, prices moved higher. But home inflation was far more pronounced in the outlying areas where residents have been fleeing to safer venues. In West Bellevue, just across the lake from Seattle, it’s not uncommon for lots to sell for $4 million, or even more, (yes, just the dirt and non-waterfront, by the way) in late 2021.
As a result, what was an immense bubble in asset prices prior to the pandemic became even more so. Housing prices in most major cities around the world far exceeded the levels of 2007, considered at the time the greatest real estate bubble ever.
The bond market, severely distorted by central bank interventions, kept interest rates suppressed even as inflation soared throughout 2021. This produced deeply negative real yields, shunting even more money into stocks and real estate. Accordingly, the bond market was unquestionably a huge factor in the exceedingly hazardous asset overvaluation shown below.
One of the many harmful aspects of negative yields, including positive nominal yields that are in the red after taking inflation into account, is what they do to productivity. With virtually the entire developed world facing the reality of deeply negative real rates, this is an extraordinarily important point to ponder. Per the below chart, you can see the impact on productivity, going back nearly 70 years, of these episodes when inflation exceeds the return on savings vehicles like T-bills.
The following chart from bond behemoth Double Line — where the Bond King, Jeffrey Gundlach, is the undisputed ruler — illustrates just how exceptional the last decade has been in that regard. Even the inflation-plagued 1970s weren’t as extreme in this regard.
And while excessively low rates are great for real estate, there is a dark side to that with regards to productivity. As increasing amounts of capital flows into existing homes, apartments and commercial buildings, there is less money invested in assets that actually enhance productivity. As The Wall Street Journal wrote on this topic in a November 28, 2020, article: “For every 10% increase in real estate prices, an industry would record a 0.6% decline in total-factor-productivity due to the effect of skewed capital allocation.”
Moreover, once the property bubble pops, there is enormous wealth destruction such as we saw from 2007 to 2010 when the housing market crashed. This creates a massive drag on a nation’s productive capabilities. In America’s case, it has led to multiple rounds of the Fed’s binge printing technique we have come to know as QEs 1, 2 and 3 (plus a fourth unofficial version). To say this entire approach has failed to deliver rewards commensurate with its immense costs is being exceedingly charitable to our grand and glorious central bank.
The corporate bond market: A case of Icarus syndrome?
An essential part of the bond market, and one that has played key roles in numerous financial crises and recoveries, is corporate debt. My hope that among the most lasting concepts readers glean from this book is the extreme criticality of credit spreads. Once again, these reflect the difference between what corporate borrowers pay in terms of interest on their debt and what the government pays on treasuries. When that gap, or spread, widens significantly, it almost always means corporate bond prices are under downward pressure.
Often during these episodes, the price declines can be severe, as seen with the debt shown above involving Enterprise Products (arguably, but not much, the strongest of the independent energy infrastructure operators). When conditions improve, the rallies can be extraordinary, as the Enterprise bond chart above clearly shows. Rapidly declining (aka, narrowing) credit spreads are like mixing Red Bull with a double espresso when it comes to hyper-stimulating a bull market in both stocks and bonds.
The ultimate proof of the vital nature of credit spreads occurred, as described in Chapter 2, when the Fed announced it was buying corporate bonds during the worst of the virus crisis. As also noted earlier, it was this disclosure that ended the shortest bear market and recession of all time. While it wasn’t the only catalyst, in my view it was the most powerful one… by far.
During the pandemic’s sheer panic phase, in the first few weeks of March of 2020, credit spreads blew out, as they nearly always do during high-stress times. But, unlike 2008-2009, the Fed prevented it from being a drawn out, death-by-a-thousand cuts affair (which is what the Global Financial Crisis experience felt like — take it from someone who bled plenty back then!). As with stocks and the economy, the corporate bond market rally and the tightly linked spread contraction were breathtaking.
As a result of this screaming rally in corporate bonds, spreads are now extremely tight. Thus, not only are rates at historic lows relative to inflation, credit spreads are, as well. (In early 2022, spreads were on the rise but remain at non-threatening levels.) On the former, never has the yield on the 10-year T-note been 4.5% below the CPI increase on Social Security.
Similarly, 2021 saw the economy’s nominal growth rate (again, real growth plus inflation, as explained in the Glossary) exceed the yield on the 10-year treasury by the widest margin on record.[iv] Most significantly, this had the effect of reducing the U.S. government’s debt-to-GDP by 13 full percentage points in a year, from 135% to 122%. In my view, this is precisely what the powers-that-be wanted to bring about — and still do. It’s basically a stealth form of default with bondholders taking a severe hit in terms of lost purchasing power. (This punitive action toward U.S. government debt owners is likely in its early stages.)
Related to how compressed both rates and spreads were in 2021’s fourth quarter, this is the first time less-than-investment-grade corporate bonds (junk), the ultimate spread vehicles, traded with negative real yields. In other words, it’s another example of a bond market that increasingly offers copious amounts of risk and precious little in the way of reward.
Accordingly, in the next crisis — one that could be precipitated, say, by millions of investors having an epiphany that rising inflation is becoming a persistent problem — corporate bond investors could lose twice: First, due to a big jump in rates and, second, as a function of materially widening credit spreads.
While not all stock market convulsions have been caused by spiking credit spreads, I’ve never seen a serious spread-widening episode that hasn’t triggered an equity downdraft. Typically, the more severe the spread widening, the more painful the correction in stocks. Consequently, even if you don’t give two hoots about bonds, because you’re an equity gal or guy, you should be aware of this aspect.
Besides unusually tight spreads and the putting-green level of interest rates, there were also unmistakable signs of complacency and frothiness in the more esoteric realms of the non-government bond market in the fourth quarter of 2021. The currently highly popular Collateralized Loan Obligation (CLO) market is almost a carbon copy (yes, I know I’m dating myself, perhaps carbon-dating myself) of the Collateralized Debt Obligation (CDO) space. It was these not-so-secure securities that nearly destroyed the planet’s financial system a dozen years ago.
Regardless, the ducks were loudly quacking again in late 2021 to be fed more yield products, with CLOs being hoovered up like spilled popcorn in a theater after a Spider-Man: No Way Home showing. This is notwithstanding that CLO yields were pathetically low and their credit risks disturbingly high.
Moreover, bond covenants meant to protect fixed-income investors had once again become exceedingly lax (favoring the borrower over the lender), as was the case leading up to the Global Financial Crisis. The term “bond” is supposed to mean exactly that: an explicit and enforceable contract between the issuer and the investor. Yet, as happens regularly when there is yield starvation — and, as I write these words, there is a mass yield famine afflicting fixed-income land — borrowers are in the driver’s seat. And, when that happens, they never fail to drive some brutally hard bargains, such as being allowed to skip interest payments without having to declare bankruptcy.
Returning to junk bonds, Michael Lewitt, the bubble-busting author of the Credit Strategist, wrote in his October 1st, 2021, issue: “Even though these instruments are called ‘bonds’, they offer few if any of the traditional protections traditionally associated with bonds. So in addition to offering negative real yields, they offer no covenants and limited liquidity.”
His last point is an important one, particularly with the wild popularity in recent years of junk bond ETFs. These allow investors to instantly buy and sell these securities which own around 1000 different underlying “high yield” bonds. The problem is that many of these trade by, as they say, appointment only.
In bull markets, that’s a no-worries situation, particularly when there are trillions in excess liquidity sloshing through the financial system. But when the inevitable ebb tide sets in, this creates the potential for severe price hits should investors decide to exit en masse, and in a hurry, as they so often do during turbulent periods. Because many of the underlying bonds are extremely illiquid, prices need to be deeply discounted in order to clear markets during a panic. You can see what it looked like for HYG and JNK, the two-leading junk bond ETFs, during March 2020.
Yet, despite negative after-inflation yields, junk bond buyers were ravenous as they absorbed record amounts of issuance, as 2021 drew to a close. Clearly, the prospects of losing money to inflation, the always substantial risk of default with most junk bonds, the liquidity problems, and the paucity of covenant protections, fazed investors not in the least.
It would be remiss on my part if I failed to point out that the unparalleled bond bubble played a starring role in the government debt saga. Pre-Covid, a decade of negligible, cum negative, interest rates enabled developed nations to pile up sovereign IOUs to levels not seen since WWII. Post-Covid, of course, the amount of governmental indebtedness reached almost incomprehensible proportions. With throw-away interest rates, though, what’s the big deal? As you can see, interest costs as a percentage of the size of the Big Seven (G7) economies is a yawner.
It’s the same in the corporate world, as well, with accumulated debt amounting to $11 trillion or 49% of GDP, an all-time high. Yet, as you can see below, debt service for U.S. corporations is a breeze.
As extensively covered in Chapter 6 on MMT, this logic-defying controversial economic thesis has taken the enabling to an entirely new, and totally shocking, level. Politicians have discovered their dream machine and they are dreaming in fantastical ways that put Hollywood to shame. The multi-trillion-dollar question is if this will eventually turn into a nightmare, as have all prior full-blown MMTs (Japan is the lone exception and it did MMT-lite).
With an increasingly stubborn inflation trend dominating 2021 — and into 2022, as well — thereby undercutting the Fed’s transitory assertions, senior officials such as Jay Powell must have been sleeping very fitfully. As noted in the MMT chapter, inflation has consistently flipped the free-money fueled booms into busts. A central element of this denouement is a cost of capital, or interest rate, that is far too low (per the foregoing 250-year-old comments by Adam Smith). When this happens, asset bubbles are inevitable. Based on rates being the lowest ever and becoming rapidly more negative in real terms as inflation predictably took off in 2021, it’s no surprise we are witnessing the type of orgiastic speculation documented in Chapter 10.
Ludicrously low interest rates also lead to obscene misallocations of capital, like the stripper in The Big Short who was able to buy seven overpriced homes due to reckless lending practices. Capital misallocation is just a fancier name for a bubble. As we’ve seen in overwhelming detail, in late 2021 bubbles were as pervasive as liars in Washington, D.C. When future generations seek to do a forensic analysis of this evolving (devolving?) disaster, they will need to look no further than the Biggest Bubble Inside The Biggest Bubble In Recorded History. As you know by now, that would be the bond market.
[i] In the first six weeks of 2022, the biggest bond bubble in history has quickly become considerably less bubbly. Yields are rocketing around the world albeit from very low, often negative, levels. The stock of bonds with minus signs in front of their yields has fallen from $14 trillion to around $4 trillion in roughly two months. If nothing else, this validates the basic contention of this chapter about the exceptional vulnerability of global bond markets as I was initially writing it in the fourth quarter of 2021.
[ii] In 17th century England, manias were looked at just a bit askance. Per American author Chris Hedges, “Speculation in the 17th century was a crime. Speculators were hanged.” It’s a bit terrifying to think that if this was the law of the land in 21st century America, how many necks would be getting stretched.
[iii] Low rates, along with ultra-aggressive mortgage lending practices, were the two main contributing factors to the 2002 to 2007 housing bubble, which nearly obliterated the global financial system.
[iv] There may have been one other very brief episode in the early 1950s.
Chapter 12: Bye-Bye Buyback Bubble?
Ironically, I originally wrote this chapter of Bubble 3.0 just as Covid was becoming a global threat. I’d started it in late January 2020, and it was published on Valentine’s Day of that year. Amazingly, despite the growing fears that a worldwide pandemic was a distinct possibility, the S&P 500 was merrily bouncing along near its highs.
The question I asked in that issue was: What could possibly bring about the end of the longest running bull market ever seen? As we learned in a matter of weeks, “all” it took was a global pandemic. By March 22nd, a mere month after the S&P had made a new high and looked impervious to almost any threat, it had tanked by nearly 40%.
Despite that we now know what it took to stop the long-rampaging bull in its tracks, it’s probably worth pondering what has been the main driver of the extraordinary, and extraordinarily singular, run by the S&P 500 since 2009, particularly, because it’s back in full swing once again. (Or at least it was until 2022 came on the scene.) By “singular”, I’m referring to the fact that during the decade leading up to the Covid crash, U.S. stocks have crushed those from almost any other country. Right before the pandemic struck, the main international benchmark excluding the U.S. (the MSCI, ex-U.S.) had essentially flatlined for nearly 14 years.
As I have conveyed many times in my newsletter series, this is despite, or perhaps because of, the extreme popularity of international stocks, especially emerging market shares, in the early part of the last decade. Note, however, per Figure 2 below, how much better those had done from the bear market low in 2009 up until 2012, and then the immense lag they’ve seen after that. (The rallying cry for emerging markets 10 years ago was that they offered a “structurally higher growth rate” versus the heavily indebted and increasingly sclerotic developed countries. This included the best of this ossified bunch, the U.S.)
Perhaps it is mere coincidence that over this timeframe U.S. buybacks were running much higher than in the rest of the world… perhaps. Shown below is the U.S. versus Europe, for the period just prior to the Global Financial Crisis and leading up to the pandemic, but the same is true compared to almost every other country. Moreover, buybacks were the only source of money flowing into U.S stocks for the decade from 2009 to 2019.[i]
The most important developing country for the last 30 years has been, of course, China. And, sure enough, throughout the twenty-teens – i.e., 2010 through 2019 – its economy grew at an 8% annual rate (with some legitimate questions about the accuracy of this number). This was compared to just 2% for America, the unquestionable stock market superstar of the last ten years.
Yet, despite China’s much faster growth — even assuming the real rate was 6% not 8% — its stock market has been a nothing-burger compared to the U.S. For emerging markets overall, it was largely the same story: superior economic growth and much lower stock market returns.
This is consistent with a study of 43 countries from 1997 to 2017 conducted by the Abu Dhabi Investment Authority. Its research found, counterintuitively, that countries with slower economic growth experienced higher stock market returns.
It also discovered that this phenomenon couldn’t be explained by other market-influencing factors such as inflation, currency fluctuations, and/or profit margins. The study conceded these less-material drivers could influence short-term lags or leads but they tended to cancel out over time. Now here’s the kicker that cuts right to the heart of this latest chapter: 80% of the variation was attributable to net buybacks.
A major factor behind this outcome is that faster growing countries need capital to fuel their expansions. This means a combination of debt and equity issuance – or at least it should if a country’s corporations want to keep their balance sheets in order, a point that will be further explored shortly. Ergo, fast economic growth requires large quantities of equity offerings, diluting existing shareholders unless the capital invested earns a satisfactory return.
In countries like China, the government often “encourages” investments perceived to be good for the nation at large but all too frequently don’t earn much for shareholders.[ii] This is almost inarguably a key reason why most Chinese stocks have been such dogs over the past 20 years, despite the economic miracle that country has produced. This has especially been the case with the big State-Owned Enterprises (SOEs) like PetroChina and China Mobile. More nimble and entrepreneurial companies such as Alibaba and Tencent had — emphasis on “had” — rocket rides similar to the U.S. tech stars but they were not included in the official Chinese stock index.
As most investors are aware, China’s long lagging market performance went from disappointing to disastrous in 2021 as its government turned on one sector after another. What initially looked to be a few isolated regulatory crackdowns morphed into a full-fledged and bizarre war against nearly its entire corporate sector. Chinese president Xi Jinping’s wealth equalization initiative, dubbed “common prosperity”, was clearly very hard on common stocks. Consequently, the divergence between the ever-rising U.S. market and China’s main benchmark, the Shanghai Composite, became even more jaw dropping.
Rather than following the Chinese model of massive investment in new capacity, U.S. senior management teams were for years extremely penurious with what is often referred to as “cap ex”. This was despite Donald Trump’s monster 2018 corporate tax cut which was supposed to accelerate capital expenditures. In reality, after a brief spurt, their long downtrend continued; however, what truly exploded was the rate of share repurchases, aka, buybacks.
Source: Deutsche Bank
The ultimate rocket fuel
There are those who contend trillions of share buybacks haven’t been the main propellant of this perpetual motion bull market. They insist rising earnings and profit margins have been the key. Undoubtedly, there is truth in that, especially when it comes to the big U.S. tech companies which are beneficiaries of the “network effect”. These include firms such as Apple, Google, Facebook, and Microsoft, where users become either locked-in or quasi-addicted to their services. The cost of acquiring new customers is very low; thus, incremental revenues from adding each newly acquired user flows almost totally to the bottom-line.
Revealing the disparity between those with a network effect and the rest of corporate America, the broadest measure of economy-wide profits is the NIPA, or National Income and Product Accounts. You can easily see the contrast compared to S&P profits which have been materially boosted by the tech titans’ earnings.
The reality is that very few companies possess the network-effect, high-margin, and rapid-growth profile of the companies often referred to as the FAANGs or FAANGMs (Facebook, Amazon, Apple, Netflix, Google, with Microsoft added in the less catchy alternate version). Thus, outside of this elite group, most of which have trillion-dollar market valuations, if not two trillion (and three trillion, in the case of Apple), profit growth has been mostly uninspiring. Ominously, this happened during what had been the longest, though slowest, economic expansion in American history.[iii]
In addition to tech being the star of the earnings show, it has also been the headliner in the buyback bonanza. However, there is a dark side to this situation. The fact of the matter is that there has been precious little actual share-count reduction for all the trillions expended on repurchases. The tech industry is notorious for lavish options and stock award packages — especially for senior management, of course.
As Barron’s reported on this in October of 2018 (and is even more true today): “Some market critics like to say that large corporations are cash-management machines for executives. In other words, companies buy back shares, put them into their treasury, and artificially boost earnings per share. Often, they aren’t all retired and a portion of them return to the pool of outstanding shares via executive stock compensation.”
Consequently, despite expending the aforementioned $4 trillion on repurchases, Corporate America only retired about 0.7% (be sure to note the zero-point!) per year of the S&P’s share count over the decade prior to the pandemic. Said differently, $4 trillion of buybacks amounted to at least 20% of the market capitalization, yet the share count has only come down about 8%. Where did the rest go, you might wonder?
Ben Hunt is one of the most iconoclastic newsletter authors I read (and he’s got a lot of competition in my world!). On the eve of the pandemic, Ben wrote a piece called The Rakes, after the name given to the person in a poker game who skims off a small portion of each betting pot. His short essay is a scathing take-down of the buyback mania and he shines a bright, revealing light on the magnitude of the corporate “rake”. This is basically the portion of a repurchase program that goes to insiders.
Even at some of America’s most admired and well-run companies, “the rake” amounts to 25%, or more, of shareholder sums expended. If this isn’t blood-boiling enough, let me share some other relevant factoids on this issue. The SEC has found that insiders sell five times as much stock in the eight days after a buyback announcement relative to ordinary days. Twice as many insiders also dispose of shares in the wake of repurchase declarations.
More infuriating yet, the House Financial Services Committee has found that some companies announce buybacks they have no intent of fulfilling in order to juice the stock price just prior to insider sales. The big picture view of this situation is that we have companies repurchasing their shares at a fever pitch while insiders are dumping said shares at an equally feverish rate. Again, please be aware this was leading up to Covid; post-pandemic, insider selling did a nosedive but was running at record levels as 2021 ended.
Source: Goldman Sachs
Source: Insider Score/Verity
The fact of the matter is that a roaring bull market is a marvelous, though ultimately impermanent, immunization against the various severe problems afflicting our country presently. When everyone is making plenty of money, why be a spoilsport… unless you’re a congenital contrarian, such as this author?
Now, you might think that “rake” is acceptable if it’s distributing wealth to the rank and file, like through employee stock ownership plans (ESOPs), as well as those at the top of the corporate pyramid. That would be nice, but in the case of this great American company Ben was shining the spotlight on, 97% went to senior management. Because of this entity’s remarkable success in a difficult industry, perhaps such a skew was justified. However, the painful truth is that this happens even at mediocre companies that make up the overwhelming majority of the aforementioned broad profit composite (NIPA). As we’ve seen, this primary measure of America’s corporate net income has pretty much flatlined since the end of 2012. Thus, such lavish senior management compensation seems inappropriate, to put it delicately.
Ben’s note has this concise summation of the set of circumstances we’ve seen over the last decade: “One day we will recognize the defining Zeitgeist of the Obama/Trump years for what it is: an unparalleled transfer of wealth to the managerial class. Not founders. Not entrepreneurs. Not visionaries. Nope… managers. Fee takers. Asset-gatherers. Rent-seekers. Rakes.” (By the way, it doesn’t look any different under the Biden administration, either.)
Another gifted newsletter writer is Jesse Felder, who around the same time wrote a piece titled, Are We Witnessing Another Corporate Earnings Bubble? (Note the word: “Another”) One of his key points is that the composition of the S&P 500 is different than the overall economy. Highly profitable companies such as tech, financials, and energy are much more heavily represented in the S&P than in the “real world”.
But another leading factor in the divergence is the differing treatment of those pesky stock options that rake off so much shareholder wealth toward senior management. In Jesse’s words: “GAAP accounting, which S&P 500 companies use, allows for a stock option to be granted and then expensed over time using the value of the option at time of the grant. NIPA accounting only expenses the option once it has been exercised, usually at a much later date and with a much higher expense.
In short, it seems that the boost in earnings over the past few years in S&P 500 profits could be, to a large degree, merely a product of the bull market rather than the other way around. Investors have crowded into a smaller number of firms that have inordinately benefitted during the current cycle and, in part, due to this crowding, these same firms have been able to report even greater profits by way of a quirk in stock option accounting.” (For an expanded version of his comments, please see the Chapter 12 Appendix.)
Based on the above, it’s reasonable to conclude that GAAP earnings are overstated and even though Jesse’s foregoing comments are a couple of years old, they are just as true at the dawn of 2022. If he’s right – and I think he is, with more on this topic in Chapter 14 – it means the market’s P/E is understated… and it’s already among the highest of all-time. Perhaps that’s why there is such a disconnect between a P/E ratio that’s high but not record-breaking and the price-to-sales ratio that is far above even early 2000, the peak of the greatest equity bubble ever.
It’s even more disconcerting to realize how many companies spoon-feed non-GAAP earnings numbers to the investing community. Some cynics, like this author, consider those to be profits excluding all the bad stuff. The gap (sorry) between GAAP and non-GAAP has been widening in recent years, as it always does late in an economic and market cycle.
All “good” things come to an end
Returning to the opening of this chapter, what might be the death-knell of buybacks? For sure, the highest corporate debt levels relative to the size of the economy are a possibility. However, it would probably take a spike by interest rates, a recession, and/or a surge in defaults to stop this insider enrichment process. (It’s worth observing that, as I write these words, inflation getting out of control could bring about all three of the above nasties.)
Another more immediate threat might be political. Pols on both sides of the aisle have buybacks in their crosshairs. Unsurprisingly, Bernie Sanders and Elizabeth Warren have railed against them. But when you hear someone like the GOP’s Marco Rubio attacking them, that’s a much more serious threat. (Please refer to the Appendix for Sen. Rubio’s criticisms of the S&P 500 constituents’ addiction to buybacks.)
Similar to his sentiments, since 2000, $6 trillion was expended on buybacks while personal income wages were up a far lower $3.5 trillion. That’s the kind of discrepancy that attracts the ire of Congress which is, as I write this, threatening to tax buybacks.
Done selectively and judiciously, there is certainly nothing inherently wrong with companies retiring their own shares. In fact, when executed at low prices, where the effective equity yield is high, they can be extremely rewarding to shareholders. For example, if a company is selling at 10 times its annual profits, its earnings yield is 10%. ($10 of earnings on a $100 market price.) If it can safely borrow money at 4%, or has cash sitting around yielding next to nothing, buybacks are value-enhancing for shareholders. However, if the P/E is 20, then the earnings yield is only 5% and the benefits become pretty skinny. The latter situation is much more common these days with the S&P trading around 20 times hoped for 2022 earnings.
A tangible example of shareholder value-enhancing buyback activity was what U.S. energy companies started doing with gusto in 2021. As noted in Chapter 9, energy producers began using the cash flow gusher they received as both oil and natural gas soared, particularly in the second half of the year, to repurchase their own shares at very high free cash flow yields. (See Glossary)
Unfortunately, such a shareholder-friendly manifestation of share repurchases has become the exception, not the rule. Frankly, most companies have no business wasting precious shareholder capital by wildly acquiring their own shares with the overall S&P 500 at one of its loftiest levels ever.
To put things in perspective, in 2018 and 2019, S&P 500 companies spent $1.5 trillion on share repurchases, 50% more than they paid out in dividends. This is an amount equivalent to the value of all the gold that’s ever been mined (but only around half of Apple’s market cap!). As pointed out above, due to Covid, buybacks cratered… briefly. But that pause was enough to bring about a rare down year for repurchases. However, in 2021, buybacks, at least based on authorizations, were on pace to hit an all-time high.
As BofA Merrill Lynch strategist Savita Subramanian has observed: “Buybacks work when there’s scarcity value. Now everyone’s doing it.” To her point, 60% of companies have done repurchases. And they are doing so at a time when the price-to-sales ratio, one of the best metrics for predicting long-term returns, is higher than it was in early 2000, at the tech bubble’s apex. This buyback binge is also occurring when the Cyclically Adjusted P/E (CAPE) is pushing 40. The latter is also known as the Shiller P/E ratio, named after Yale’s esteemed Prof. Robert Shiller. While it’s not quite as high as it was in early 2000, compared to all other prior peaks it’s extremely elevated, even above where it was in 1929, as we saw earlier.
The dark side of this shareholder cash return frenzy was that it pushed net-debt-to-cashflow to a 16-year high on the eve of the pandemic. This was a direct result of dividends and buybacks running above the available cashflow necessary to fund them since 2013.
Similarly, the ratio of Corporate America’s enterprise value (EV) relative to its aggregate cash flow is at an all-time high. (EV means equity and debt values combined.) In other words, both debt and equity valuations relative to cash flows are extremely elevated. As noted at the outset, prudent companies are careful not to let their debt/equity ratios get out of line even when spending on growth initiatives. Sadly, prudence has been increasingly MIA in corporate boardrooms in recent years.
Source: Bloomberg, Evergreen Gavekal
To elevate debt to dangerous levels to enable share repurchases — which usually lowers profits because of the increased interest costs — is the antithesis of judicious corporate stewardship. When this chapter first ran, I opined that this wasn’t likely to become an issue until the next recession. Little did I know then that it was mere weeks away and that it would be one of the most severe, despite its brevity. Notwithstanding that the Covid recession only lasted a month, the nearly overnight shutdown of most of the global economy had a profound impact on buybacks. Basically, repurchases collapsed with profits.
Due to intense rating agency pressure, myriad publicly traded U.S. companies were forced to suspend buybacks, per Figure 11. This was a great misfortune for shareholders as many were down 50% or more. This created exactly the opportunity for which capable and prudent management teams hope when it comes to repurchasing their own shares. To make matters far worse, a large number were forced to sell shares, as we will soon see.
Even prior to Covid, there were sneak previews of the coming horror film. As covered in a number of our newsletters as it was devolving, GE was a badly tarnished example of this phenomenon. It bought back tens of billions in stocks at high prices, and then was forced to issue equity at depressed levels to strengthen what became a precarious financial condition. Some accounting experts were even predicting it would become another Enron. (Fortunately for its long-agonizing shareholders, it appears to have finally found a CEO, Larry Culp, who has been able to repair at least some of the damage; appropriately, he is the son of a welding shop owner.)
Mining and energy companies did the same thing. They were aggressive buyers of their own shares during the boom years of the early twenty-teens. Then, after each industry’s bust, many were forced to sell shares on the cheap to shore up their weakened balance sheets.
Cruise lines, hotels, theaters, restaurants, department stores, and all of the other prime victims of the pandemic had near-death experiences, and many were forced to sell shares to stay afloat (literally, in the case of Carnival and Royal Caribbean). This was despite hundreds of billions of federal bailouts. And, in most cases, these companies had been aggressive buyers of their own shares prior to Covid.
Naturally, politicians were further incensed that a plethora of companies, which had been employing the management enrichment technique of overpriced share buybacks, were now using taxpayer money to stay alive. There was much discussion of bringing back the same requirement from the 2009 financial bailout that, in return for survival funding, the Treasury would be awarded warrants. As we saw earlier, these made the U.S. government (and, hence, taxpayers) lush — and unexpected — profits after the Great Recession. However, a few firms, like Boeing, refused and, inexplicably, the government acquiesced. As a result, huge gains for taxpayers were forfeited.
Unquestionably, the speed with which the economy and the stock market recovered was why the cacophonous uproar over buybacks died down just as quickly. As we’ve seen before, like with winning in sports, a raging bull market is a powerful deodorant. However, in my opinion, Corporate America is setting itself up for another thrashing as it madly repurchases shares at even more overvalued prices.
Although the Banana Republic monetary policy of MMT has delayed the day of reckoning – when it is revealed how much overpaying has occurred – rest assured that it’s very much a case of postponement, not cancellation. As you may have noticed, the concept of an inevitable payback, due to the countless can-kicking tricks to which our policymakers have repeatedly resorted, is one of the main messages of this book.
[i] It’s been a very different story in 2021 and into 2022, despite the rocky start to the new year. Retail flows into stocks have been enormous. These have particularly streamed into the more speculative market corners, often gravitating toward companies that have had scant familiarity with profitability.
[ii] Other emerging countries also often treat their private sector as an extension of the state, frequently preventing them from earning fair market returns on at least some of their assets. However, China is often the most aggressive practitioner of this approach.
[iii] Moreover, profits for all U.S. companies have been artificially propelled by $6 trillion of federal deficit spending. This creates added demand and without the drag from higher taxes; basically, it is a massive gift to the corporate sector.
Chapter 13: I Hate To Burst Your Retirement Plan Bubble
The post-retirement society
Many social commentators, probably rightly, assert that Western culture is in the post-phase: Post-modern, post-religion, post-civility, post-bipartisan, post-patriotic, post-prudence, post-hope, post-tolerance and, perhaps, most inarguably, post-truth. But the “post” that is the topic of this month’s chapter of Bubble 3.0 is based on the thesis that the relatively recent phenomenon of a comfortable retirement is now also increasingly a thing of the past.
One does not have to be a history major to know that it’s only been in the last four or five generations that most individuals in the West were able to plan for financial security during their so-called golden years. In fact, it’s largely been since WWII that the idea of 20 or 30 years (or maybe 40 or 50, if you worked for the Federal government or the State of California) of financially secure leisure after retiring was anything other than a pipe dream for the average person. Unfortunately, we may well be in the process of going full circle in this regard.
One critical aspect that has increasingly gone “post” over the last few decades is the once sacrosanct defined benefit pension plan. (Government workers have largely been shielded from this shift but that may be changing.) In its place, the now nearly ubiquitous 401(k) has emerged as the main retirement asset-builder, especially for private sector workers.
At this point, a brief tutorial is in order. A “defined benefit” plan is exactly what it sounds like: a specific dollar amount per month is provided, typically based on years of service and income earned (up to a maximum threshold). The most familiar and popular version of this is, of course, Social Security. But in the pre-post-retirement era, it was common for millions of rich country workers to have some kind of guaranteed pension plan… at least if they worked for a medium-to-large-sized company or, of course, for their government. Unfortunately, particularly in the U.S., one of the casualties of the relentless effort by America’s corporate managers to drive down costs has been the once commonplace defined benefit pension.
The lengthening of American lifetimes, at least until recently, also played a role. Obviously, providing a monthly stipend became increasingly costly as life expectancies improved. Combined with the soaring costs of retiree healthcare benefits, U.S. companies tried to do whatever they could to lower their future liabilities. Since it was most challenging to try to get out from under the retiree healthcare burden, at least for current employees, the lower hanging fruit became the defined benefit plan. Thanks to a surging stock market in the 1980s and 1990s, the timing was ideal for a switch to a defined contribution model, typically the now nearly omnipresent 401(k).
The reason this worked so well in an epic bull market is because the high returns it produced accrued to the account beneficiary rather than the plan itself. You may recall it was quite common, especially in the 1990s, for those pension plans that were still in place to have become highly “overfunded”. This allowed companies to defer contributions, often for years, flattening profits. (Companies frequently adopted a two-tier approach where older workers were covered by defined benefit plans while newer and/or younger workers were sent into 401(k) plans. Often, veteran employees were able to keep their previously accrued defined benefit credits while shifting new contributions into 401(k)s.)
But once the tech bubble burst in 2000, it was an entirely new ballgame. Due to the fact that the S&P 500 had become heavily exposed to tech and telecom stocks by the end of 1999, with almost 50% of market value in just those two sectors, the 82% and 73% declines they experienced, respectively, caused the market to be basically cut in half. It was at that time we first heard the sardonic, but not entirely distorted, joke: “My 401(k) is now a 201(k).”
In the past, the ravages of a ferocious bear market would have hit a retirement plan participant’s company and not his or her own account balance. But, as my wife likes to say, “You can’t have it both ways”. Unfortunately, in 2008, after a few good years from 2003 to 2007, it was time for another 50% wipe-out. The 201(k) was back.
However, on the fortunate side, at least for those who didn’t panic during either the Global Financial Crisis of 2008/2009 or 2020’s Covid flash-crash, stocks have experienced one of the best 12-year periods in history. In fact, the rally has been so powerful that the S&P 500 has now returned 17.55% per year from the March 2009 trough.
Interestingly, though, going back to the start of the century/millennium, it’s been a not-so-grand or glorious 5.7% per year. This reveals the deleterious impact of the first 10 years, often referred to as the market’s “Lost Decade”. That 20-year return was less than what long-term treasury bonds were yielding as of 12/31/99 but at least it is now a positive number. As recently as 10/03/2011, it was still negative. (However, in gold terms, stocks are lower than they were at the end of the 1990s, illustrating how much of S&P returns of the last two decades are likely a “money illusion”.)
Readers with a facility for numbers might recognize there’s a glitch with that 5.7%, particularly for the remaining defined benefit pension plans, which includes virtually all state and local retirement programs. Because return assumptions have long been in the 8% to 9% range, a nearly 20-year output of less than 6% from what should be the highest returning portion of plan assets (at least for the publicly traded portion) is more than a bit problematic.
It’s also a safe assumption that most 401(k) plans have struggled to keep pace with this modest return since many participants have an unhelpful tendency to shift into stocks when they’re high and get out after big declines. Furthermore, being diversified in overseas equities has not been a boon. This is due to the fact that the main international benchmark, the ex-U.S. MSCI World Index, has generated a total increase of only 3.8% annually from the end of the 1990s until now. In fact, this index is still 18% below where it traded in 2007.
But back on the sunny side, bonds have helped offset this poor equity showing. Falling interest rates have produced unusually high returns. If one was savvy enough at the end of 1999 to buy a 30-year zero-coupon Treasury bond in their 401(k) — assuming they had that choice (many plans do not offer that option) — the annual gain would have been 9.25%. Other bond-type investments have generated very healthy returns, though not as lofty as a long-term zero-coupon treasury, since those benefit the most from falling – make that collapsing – interest rates. For example, the Merrill Lynch long-term corporate bond index has returned 7.6% per year since the start of the 2000s.
Of course, stocks, at least in the U.S., have been big beneficiaries of the interest rate implosion. This has allowed the S&P 500 to trade within spitting distance of its highest P/E ratio ever and at its loftiest price-to-sales ratio of all-time, as we saw in the last chapter (Chapter 14 will home in on copious amounts of stock market data, with the underlying message being: “Watch out below!”). But it’s a bit scary to contemplate what that sub-par 5.7% return over almost 20 years would have been without such a hurricane-force tailwind from crashing bond yields. Remember, per Chapter 11, we’re now living with the lowest interest rates in 5000 years. Perhaps it’s just my weird way of looking at the world, but I think that’s a rather extraordinary development.
Underscoring the magnitude of the uplift from rising stock and bond prices, particularly in America, please review another chart from a thoroughly illuminating June 23rd, 2021, report by BofA Merrill Lynch. It was pithily titled, Dr. Strange Dove or How You Learned to Stop Worrying and Love the Bond. If nothing else, this graphic points out one of the key rationales for my quixotic endeavor to write Bubble 3.0 and for asserting we are living through the third iteration of hyper-valuation over the last 20 years. Since this piece ran, the below metric has become even more dangerously extended.
Additionally, on the scare-inducing front, is what the overall pension plan funding status would look like if stock valuations weren’t so generous and bond returns hadn’t been unusually luscious. According to Moody’s, one of the two main bond rating services, along with S&P, state and local retirement plans are underfunded to the unpleasant tune of $4.4 trillion. The Fed believes the shortfall is over $6 trillion. To put this in perspective, total state and local government revenues are $3.1 trillion. (Data as of 2019)
Financial newsletter guru John Mauldin observes, quoting the American Exchange Council, that these plans have only about one-third of the assets they need to fund future benefits. Specific states like Illinois and New Jersey are in such deep holes that a recent JP Morgan (JPM) research piece called their dire conditions “practically irreversible”. To back this up, JPM’s Michael Cembalest ran this graphic showing the percent of state revenues that would need to be dedicated to paying retiree pension and healthcare benefits using lowered but still unlikely-to-be-attained assumptions. Please notice the difference between the blue and brown bars, with the former based on a much more plausible 6% assumed return (more to follow on that point).
Source: J.P. Morgan
The great state of California and the U.S. Federal Government are also interesting case studies on the dangers of rocketing and unfunded entitlements. Thanks to increased taxes on California’s wealthiest, and the capital gains windfall from inflated stock and real estate prices, the Golden State is running a hefty surplus. The federal government has been another crucial source of deliverance, sending $160 billion in aid to the state post pandemic. It has now swung from an estimated $50 billion deficit in the Covid-wracked year of 2020 to a $75 billion surplus for 2021. Yet, there is a powerful storm lurking off its beautiful coastline.
Firstly, its massive public employees’ retirement entity, CalPERS, is only 71% funded despite using a lowered, but nonetheless improbable-to-be-realized, 6.1% return (more to follow on this topic, as well). This is also despite the fact that all the revenue from the “Millionaire’s Tax Initiative” California enacted in 2012, that raised the top rate from 10.3% to 13.3%, has been used to cover retirement benefits.
Secondly, and likely most significantly, Medi-Cal is becoming a tax revenue sinkhole — both for state and national taxpayers. Medi-Cal, California’s version of Medicaid, the health program for the poor, now covers nearly 14 million people, roughly one-third of its total population. It “boasts” an annual budget of $100 billion, three times Illinois’ overall budget. Enrollment is swelling, despite a resurgent economy.
As Medi-Cal has grown, so have emergency room (ER) visits. These vaulted by 75% from 2011 to 2016 which cost, on average, five times as much as a regular doctor visit. Often, trips to the ER are for routine illnesses. ERs are so clogged that Californians are told that if they truly need urgent care, they should call 911 and be taken in an ambulance since this puts them at the head of the ER queue. Obviously, the waste from all the above is immense. Even if you don’t live in California, you should care since the federal government roughly matches what the state spends on Medi-Cal (other states with lower income get even bigger Federal subsidies).
A rabbit hole with no bottom
There seems to be a belief that Federal deficits and spending gone wild is of no import. This is particularly the case with socialists and quasi-socialists. They are proposing enormous new entitlement programs on top of what were already unprecedented budget shortfalls — 5% of GDP or $1 trillion — in an economic expansion under Donald Trump.
Of course, post pandemic the deficits went totally bonkers (like, it seems, so much in our world today). In the federal fiscal year 2020 (again, this ends on September 30th), the budget shortfall was $3.1 trillion. But what happened next was even more astounding…
For fiscal year 2021, the U.S. government ran a $2.8 trillion deficit despite real GDP growth of 5.8%, about three times a good year in the post-financial crisis era. That was out of a total revenue base of $4 trillion! Spending was $6.8 trillion so the government spent about 70% more than it brought in and ran a deficit of 70% of its revenue base. At least it’s consistent with the 70% part.
Accordingly, since the pandemic, it has added nearly $6 trillion to the national debt in just two years. Incredibly, the $2.8 trillion of red ink in 2021 was despite an 18% revenue surge to the highest ever.
It’s fair to note that backing out the mind-blowing federal largesse, the economy would have been at stall speed. A $2.8 trillion deficit is basically about what GDP increased nominally (i.e., including inflation). Thus, in the absence of the budget blowout, the U.S. economy would have had a mild recession. Maybe it’s just me but I think that would have been a far better outcome than totally destroying our national balance sheet and opening the door to high inflation. Yet that’s not the main point of this chapter.
What is germane is that federal government entitlements — which are, naturally, off-balance sheet and unfunded — are estimated to be around $150 trillion currently. (However, on a present value basis they are considerably lower, though still so large as to be impossible to fund.) In many ways, the federal government is the worst offender in this regard. Even basket-case states like New Jersey have some portion of their retirement obligations funded by actual assets. But not the U.S. government. As I’ve written multiple times in my newsletters, the vaunted Social Security “trust fund” is empty as a politician's campaign promises. There is nothing in it but federal IOUs. Imagine if New Jersey tried to fund its entitlements entirely with its own debt obligations.
It continues to be my contention that failing to invest the multi-trillion-dollar surpluses Social Security accumulated since the 1980s into a diversified portfolio of corporate stocks and bonds was one of the greatest policy errors of the last three decades. And, it’s no exaggeration to say, there is a long list of those to choose from.
Gene Epstein, a former long-time columnist for Barron’s, is one of the very few I have seen comment on this incredible blunder. This is an excerpt from an article he wrote in September 2017, which is even more true today: “There could have been a bona fide trust had the surpluses generated for many years by Social Security been invested in other assets, in the same way countries maintain sovereign wealth funds. Instead, all the surpluses were spent, and IOUs known as Treasuries were created in their place. The term ‘trust fund’ is thus a form of Orwellian Newspeak: no fund, and surely no trust.” Maybe this should create another “post”, as in post-trust.
Medicare and Medicaid also have no assets, other than the payroll taxes they collect which are already falling several hundred billion dollars short of outlays, requiring the Federal government to come up with the rest. This deficiency is almost certain to continue to grow barring significant tax increases.
None of the local, state, or federal entitlement situations are sustainable. Yet, as mentioned, even more enormously costly social programs are being proposed, on top of Donald Trump’s “yuge” corporate tax cut that further impaired Federal revenues. This is one of the reasons, along with spending gone viral under what was a totally GOP-controlled government in 2017 and 2018, that in 2019 the all-in deficit was over $1 trillion. This is based on what was actually borrowed, not just the official shortfall.
Moreover, this torrent of red ink occurred despite a relatively robust economy in 2019, at least by recent anemic standards. And, of course, this excludes all the aforementioned unfunded entitlement obligations which are now going to require real money outlays as the Boomer generation moves from partially to mostly retired. This will be particularly painful since, as noted, there is no bona fide trust fund to cover these payments.
This is another area where our policymakers have totally relinquished any fiscal credibility they have left. Of course, they’ve been greatly aided and abetted by the Fed which has allowed the U.S. government to spend trillions it doesn’t have with — for now — zero adverse consequences, other than the now nagging inflation problem. Frankly, I think the lack of faith and confidence in our nation’s leadership, at multiple levels, is one of the gravest threats we face right now.
This terrifying situation is far more than a U.S. problem. Globally, the retirement funding shortfall (which some refer to as “the savings gap”) amounts to $70 trillion, and that was back in 2015. By 2050, this is projected to be $400 trillion. As in America, the demographics are daunting. Worldwide there are now 600 million souls over 65 years old. By 2050, that age cohort is projected to rise to 2.1 billion. The inescapable reality is that the planet’s pension systems were built under the assumption that people would live roughly 15 years in retirement; instead, more and more are living 30 to 40 years after retiring. (In the United Kingdom, as of late 2019, its national retirement fund was underfunded by five trillion pounds on a seven-trillion-pound pension system!)
Right before Covid made its world-terrifying appearance, the non-profit Employee Benefit Research Institute estimated that Americans between the ages of 35 and 64 were looking at a $3.8 trillion retirement savings shortfall. It forecast that 41% of U.S. households would face an investment asset deficit in their later years. (Source: The Wall Street Journal, 12/20/19)
As bad as all of the foregoing is, the actual predicament might well be worse. This is where the repercussions of Bubble 3.0 come into perverse play, and it relates to the previously mentioned unrealistic return assumptions. As you can see below, per the National Association of State Retirement Administrators, the assumed rate of return for U.S. defined benefit (DB) plans has been reduced by a miniscule ½% over the past 19 years, from 8.05% to 7.56%. And that original return assumption of roughly 8% was made in 2002, when corporate bond yields were in the 7% to 9% range and U.S. stocks were yard-sale cheap. Can you say nonsensical?
Showing how desperate some plan sponsors have become, the Pennsylvania Teachers’ Retirement Fund has shifted over half of its assets into aggressive investment vehicles. As reported by The New York Times on May 12th, 2021, this included pistachio farms and payphone systems in prisons. Notwithstanding this higher risk pivot, its performance has still fallen short of expectations. It also overstated returns, necessitating teachers who were hired in the past decade to increase contributions for the next three years. This accounting flub has even attracted the attention of the FBI.
This is a monstrous problem that has been festering for years. The Stanford Institute for Economic Policy Research reported in 2017 that for the years 2008 to 2015, the aggregate unfunded liabilities rocketed from $2.63 trillion to $5.6 trillion. And, as noted by my friend John Goode, a long-time senior portfolio manager at Morgan Stanley and author of the piece containing this factoid, that was during a ripping bull market. Despite that, unfunded liabilities compounded at an 11.4% rate.
The main theme of Chapter 11 was the inarguable fact that bonds are the most expensive — hence, they are the lowest yielding — of all-time. The chart in that chapter showing yields at a 5000-year low should be all the proof needed to validate this view. If you need more, consider that, as I write this, there are still around $4 trillion of bonds around the world with negative yields (down from a peak of $17 trillion in the summer of 2021).
Even in the U.S., one of the higher – make that “least lower” – yielding developed countries, the 10-year treasury note yields just 2% (though, I suspect, not for long). This is despite the prevailing 5% to 6% de facto CPI, as evidenced by the 5.9% cost-of-living hike for Social Security recipients in 2022. As a point of reference, during the worst days of the Great Depression, the lowest 10-year T-note return hit was 1.9%, when consumer prices were falling — hard!
Invariably, when I’ve discussed the topic of negative-yielding bonds with clients, I’m often asked a simple and rational question: “Why would anyone buy a bond where the lender pays the borrower?” To answer that question, I’ve included a brief excerpt from one of my intellectual heroes, Charles Gave, on precisely this topic.
To wit: “When meeting some clients a few weeks ago in Amsterdam, I made my usual remark about the stupidity of running negative interest rates. In response my host told me a sobering story. He manages a pension fund and had recently started to build large cash positions. One day he was called by a pension regulator at the central bank and reminded of a rule that says funds should not hold too much cash because it’s risky; they should instead buy more long-dated bonds. His retort was that most eurozone long bonds had negative yields and so he was sure to lose money. ‘It doesn’t matter,’ came the regulator’s reply: ‘A rule is a rule, and you must apply it.’ Thus, to ‘reduce’ risk the manager had to buy assets that were 100% sure to lose the pensioners’ money.”
(If you’ve got the time, you should read Charles’ full piece to which we’ve placed a hyperlink in the Appendix. It's only a little over a page long and it describes how negative-yielding bonds are a cancer eating away at Europe’s entire savings industry, with truly disastrous long-term implications.)
Because bonds are such a vital part of retirement plans, this yield extermination is an unmitigated disaster for these “schemes”, as the Brits call them. The same is true for those 600 million 65-and-over global investors. Income from fixed-income investments has been a mainstay of portfolios since the end of WWII, if not even earlier.
Neutering yields from bonds has essentially created a massive wealth transfer to hedge funds, private equity firms, and all those entities that can afford to take on high risks, and away from retired and wannabe retired investors (who are “gonna, wanna” for a lot longer thanks to yields gone missing). Further, hedge funds, et al, typically use leverage to goose their gains. And, of course, U.S. corporations have also “debted-up” to buy back shares, inflating stocks prices and senior management option packages, per Chapter 12.
As you can see below, showing the debt-to-GDP ratios of both advanced and emerging countries, the world has been on a debt bender that is without precedent. Go figure — central banks destroy interest rates and the planet gorges on debt! What a shock!!
Ok, so it’s LCD clear that fixed-income should be renamed “nixed-income” and can’t be counted on to produce anything close to normal yields for years to come. So then, it’s up to the stock market, and real estate, as well as alternative investments, like private equity and credit, to bring home the bacon or, perhaps these days, the vegan sausage. The problem is that all these asset prices have already been driven up to levels where future returns are highly likely to be disappointing. (This is truer in the U.S. than overseas, where stock and real estate values are often much more reasonable but, paradoxically, bond prices are much higher — and, thus, yields far lower — than in the States.)
If you don’t believe me on the disappointing return part, the prestigious market analytics firm Ned Davis Research has back-tested Warren Buffett’s favorite long-term stock valuation metric, total capitalization compared to the size of the economy, over the past 94 years. In their words, “no indicator we’ve tested has done better than this historically when looking out 5 to 10 years”. The sobering news is that on this basis they project stocks to produce a string-bikini skimpy 1.4% over the next decade.
A bit more encouragingly — but not much — the late and very great Vanguard founder Jack Bogle predicted a lowly 3 ½% annual return over the upcoming 10 years from a blended stock/bond portfolio. And that was back in 2017 before prices moved even higher. Consequently, the miniscule Ned Davis number for stocks could be closer to the mark.
With the trillions of dollars from return-starved pension plans flowing into private equity, it’s hard to believe that area will be able to provide its historically high returns. For a time, that might not be apparent, as they are presently able to sell businesses they took private years ago into a hyperventilating U.S. new-issue market, realizing big profits. But that window won’t stay open indefinitely. Too much money chasing too few superior opportunities has never ended well in the past and I don’t expect it to this time, either.
To close this chapter of Bubble 3.0, I’d like to attempt to drive home the point that the entire paradigm of central banks forcing interest rates down to nothing, or less than, is a dagger to the heart of retiring Baby Boomers around the world. Not only are their portfolios almost certain to produce inadequate returns to maintain their lifestyles, unless they are wealthy in the extreme, their pension plans are also at risk. Benefit cuts are nearly inevitable though, undoubtedly, politicians will do all they can to delay the reckoning, thereby worsening the eventual pain.
A lack of safe returns and the escalating threat to pensions (as well as healthcare benefits) is a terrible double-whammy. Consequently, the odds are high that the golden years will be anything but for tens, even hundreds, of millions of people. Perhaps that’s why the percentage of Americans aged 55 to 64 who are still working has risen from 56% in 1990 to 65% today. It’s a pretty safe bet that number will keep climbing once we have the next bear market and Boomers are left with the worst of both worlds: a devastated equity portfolio and the present reality of negative bond yields net of inflation. (Covid has been reversing this trend for a variety of reasons — including return-to-workplace fears, vaccine reluctance and a roaring stock market — but, as the bitter economics become obvious, it is likely to resume.)[i]
When I first wrote this chapter back in 2019, I conceded that deflation fears might return once again, as they did after the financial crisis. If so, buying a 10-year T-note at a 2% yield might look smart... for a while. And for a brief time, during the most extreme Covid lockdowns, that’s exactly what happened with the yield on the 10-year T-note crashing to 0.5%. However, I opined it would probably have a short shelf life when I wrote these words: “That is until the powers-that-will-be, whether from the left or the right, decide to try something like Modern Monetary Theory (MMT), ejecting what’s left of fiscal prudence out the window.” Of course, that’s exactly what has happened, but far faster and to a much greater degree than even I anticipated and feared.
Returning to the opening theme of this Bubble 3.0 installment, it’s a most post world we find ourselves in today. Along with post-truth, perhaps another profound “post” is sanity. And, believe me, it’s no fun to be one of the few sane “guests” in an insane asylum, especially one that offers an extended stay package worthy of the Hotel California.
[i] One wise man, quoted by my friend, acclaimed financial commentator and investment newsletter scribe Danielle DiMartino Booth, believes that over the next decade one-third of those turning 65 will be in poverty. If so, it’s hard to believe all these folks, and even those who are one or two rungs up on the wealth ladder, will be free spenders. That’s certainly a factor in favor of the low inflation argument but the flipside is aggravating the already acute labor shortage—at least until the older set realizes they need to keep working longer, probably much longer.
Chapter 14: Every Investor’s Favorite Bubble
Let’s get real… about our returns
Who doesn’t love a raging bull market? Especially one that just keeps romping and stomping, aside from some brief stumbles when an out-of-the-blue shock comes along. Because I’ve been in the investment business longer than a lot of today’s analysts, traders and portfolio managers have been alive, I can personally attest that bull markets are much more fun than bear markets.
On that point, this bull has been running for so long that many financial professionals have never seen a deep and lasting bear market. The same is true with today’s new crop of investors, millions of whom have only seriously become involved with stocks since the pandemic. But an organization with serious Street cred (as in Wall Street credibility) has some sobering news for the market newbies.
Among investment firms with the best long-term asset class return forecasting records is Boston-based Grantham Mayo Otterloo (GMO), which manages nearly $64 billion on behalf of its clients. As the S&P has steadily risen from undervalued back in 2009, to fairly valued by 2012, to heroically priced in 2014, then to extraordinarily pricey by the summer of 2018, and, ultimately, egregiously overvalued by the fall of 2021, GMO methodically lowered their return expectations over the next seven years.
What they are projecting is anything but fruitful. Essentially, with a 50/50 mix of U.S. stocks and bonds, GMO is looking for around a 5% average annual negative return, inclusive of inflation. Even though these are real or after-inflation numbers, the implications are enormous if they’re right. This is particularly true for the tens of millions of Baby Boomers who need to live on the fruits of their portfolios. (It is fair to note that GMO has been projecting poor returns for the last eight or nine years. Yet, as noted, they have increasingly marked down those future numbers as U.S. stocks have continued to push higher. Their long-term track record argues in favor of expecting them to be right at some point with more color on when that might be to follow.)
One of Warren Buffett’s classic adages, “Be fearful when others are greedy and greedy when others are fearful” is predicated upon a crucial and rather obvious notion: you need to have cash on-hand to capitalize on others’ fears. But all too often, people become complacent during boom times and allow their capital to remain in investment sectors, areas, or asset classes that are way beyond their sell-by date. Moreover, there is a strong and highly destructive tendency to move funds from underperforming vehicles into the hottest areas which then sets the stage for actual losses once the skyrocketing sector, style, or stock inevitably succumbs to the laws of gravity.
If there is a devil-like being at work in the financial world, one of his nastiest tricks is making the most dangerous (i.e., grossly overpriced) asset classes look irresistibly attractive. Often, these slices of the investment universe have been generating outrageous returns for several years. The action in tech stocks back in the late 1990s was a graphic, though long ago, example of this.
More recently, it has been the relentless rise in the S&P 500, with but a single down year since 2009. Thus, as of this writing, it’s been almost 13 years of a singular bull market, if one ignores the slight negative print for 2018 and the Covid catalyzed flash-crash. This also excludes some less serious gut-checks like early 2016.
There is simply no question this has been one of the most spectacular bull markets in U.S. history, going all the way back to when stocks were traded under the Buttonwood Tree in New York’s nascent financial district. (It must have been quite a challenge to keep all the birds on the tree limbs from leaving their own marks on the cash and stock certificates.)
This bull rampage is right up there with the 1920s and the 1982 to early 2000 mega-runs. (It’s also fair to note what happened in the wake of those was a mammoth give-back of what looked to be permanently accrued profits; again, more on that shortly.)
Bull markets, especially when they are particularly powerful and/or long-lasting, create a situation where investors become afraid to sell. We humans have been programmed over the eons to pursue activities which provide an immediate reward and avoid those that produce near-term pain or disappointment. That reality has helped us survive endless adversities (that we keep voting for our feckless politicians would seem to be an exception to this rule). It goes against every helix of our DNA to pull out of an activity that’s earning money even when wisenheimers like this author trot out a copious collection of charts and graphs to show that the S&P 500 is dangerously inflated (those shall be soon forthcoming).
Thus, in a way, late-stage bull markets become like an elaborate con job. Perhaps some older readers might recall the entertaining film from the early 1970s, starring Paul Newman and Robert Redford, The Sting. Messrs. Newman and Redford portrayed thoroughly likable conmen who come up with an elaborate scheme to bilk a rich crime boss, played by Robert Shaw. The key to making their ploy work was to let “the mark” win. Once he’d scored a bunch of easy money, he was ripe for the plucking.
And so it goes with investors. When we’re sitting on years and years of double-digit gains, we become convinced that: A) the market is safe, and B) the high returns will continue. In these situations, investors act as though the lavish profits they’ve “earned” in recent years are somehow securely tucked away, as in a bank. They lose sight of the historical fact that returns during late-stage bull markets are about as lasting as a politician’s campaign promises. In reality, those gains tend to be wiped away almost overnight and the more inflated the market has become, the more years of “in the bank” gains are suddenly repossessed.
However, in an era where there have been tens of trillions of central bank funny money created around the world, bear markets seem to have gone the way of the dodo bird, particularly in the U.S. This has made it very tough on folks like those at GMO who believe one of the few constants in the financial markets is reversion to the mean. (It’s also been challenging for this author though, fortunately, Evergreen has pounced on the brief downdrafts seen since this bull’s birth in 2009, particularly the Covid crash.)
Flash crash flashbacks
As noted in earlier Bubble 3.0 chapters, the 1987 crash was the first time that computers played a starring role in a major market collapse. Since then, of course, we’ve seen a number of those computer-driven cliff dives, although they’ve been limited to, thus far, the “flash crash” variety. These “now-you-see-them, now-you-don’t” panics happened in 2010, 2011, 2015, 2016, 2018 and, of course, 2020.
In some cases, there were some remarkable buying opportunities — if an investor moved at hypersonic speed. For instance, in August 2015, one ironically classified “low-volatility” ETF plunged 43% in less than an hour!!! More recently, another highly defensive equity security, the iShares Preferred and Income Securities ETF, fell 40% in four weeks, from late February to late March of 2020, with most of the plunge happening between March 16th and 23rd. These types of moves in conservative issues simply should not happen were markets truly efficient.
Today, as we all know, or at least we should, computer- or algorithm-based trading is dominant to a far greater degree than it was in 1987. Estimates are that these now represent 80% to 90% of New York Stock Exchange volumes, though that seems high to me. What is less well understood is that these systems generally don’t try to anticipate the future, as financial markets typically have in the past.
For example, if certain words in Fed press releases have led to market rallies, the same relationship is projected by the machines to happen again. One fascinating factoid in this regard is how much more the market has risen, like 80% of all returns, on Fed press conference days (even if those brought rate hikes) than it has the rest of the time. But don’t ask me to explain why. My only insight is that it simply shows that perhaps the only force driving the stock market these days that is more powerful than the “algos” and computers is the Fed.
Source: Liberty Street Economics as of 11/26/2018
This is definitely not how markets formerly behaved. As the celebrated economist Paul Samuelson once quipped, the stock market at one time had discounted nine of the last five recessions. In my opinion, the enormity of this shift has not been even close to fully appreciated. Most investors seem to believe the market’s discounting mechanism is largely unchanged.
Yet, as my astute partner Louis Gave has repeatedly pointed out, this is decidedly not the case. Rather than a market driven by myriad individuals spending endless hours analyzing economic, corporate, and geopolitical information, most of the movements these days are caused by the way in which computers react to current news events. This is not to say research isn’t still conducted but rather that it is overwhelmed by computerized-trading and, of course, the trillions of dollars that have shifted from actively managed vehicles into index funds.
The passive investing bubble
It’s common knowledge that the active investing community has been losing hundreds of billions, if not trillions, to its passive counterparts over the past 15 years. The chart below makes that abundantly clear.
Source: Michael Mauboussin, Morgan Stanley
By definition, there is no research performed by these index-type vehicles. In the “good old days”, the assumption was this was not a problem since markets were dominated by active managers who performed intensive analysis. The relatively limited number of passive players back then were effectively coattail riders and minimally impacted prices.
This was the cornerstone of the efficient market hypothesis (EMH) which, in turn, was, and still is, the essential assumption of passive investing. Even in bygone days, markets would become highly inefficient during bubbles and anti-bubbles (i.e., panics.) This is a key reason why stock prices have always been more volatile than underlying fundamentals would indicate.
But think deeply about current conditions in this regard. Active managers are no longer the elephants, they are the fleas. The monster pachyderms today are computers and passive funds. In other words, most money now is pushed around by entities that are not conducting much forward-looking research, if any at all. If that doesn’t raise red flags in your mind, you are way too invested — literally — in the current “don’t worry, be happy” mindset of the moment. There is a significant upside to this situation, however… at least for independently minded and research-driven investors. Because indexing is so brainless–constantly making expensive stocks more expensive and cheap ones cheaper – even in a market as hyper-valued as late 2021 and early 2022 there were bargains. Some were even of an extraordinary nature. This was particularly the case after the severe damage that was done to a multitude of stocks since the fall of 2021, despite that the overall market was close to record highs in early 2022. This fits within one of my main themes of a
“Great Rotation” now under way toward value stocks and away from growth issues that have been the dynamos of the last 15 years. As they say, especially with such divergent valuations across sectors, it’s a market of stocks, not a stock market.
Money manager Seth Klarman has one of the finest track records in the investment business and he’s definitely a thinking investor. He’s been able to generate stellar returns despite the difficulty of besting passive vehicles (which are always fully invested) in a seemingly immortal bull market.
Here’s what he has to say about the dangers of this phenomenon: “When money flows into an index fund or index-related ETF, the manager generally buys into the securities in a proportion to their current market capitalization… thus today’s high-multiple companies are likely to also be tomorrow’s, regardless of merit, with less capital in the hands of active managers to potentially correct any mispricings.”
He went on to observe: “Stocks outside the indices may be cast adrift, no longer attached to the valuation grid but increasingly off of it. This should give long-term value investors a distinct advantage. The inherent irony of the efficient market theory is that the more people believe in it and correspondingly shun active management, the more inefficient the market is likely to become.” (Emphasis mine)
This reality may be why there has become such a disconnect between an America that seems to be unraveling and financial markets that are behaving like times are about the best they’ve ever been – with a massive assist, of course, from the Fed’s Magical Money Machine. As long as trillions of new liquidity are being created, the computers and passive vehicles couldn’t care less about underlying fundamentals.
For years and years, this paradigm has been investment nirvana, at least for all those who went with the flow. The algorithm-driven computers have almost exclusively been on the buy-side due to things like serial quantitative easings (QEs, now escalated to MMT, per Chapter 6), massive and deficit-financed corporate tax cuts, mostly rising earnings (especially in the U.S.), the highest profit margins in history (again, in the U.S.), and, most important of all, zero, and even negative, interest rates that made nearly every risk-asset (like stocks) look irresistible.
For decades, one of the best warnings of stock market trouble was the so-called Shiller P/E. It is the brainchild of famed Yale professor Robert Shiller, who also created the Case-Shiller Housing Index. Like me, Prof. Shiller issued advanced warnings of both the tech and housing bubbles (and, like me, he was largely ignored… until after the fact). His metric is also referred to as the Cyclical-Adjusted P/E (CAPE) which is more descriptive. As it sounds, it seeks to smooth out earnings over a ten-year timeframe and, further, it adjusts them for inflation.
The cyclical adjustment is critically important, in my view. For example, if you didn’t do this you would have stayed away from stocks in 2009, at the bottom, because earnings had collapsed. Consequently, at that point, the unadjusted, or unsmoothed, P/E was very high. The reverse is true late in an economic up-cycle when profit margins are near peaks. As you can see below the CAPE gave solid buy signals in 2003, early 2009, and again during the Covid crash.
In decades past, the CAPE actually got much lower during bear markets than in 2009 or March 2020. There has clearly been a major upward shift in valuations that has happened over the last 30 years. The long decline by interest rates has undoubtedly been one crucial factor in that regard. But my great friend Vincent Deluard, chief strategist at StoneX, has discovered another influence at work.
He divided the last 140 years of U.S. stock market history into two sections: one being the 112 years prior to the creation of the S&P 500 index ETF (SPY) and the nearly 30 years after that with one decade carved out. As you can see in the following two charts, there has been an obvious trend change to the upside. Said differently, the prior reversion to static mean, or average, tendencies no longer exist. (Note: Vincent left a gap in his charts from 1993 to 2003 because he felt that period was a transition phase from the former active-investor-dominated era to that of passive dominance. I have added a chart that shows the CAPE continuously and, as you can see, on this basis the U.S. stock market is more highly valued than it was in 1929, though not quite as insane as 1999.)
As bad as the above portends for future U.S. equity returns, it’s actually worse when you dig deeper. Profit margins are exceptionally elevated for publicly traded corporate America. While they’ve been in rarified territory for an unusually long time, there are changes afoot. Typically, margins are highly mean reverting. In a freely operating capitalistic system, it’s exceedingly hard to maintain fat profit margins because they nearly always attract intense competition.
Certainly, as noted earlier, companies with unusual barriers to entry — like the mega-cap names such as Microsoft, Amazon, Google, Facebook, et al — qualify as exceptions to the usual profit cannibalization which capitalism generally ensures. (This assumes markets and economic actors are allowed to do their competitive thing).
In the case of the “FAANGM” stocks, the so-called “network effect” makes stealing away their customers with lower prices extremely challenging. But even for this elite cohort, the future looks less hospitable. Political and regulatory pressure is rapidly mounting. China is a graphic illustration of what can happen to big tech companies when their own government turns on them.
For corporate America overall, the threats to structurally high profitability are accumulating. One obvious change is inflation. While some companies have been able to easily pass on price increases to offset soaring input costs, many were not so fortunate as inflation erupted in 2021, despite the Fed’s repeated assurances that it was transitory. FedEx and Kimberly-Clark were two blue-chip examples of impaired earnings because of costs rising faster than sales.
Closely related to this, employee compensation began to heat up as 2021 progressed. Labor shortages became so acute that employers were offering lavish inducements with behemoths like Amazon offering $3000 “signing bonuses”, up to $22 per hour pay, and free college education to new hires. The following image (taken by this author at an Exxon gas station in Coeur d’Alene, Idaho, over the summer of 2021) reveals the extreme labor shortage at the time. Though an anecdote, it was one of countless along these lines that almost all of us have repeatedly seen in recent years.
Since labor is almost always the largest corporate expense item, this is a powerful threat to profit margins. Thus, it’s difficult to envision they will stay at the levels seen below.
Veteran money manager John Hussman has pioneered a way to adjust the CAPE for variable profit margins. Appropriately enough, he has dubbed it the Hussman Margin-Adjusted P/E (MAPE). Interestingly, during the late 1990s boom, margins were not that stretched — certainly not to the degree they were for much of the 2000-teens. As you can see, using his methodology, the U.S. stock market took out the 1999 peak early in 2021. Because of the hefty appreciation throughout the year, the Hussman MAPE rose even further into the ionosphere.
A market commentator could rationally argue that record profit margins deserve a lower P/E, not a higher multiple, since the odds are high of an eventual plunge in margins below normal, as occurs during recessions. Of course, if one believes that margins have hit a permanently higher plateau, it’s a different, more bullish, story. History would indicate that’s unlikely and, based on the aforementioned threats to profits, I’d argue it’s best to side with historical precedents. But, obviously, based on the shockingly high valuations that have prevailed for so long, the market is oblivious to the obvious.
As my good friend and fellow financial newsletter scribe Jesse Felder emailed me in September 2021: “The problem I have with PE ratios is that in order to use them you have to make the assumption that profit margins will remain steady indefinitely into the future. In other words, when profit margins are high (as they are today — record high, in fact) the PE ratio is suppressed to a degree… Jeremy Grantham has called margins ‘the most mean-reverting series in finance’. They haven’t mean-reverted for the past couple of decades but that doesn’t mean they won’t going forward. To the extent they do, current PE ratios will understate the risk valuations currently present to investors.”
This gets back to the increasingly powerful influence of passive, research-free investors. As Vincent Deluard rightly observes, index funds are price insensitive. In other words, when the money comes in, it needs to get deployed, regardless of how inflated prices might be versus historical measures like P/Es, price-to-sales, and the overall market value relative to the size of the economy (often referred to as the Buffett indicator, per Figure 9 below).
At a time when trillions upon trillions of fake money — that “pseudough” I mentioned earlier — are created on a yearly basis, the torrent of dollars into stocks has become overwhelming. This is a source of price insensitive demand never seen before. As described in Chapter 1, the staid Swiss National Bank has even printed money to directly buy U.S. stocks. In other words, it hasn’t made any pretenses as has the Fed and the ECB about only buying bonds and leaving it up to market participants to redirect the proceeds of their binge-prints into equities.
This effect has only reinforced the natural trend-following instincts of retail investors. After years of being largely disinterested in stocks (at least since the late 1990s tech orgy), Mr. and Mrs. America are buying stocks like never before; meanwhile, globally it’s the same story. In fact, this tsunami of new money has been so extreme that the annualized inflow for the first half of 2021 was greater than for the prior 20 years combined!
Consequently, it’s the same old value-destroying story of retail investors buying the most at the top, as I’ve chronicled in earlier chapters.[i] One could certainly challenge the “at the top” phrase, but when you see the kind of visuals displayed below, it’s fair to say we have to be at least in the zip code of Taurus Terminus. Similarly, U.S. households have 36% of their net worth in stocks, materially higher than the 32% seen during 1999 and early 2000, what was the biggest stock market bubble in American history. BofA Chief Investment Strategist Michael Harnett stated in September 2021 that his firm’s high-net-worth clients were 65% in stocks, the highest ever.
Potential pinpricks in waiting
It takes a healthy dose of denial not to concede that at some point the downside reversal is nearly certain to be cataclysmic. Yet, in fairness, as you can easily see from the three images above, the U.S. stock market has been in the valuation danger zone for years. Why should that change anytime soon?
One potential “valuation restoration” factor might well be supply. Unlike for nearly all of the bull market that began in March 2009, there is now a glut of initial public offerings (IPOs), as you can see below.
Source: Federal Reserve Board
Another source of supply is coming from corporate insiders. As shown in Figure 11, insiders sales relative to buys have rocketed to a level far above anything seen during the giddiest years of the great bull market of the past dozen years.
In reality, insider dispositions don’t create much in the way of supply. However, when the number of sellers swamps those on the buy side to the degree seen above, it’s a strong signal by those who know their companies the best… and, clearly, it isn’t a bullish one. After all, as others have noted, there are many reasons why an insider might sell her or his own shares but believing the share price is undervalued isn’t one of them. This was another profound “tell” that the U.S. stock market was exceptionally expensive in late 2021.
Next, there is a growing threat on the demand side. As noted in Chapter 13 on buybacks, these have been an extraordinary source of market ballast. Buried within the Build Back Better legislation being wrangled over in Congress as I write these words is a 1% tax on share repurchases. Its fate is unknown at this time but it does show the swelling antipathy toward repurchases by U.S. policymakers, as chronicled in more detail in Chapter 12.
Leverage is, of course, an additional, though very fickle, source of demand. In the case of the stock market, when margin debt is increasing, there is incremental buying power being created. As in all late-stage bull markets, margin debt has risen to dangerous heights. As you can see in the following visual from my Katmandu-based friend Paban Pandey, this is no stock market version of Shangri-La. The growth rate for margin debt on a year-over-year basis was about 72%, a pace only exceeded during the wild blowoff in the terminal stages of the late, not-so-great tech bubble. You might say stock market leverage became Himalayan.
Sourced from Hedgopia
When deleveraging sets in, as it inevitably does, this quickly morphs from a source of demand to a source of supply. For contrarians with cash on hand, the forced liquidation that accompanies what are essentially massive margin calls are fantastic buying opportunities. For the millions of investors who are far out over their skis with leverage, these reckonings are catastrophic. It’s highly improbable this time will be different.
The late Barton Biggs, for many years Morgan Stanley’s Chief Strategist (and one of the few to give an advance warning of the tech wreck), once quipped: “A bull market is like sex. It feels best just before it ends.” For millions of retail investors, it hasn’t felt this good since… well… that would be the tech bubble. That’s the last time they were so engaged with stocks and making such immense sums of easy money.
Super-investor, financial author and Wall Street Journal columnist Andy Kessler gave some cogent clues in his WSJ “Inside View” Op-Ed on March 8, 2021 as to, in his words, “When the Boom turns to
Bust”. To wit: “How do these bull bashes end? When the last skeptical buyer finally sees the light and buys into the dream that every car will be electric, that crypto replaces gold and banks, that we overindulge on vertically farmed ‘plant-based steaks’ while streaming ‘Bridgerton’ Season 5 before we hop on an air taxi for Mars. Those last skeptics (maybe already) convince themselves there’s no longer any downside. And then boom, it’s over.”
When you see cover stories like this from Barron’s, the WSJ’s sister publication, rationalizing meme mania, one has to suspect that “And then boom, it’s over” is nigh at hand. Furthermore, when two-thirds of all the companies in the Russell 3000 Growth Index are losing money, that’s another alarm bell going off that peak nuttiness might be around the corner… or at least in the neighborhood.
Yet, the demise of a mammoth bull market usually requires a catalyst. Inflation has the pole position to be that trigger, in my view, as 2021 dissolves into history. The bright folks at against-the-herd money manager Crescat Capital have pointed out that when inflation runs much higher than interest rates — which is exactly the situation in late 2021 — the stock market derates on a P/E basis. This is a polite way of saying “lookout below”. In fairness, they note that this risk arises when real rates have been negative “for a long period of time” which has not been the case… yet. However, they further opine that it’s the first-time negative yields have occurred with record-high valuations.
A key reason why the 2021 inflation outburst is particularly problematic at this point is that it is already placing considerable pressure on the Fed to shut down its Magical Money Machine. If that happens, especially if it happens quickly, it could have a powerfully deleterious impact on the frothy-to-the-max U.S. stock market. As I write this chapter, there is a developing riot in bond markets around the world as other central banks renounce their fanatical devotion to QE and MMT policies. Many of the yield spikes are truly breathtaking, particularly on the shorter end of the yield curve. Should this bond carnage spread to America, it might be the ultimate pinprick for what I believe has been the most outrageous example of mass speculation in the history of this once great nation.[ii]
[i] A fresh example of this recurring phenomenon happened in 2021 related to the once unstoppable Cathie Wood and her ARKK funds. Despite a punishing 60% decline from its February 2021 apex, her flagship ARKK Innovation fund remains up 300% since inception. Despite this, the aggregate return to investors, based on the timing of their inflows and outflows, is now negative, due to investors flooding it with money after it did its Blue Origin imitation.
[ii] After writing these words in late 2021, this is precisely what happened, even in the U.S.
Chapter 15: Debts and Deficits: Essential Bubble Ingredients
The debt hockey stick
There are many reasons asset bubbles create agonizing hangovers but one of the most pernicious relates to debt. You may have heard of the neutron bomb where the people are gone but the buildings remain. Apropos to bubbles, which are often heavily funded by wild borrowing cycles, the assets are eventually nuked but the debt remains.[i]
There is most definitely a very long list of negative effects from 12 years of money for — and from — nothing central bank policies. However, none are more harmful than encouraging the leveraging up of pretty much the entire planet. In the pages to follow, I will present a multitude of evidence on the outrageous accumulation of debt that has been very much of global affair.
The Global Financial Crisis (GFC) of 2008/2009 was assumed to be a peak in reckless credit creation that would not be exceeded for generations… if ever. Its implosion was so intense that it took credit spreads (please recall how vital those are from earlier chapters) to peaks unseen since 1932. As I wrote at the time, stocks got somewhat undervalued in early 2009 but nothing within light years of the kind of bombed-out valuations seen in the early 1930s. But for credit instruments — bonds, mortgages, preferred stocks, collateralized debt obligations — it was déjà vu 1932 all over again.
Yet, as you can see in the following chart, a mere four years after that epic debt reckoning, global debt levels had risen well beyond those seen during “the bubble to end all bubbles”. Now, 12 years removed from it, we’ve taken that number up by another $130 trillion. That’s “only” about $200 trillion more than the world collapsed under in 2008. Maybe, just maybe, these reckless central bank monetary policies are the Viagra in this latest wild debt orgy.
Source: Grant Williams, TTMYGH
Source: Institute of International Finance
The debt trend pre-pandemic was terrifying enough but in its wake the slope of the curve went nearly vertical (in calculus speak, almost undefined). In the case of our Federal Reserve, it was fabricating roughly $1 trillion per month during the worst of the crisis. Other central banks were also in hyper-print mode. However, the U.S. definitely was the leader in the clubhouse—and is still winning the tournament—when it comes to monster stimulus payments nearly all funded, directly or indirectly, by the Fed.
As noted at the outset of this book, in the wake of the GFC government spending initially spiked but, shortly thereafter, it began to level out. In fact, as a percentage of GDP it actually fell through most of the Obama administration’s term. The fiscal response to Covid, however, has been the antithesis of austerity. (Tea Party, where have you gone?)
Source: Grant Williams, TTMYGH
Unquestionably, this has been a joint crisis response. In other words, unprecedented monetary stimulus (cutting interest rates and printing trillions) combined with equally unprecedented fiscal stimulus (the two biggest annual post-WWII budget deficits). This is how the U.S. government turned the deepest recession since the 1930s into the shortest recession ever. But the legacy for future generations is the extreme indebtedness seen below.
Just to recap how mammoth the U.S. government’s spending and debt accumulation has been, let’s review the numbers as of 9/30/2021. Over the last two mostly Covid-impacted fiscal years, the federal government spent $14 trillion, or about $7 trillion per year. This was about $6 trillion more than its total revenues; accordingly, the 2020 deficit was $3.1 and 2021 was only $300 billion less. The next closest was a $1.2 trillion shortfall during the Great Recession/GFC era.
The remarkable aspect about the $2.8 trillion fiscal year (FY) 2021 deficit, which ended on September 30th, was that it coincided with another “largest ever” — in this case, government revenue intake. That’s not a typo. In FY ’21, the treasury brought in over $4 trillion in revenue, up 18% from 2020. Since Covid impaired the government’s receipts in 2020 that’s not totally shocking. But FY 2021 was also up nearly 15% from the virus-free fiscal year 2019! Yet, despite that remarkable resilience in tax receipts, the red ink was approximately 70% of total federal revenues.
Of course, these stunning deficits manifested themselves in equally stunning debt accumulations. When it comes to the U.S. government, deficits and debts are joined at the hip, perhaps the right hip. Affixed to the other hip is the Fed’s balance sheet. That’s where all the securities it buys wind up, acquired with the digital reserves it creates from its Magical Money Machine (literally, its computers that buy mostly government debt from the Wall Street primary bond dealers such as JP Morgan). You can see how closely that balance sheet impregnation has tracked the U.S. government’s torrents of red ink.
In the distant past, like the 1950s, one dollar of additional government debt translated into over seven dollars of economic growth (possibly, because this was during the Eisenhower build-out of the Interstate Highway System with its massive productivity enhancements). In other words, in the ‘50s there was a powerful positive multiplier on each marginal dollar of debt. Today, however, the multiplier has gone negative; each incremental dollar of debt produces just 70 cents of increased GDP. Consequently, since around 2007, GDP has grown far less than federal debt outstanding.
This is the classic definition of a debt trap. A country can’t keep growing what it owes faster than its total economic output indefinitely… though the U.S. is giving it its best — or worst — shot these days. It is noteworthy that the first time the multiplier went negative was right around the time of the housing boom and bust.
That period saw immense amounts of borrowing to buy unproductive assets (i.e., overpriced homes). Said differently, it was a multi-trillion-dollar exercise in capital misallocation. That bubble’s demise not only destroyed vast amounts of wealth, it also set off the chain reaction of increasingly desperate Fed policies to prop up the system, as noted at the outset of this book. Covid merely intensified the trend of money fabrication run amok already in place.
As Charles Gave has often written, debt-funded financial engineering — be it due to leveraged buyouts of companies (LBOs) or to issue myriad amounts of sub-prime mortgage debt to inflate a housing bubble — is bad for productivity. This would also include the unparalleled surge in buybacks, per Chapter 13. Because financial engineering has gone viral over the last two decades, it’s unsurprising that productivity has been in a long bear market. It’s also no shock that economic growth has been consistently disappointing since the turn of the millennium, as I’ve previously observed. (We will see shortly that this has been a deviation from a growth trend in place since the end of the Civil War).
There is also a correlation between high levels of government spending and deficient productivity. One reason for this link is that eventually inflated levels of federal expenditures lead to higher taxes. (Another critical aspect is that the government is notoriously a less efficient allocator of capital than the private sector, especially, when as shown in Figure 8 above, most of the spending is on social transfers that often discourage productive endeavors, aka, work.) The Organization for Economic Cooperation and Development (OECD) has found that a 1% increase in a country’s tax rate leads to a 1.4% drop in hours worked per capita in the working age cohort. As the late Ed Lazear, former chairman of the President’s Council of Economic Advisers from 2006 to 2009, wrote in a February 2018, Wall Street Journal Op-Ed: “US data dating to the 1970s also shows that higher taxes cause workers to limit their hours, reducing economic output.”
Sophisticated studies really aren’t necessary because you can simply look to heavily taxed Europe to see a graphic example of the drag caused by punitive tax rates. In the U.S., hours worked were nearly double the tax ratio to GDP whereas in France hours worked were only about 75% of the tax ratio to GDP. As Professor Lazear went on to note in his Op-Ed, “The international comparisons suggest that a 4% increase in (government) spending associated with a decrease of roughly 0.5% in the average annual growth rate.”
Doing a Zimbabwe-lite
Since 2000, America has become increasingly European when it comes to government spending and deficits. It stretches credulity to believe it was a coincidence that from 1870 through the 1990s U.S. per capita GDP growth was 2.2% per year and, since then, it has been halved to 1.10% per year. It’s further unlikely it was mere happenstance that the beginning of the 21st century ushered in an era of frantic monetary policies in the wake of tech’s spectacular splashdown, causing the aforementioned growth buzz-cut. While a 1% per year growth shortfall doesn’t sound that meaningful, over time it has compounded into a 26% reduction in the size of America’s economy.
The reality is that the GOP is every bit as much to blame as the Democrats for this sad outcome; even more disheartening, the future is bleak. U.S. debt-to-GDP is projected to be 195% by 2050, up from an already extremely dangerous 125% in late 2021. Moreover, this excludes the unfunded entitlement overhang, as previously discussed. As a disquieting reminder, those are estimated to be in the neighborhood of $160 trillion, according to the reigning King of Bonds, Jeffery Gundlach.
Source: Marathon Resource Advisors
To put the enormity of this number into context, please refer to Figure 2 showing total global debt to be $300 trillion. (Admittedly, that could be underestimated in other nations, especially the eurozone, for much the same reason as in the U.S. — bogus government accounting.) Even using the official, much more charitable, aggregate liability number, federal debt per capita has rocketed from $69,000 to $82,000 since Covid graced us with its presence.
It is this deepening debt trap that has caused Lacy Hunt, also one of the most acclaimed bond managers of all-time, to believe inflation and growth are going to remain muted as they have for the last two decades. This is because he has reviewed extensive academic studies showing that high levels of government spending clearly hurt growth, highly consistent with what both Professor Lazear and Charles Gave have determined, as well.
This is a politically contentious issue, of course, with many, mostly on the Left, such as Paul Krugman, strenuously disagreeing. Yet, it’s hard to blow off the flaccid results we’ve had over the past two decades as we morphed from running budget surpluses in the late 1990s (under a Democratic president, by the way) to increasingly monstrous deficits in the 2000s. Again, what’s happened in Europe over the same timeframe also argues emphatically that exploding government spending and deficits is growth inhibiting, not accelerating.
Nevertheless, Western policymakers seem intent on doubling, or even tripling, down on borrow-and-spend tactics. In reality, instead of borrowing the old-fashioned way via the bond market, the primary go-to funding source in the post-financial crisis era has become the central banks' new-age printing presses. As I’ve explained before, this is debt monetization, a process once believed to be the domain of developing world countries that were in the process of reverse development, such as Venezuela and Zimbabwe.
Returning to the thesis that excessive government spending is economically sedating, for the first time more than half of all Americans are receiving some type of government check. Much of this is in the form of unemployment benefits, particularly during the virus crisis. Initially, this was the rational and humane course of action. However, it became clear as early as August of 2020 that these overly generous benefits (in many cases) were creating a labor shortage. As 2021 progressed, that became increasingly and more undeniably obvious. In fact, I believe it is fair and accurate to say that the U.S. economy has never faced a worker shortage as acute as we are seeing at this time.
In my 43-year career of working with thousands of affluent to highly affluent Americans, very few of them deny the need to aid those who are handicapped or impoverished children. However, the kind of absurd federal outlays that have characterized the pandemic recovery era are almost certainly a big factor behind the Democratic party’s shocking popularity plunge that began in the second half of 2021. For example, the highly contentious Build Back Better act, which is still lingering out there somewhere in legislative limbo, would provide paid family leave for up to 12 weeks per year. Married couples earning as much as $400,000 combined could potentially receive $24,000.
Similarly, the bill sought to expand ObamaCare benefits. These would provide a household earning as much as $350,000 — in a moderate-income region such as Prescott, Arizona — the ability to receive an ObamaCare subsidy of $21,309. Also, on the bankrupting of America via uncontrolled healthcare spending front, 37% of Californians, or almost 15 million people, are on Medicaid, a program meant to provide a healthcare safety net to the truly poor. (If that’s actually the number of destitute people in the so-called “Golden State”, it certainly doesn’t reflect well on 40 years of a consistently intensifying leftward lurch in its politics.)
In days gone by, a sizable percentage of America’s sovereign funding needs were met by overseas investors. In the 1970s, OPEC was among the biggest buyers of treasuries, as it recycled its billions (back when a billion was real money) of petrodollars into the U.S. In the 1980s, it was Japan that took the lead in this regard, redeploying its surging trade surpluses back to its main customer’s bond market. (This was in addition to pouring vast sums into trophy real estate on which it often grossly overpaid, leading to huge eventual losses). By the 1990s, America’s trade deficit with China was going vertical. In this case, it would last for much more than a decade and China quickly rose to second, only behind Japan, as the largest holder of U.S. treasuries.
Starting around 2013, however, a funny thing happened. As U.S. cumulative federal indebtedness was in the process of doing a moonshot from around $15 trillion then to $29 trillion today (i.e., nearly doubling what had taken 237 years to amass!), foreigners decided to mostly sit on their hands. Though their treasury holdings rose by a couple trillion or so, the other $13 trillion needed to come from somewhere else. As we’ve repeatedly seen, that somewhere else has mostly been the Fed, courtesy of its Magical Money Machine.
This is a dramatic change indicating growing international unease with the prospects of getting repaid, at least in non-debased dollars. Considering the rate at which dollars are being created these days, that’s a most understandable reluctance.
Another reason foreign investors are edgy as they appraise America’s ability to service its debts and maintain the integrity of the U.S. dollar, is the other deficit — as in, trade. Back in the 1980s, there was tremendous angst over our “twin deficits” under the Reagan Administration. While those days are looked back on fondly as an economic nirvana, the rapid GDP growth seen that decade coincided with soaring federal budget and trade deficits — the “terrible twins”.
However, the handwringing over this not-so-dynamic duo turned out to be misplaced. As noted above, by the latter years of the 1990s the U.S. moved into a budget surplus status, shocking everyone. By the end of that decade, the black ink was growing so rapidly that then-Fed chairman Alan Greenspan fretted before Congress that there might not be a treasury bond market by 2010 because the government was on track to retire all its debt by then! Suffice to say, it was another way off the mark forecast by a leader of the Fed, a proud tradition that has been maintained in the 21st century.
What’s especially shocking about the current $1 trillion U.S. trade deficit is that it’s happening despite America having effectively eliminated its once massive oil importation expense. Without the unconventional oil revolution, which has allowed America to be “energy independent” for the first time since the 1960s, our trade deficit would be almost $200 billion, or 20%, higher. Of course, presently, there isn’t a lot of love flowing between Washington, D.C., and the prolific Permian Basin that straddles Texas and New Mexico. Rather, the Biden Administration is restricting U.S. oil output, as noted in Chapter 9, and pleading with OPEC to increase output. This bizarre stance is likely another factor in the drastic plunge in President Biden’s approval rating… along with spiking energy prices of all types.
But, per the main theme of this chapter, it’s becoming increasingly clear that Americans, including moderate Democrats and Trump-loving GOPers, are exceedingly alarmed about the fiscal condition of our nation. Even though the stock market kept making records in late 2021, there was an underlying sense of unease with the artificiality of this boom, which desperately depends on an ever greater amount of debt and the avoidance of a deleveraging cycle at all costs. (The latter because of the severe deflationary implications such as those seen during the housing bust.)
Though the average voter may not have access to the precise statistics, they sense that Corporate America is playing a dangerous game with its affinity for leverage and share buybacks, as we saw in Chapter 12. For those readers who are also not aware of how debt-drenched U.S. companies are, the two charts below are illuminating.
Perhaps the most interesting way to look at how leveraged-up U.S. corporations have become is shown below. This view is one I very rarely come across but it’s equivalent to the price-to-sales ratio in the stock market, which has one of the best track records in revealing under- and overvaluation. It is, basically, a debt-to-sales metric and it is clearly flashing red.
Looking beyond just Corporate America, the USA’s overall non-financial debt (i.e., this excludes the banking system which would lead to double- and triple-counting of liabilities) is at record levels. For sure, other countries are even worse though I’m not sure that’s particularly comforting when it comes to the soundness of the global financial ecosystem. The other image reflects the degree to which the percentage of companies can’t service their debt — despite extremely borrower-friendly interest rates.
Source: Marathon Resource Advisors
This brings me to a meme often expressed that puzzles me. Perhaps you’ve read about it too with perplexity – namely, that the reason inflation has been subdued for so long, until 2021, is that there is a worldwide savings glut. How can that be given the appalling debt statistics shown above? A planet that is sinking deeper and deeper into a debt trap strikes me as coping with the antithesis of a savings glut.
It's fair to say that there are certain components of the world’s economy that are big-time savers. For example, as discussed in earlier chapters, the U.S. consumer has amassed a war chest of about $2 ½ trillion of excess savings since Covid struck. Japanese corporations are another source of bountiful cash holdings, as are Chinese, and most Asian, consumers. However, global governments have run such astronomical deficits for most of the last 20 years — and at an accelerating rate — that they have essentially off-set nearly all of the private sector’s thriftiness. In other words, the next time you hear the words “savings glut”, be very dubious.
Source: EPB Macro Research
A final area of excess indebtedness risks pertains to leveraged loans. This is a non-traded part of the corporate bond market where yield-starved institutional investors, like insurance companies, have become involved to a rapidly growing degree. Even former Fed chair and current Treasury Secretary Janet Yellen has been warning about the mounting dangers in this debt market realm for the past two years. The risks have risen notably since then, but this is what she told the Financial Times in August of 2019: “I am worried about the systemic risks associated with these loans. There has been a huge deterioration in standards; covenants have been loosened in leveraged lending.”
She went on to tell the FT that she feared widespread bankruptcies due to the extensive use of leveraged loans in the next recession. Had the Fed not intervened in the corporate debt markets in March 2020, it’s likely she would have seen her fears realized in less than a year. But that reckoning has been delayed, though certainly not eliminated.
Collateralized Loan Obligation (CLOs), which are packages of leveraged loans, are being created in vast quantities. These are of the same DNA strain as Collateralized Debt Obligations (CDOs) that nearly blew up the entire planetary financial system back in the Global Financial Crisis (GFC). Like the CDOs of yore, the high-quality slices, or tranches as they are known in Wall Street lingo, are often rated AAA. This is notwithstanding the reality that the underlying loans are typically mostly, if not totally, junk. It was this magic alchemy that essentially destroyed AIG back in 2008 when those AAA-rated CDOs crashed to as low as 30 cents on the dollar. (Please see Chapter 4 for a refresher on that fiasco… if you can stomach it.)
Source: Financial Times
There are yet more echoes of the reckless lending and overzealous borrowing that characterized the years leading up to the GFC. Zero-down sub-prime mortgages have made a comeback; lowly rated auto loans are selling like hangover treatments in Vegas on a Sunday morning; and three-quarters of commercial mortgages were interest only leading up to the pandemic, the highest since late 2006.
When you step back and consider the totality of the images and factoids presented in this chapter, it’s hard to suppress a high degree of rage over how our policymakers allowed us to do a return trip to crazy land. The worst part is that it’s even more insane today than it was in 2008. How could they have allowed this to happen? Where are the regulators? How could the Fed possibly have acted as such a blatant enabler of the massive leveraging up of the government and the financial markets?
Yes, bubbles are fun on the way up, but they are horrific during the implosion phase. Moreover, the worst kinds of busted bubbles are those that were inflated by immense sums of cheap borrowed money. This is yet another example of how what we’ve been living through in recent years is truly “The Biggest Bubble Ever”. In the next chapter, I’ll unleash even more on the ultimate perp behind this disaster in the making.
[i] What is happening in the Chinese property market in late 2021 is another example of this phenomenon. Leading residential developer, Evergrande, is teetering on the brink of failure as prices and sales have declined sharply yet the company remains on the hook for its immense debts.
Chapter 16: Behind Every Great Bubble Stands… A Surprised Central Bank
A creature from a crisis past
To kick off this critical chapter, one of the most significant of Bubble 3.0, let me make it clear that I believe the men and women who run the Fed are honorable and well-intentioned. I also believe they need to take responsibility for the chain reaction that I described in the Prologue:
1. Allowing the tech mania in the 1990s to inflate into the biggest equity bubble ever, at least up to that time (Bubble 1.0).
2. In response to the mild recession this crash precipitated, it reduced interest rates to levels last seen in the Great Depression, pumping immense amounts of helium into the emerging housing bubble and failing to rein in exceedingly reckless lending practices (Bubble 2.0).
3. Once that popped, the Fed then resorted to four separate Quantitative Easing programs (one unofficial); then, after Covid hit, it did even greater debt monetization, inflating almost all asset classes to unprecedented overvaluation, setting the stage for the next crash (Bubble 3.0).
Through these interrelated events, the Fed has waged a nearly 20-year war against interest rates, which have now essentially gone the way of the T-Rex, especially on a real basis. It has also continued what was supposed to be a temporary QE program into its second decade. It’s become glaringly apparent to all but the most ardent Fed apologists that it can’t kick the habit of massive stimulus even when a given crisis has passed.
Consequently, it has become a serial bubble-blower. If you don’t believe me, just wait (and also, please see Chapter 17 for asset protection strategies). Now, let’s go back and consider the conditions and attitudes that were prevailing after the implosion of the worst of all bubbles, the type that involves the banking system.
In the immediate wake of the Global Financial Crisis (GFC) — i.e., the collapse of Bubble 2.0 — the Fed’s shock treatment of fabricating one trillion dollars from its Magical Money Machine (the first quantitative easing or QE), created tremendous suspicion among many investors. It was also a factor behind the Tea Party movement that helped moderate government spending, at least for a few years.
The acute angst over this unprecedented money fabrication also revived the fortunes of a book written years earlier called The Creature from Jekyll Island, a scathing attack on the Fed. It became a business book best-seller, despite sounding like the title to a horror film. Based on what’s transpired since then, perhaps that is an apt analogy and, certainly, in the mind of the author the Fed is a financial monster.
You may have a vague recollection of this purported exposé because it attracted a cult following at the time. This was likely a function of its resonance in those days with the mindset of millions of Americans toward the brazen and presumably highly inflationary action by the Fed with its maiden QE voyage. In fact, nearly two dozen prominent money managers, professors, and economists penned a letter to The Wall Street Journal when QE I was first launched asserting it would surely bring about an inflation disaster.
Here’s an excerpt: “We believe the Federal Reserve’s large-scale asset purchase plan (so-called ‘quantitative easing’) should be reconsidered and discontinued. We do not believe such a plan is necessary or advisable under current circumstances. The planned asset purchases risk currency debasement and inflation, and we do not think they will achieve the Fed’s objective of promoting employment.”
In hindsight, these dignitaries were half right; they whiffed on the inflation call but were right about its ineffectiveness on the jobless front. It took many years for the unemployment rate to recede back to where it was prior to the GFC.[i]
Around this time, the author of The Creature From Jekyll Island, Edward Griffin, pulled no haymakers when he discussed his views of America’s central bank before a live audience. To wit:
“I came to the conclusion that the Federal Reserve needed to be abolished for seven reasons. I'd like to read them to you now just so that you get an idea of where I'm coming from, as they say. I put these into the most concise phrasing that I can to make them somewhat shocking and maybe you'll remember them.
1. The Federal Reserve is incapable of accomplishing its stated objectives.
2. It is a cartel operating against the public interest.
3. It's the supreme instrument of usury.
4. It generates our most unfair tax.
(To see the rest of Mr. Griffin’s comments, please refer to the Appendix for this chapter.)
Mr. Griffin contended the Fed’s formation needed to be a furtive event because if Congress got wind of their plans to launch America’s first central bank it would have been highly disinclined to pass the authorizing legislation. That part was most likely true, though I find a number of his points listed above to be truth-stretching, to say the least. But here’s his wrap-up:
“Let's summarize. What is the benefit to the members of the partnership? The government benefits because it is able to tax the American people any amount it wishes through a process which the people do not understand called inflation. They don't realize they're being taxed which makes it real handy when you're going for re-election. On the banking side they're able to earn perpetual interest on nothing.
I emphasize the word ‘perpetual’ because remember when the loan is paid back it's turned around and loaned out to somebody else. Once that money is created the object of the bank is to stay ‘loaned up’ as they say. In reality the banks can never stay 100% loaned up and that ratio varies a lot but the objective is to stay loaned up to whatever extent is possible. Generally speaking once this money is created in the loan process it is out there in the economy forever, perpetually earning interest for one of the members of the banking cartel which created that money. There you have in a condensed form, a crash course, on the Federal Reserve System and I can assure you that you know more about the Federal Reserve than you would probably if you enrolled in a four-year course in economics because they don't teach this reality in school.”
The brief groundswell of interest in The Creature from Jekyll Island rather oddly faded away even as the Fed set sail with QEs II, III, and, unofficially, IV. A rational observer would think that such repeated and ineffectual attempts to restore the U.S. economy to its once trendline real growth rate of 3% to 3.5% would have further enflamed the anti-Fed fires. Yet, except among some of its more dogged critics, such as the aforementioned Jim Grant (a co-signer of the letter to The Wall Street Journal), it didn’t. You might reasonably wonder, why?
In my view, it was one thing and one thing only: a relentlessly rising stock market. Fortunately, for the Fed a bull market is like winning in sports; it’s a wonderful deodorant, as I mentioned in Chapter 12. Similarly, it’s probable that one of the reasons for the popularity of The Creature from Jekyll Island, fleeting as it was, can be attributed to the multi-trillion-dollar hits that people incurred during the GFC. Understandably, they were furious over how much money they’d lost — particularly, those who sold out in terror and missed the screaming rally that came out of the blue on March 9th, 2009.
As previously discussed, it was the suspension of the ill-advised, at least in a panic, mark-to-market rule in March of 2009 that immediately killed the bear and birthed the bull. It was a precursor of what would happen in another March — as in, 2020 — though, in the latter case, at even a more breathtaking speed.
However, as we’ve seen, in the second instance it was the Fed to the rescue, with its radical corporate bond market intervention, not an arcane accounting rule change. And, as I opined at this book’s opening, the Fed could have avoided a tremendous amount of pain — along with over a decade of QEs I, II, III and IV and likely avoiding the need to go into MMT-mode post-Covid — had it used a relatively modest amount of real money (i.e., not printed) to support the credit markets in the fall of 2008. As I’ve observed before, but it bears repeating, one of the smallest interventions the Fed did over the last 20 years was its corporate bond-buying program during Covid. Yet it produced a multi-trillion dollar market rally. It was also a critical factor in causing the shortest recession in U.S. history.[ii]
Perhaps it was because the Covid crash lasted a mere month that another Jekyll Island-like book wasn’t published in its wake. Or, on a related note, maybe it was because the Fed engaged in such creative and immediate support of markets — such as its coup de grace with corporate debt — that it was spared the kind of withering scorn it received from some quarters after the GFC. (However, in early 2022, a much less hyperbolic book criticizing the Fed was published, The Lords of Easy Money, by Christopher Leonard; it is an ideal companion piece to Bubble 3.0).
It might have also been due to the fact that, as described in Chapter 2, the Fed’s fingerprints were all over the housing boom — Bubble 2.0 — and the subsequent bust. Conversely, it was impossible to blame the Fed for Covid (I don’t think even Edward Griffin would allege that!). Regardless, it was spared the kind of vilification it received a decade ago. In fact, the maniacal stock market activity in 2021, especially among the millions of new Reddit and Robinhood “investors”, created a mythical aura around Jay Powell and, even, his three immediate predecessors, as these images reveal.
Figures 1 & 2
“Jay Powell: Our Lord and Savior”
Deification: A fickle phenomenon
Unfortunately for Mr. Powell (aka, JPOW, to his legions of adoring meme stock-trading fans) his halo began to slip a bit during the summer of 2021. This slippage was caused by Mr. Griffin’s fourth cardinal sin enumerated above — inflation — a scourge he correctly referred to as an “unfair tax”. On that score, the following visual, which is a twist on the one shown in Chapter 6, illustrates the reality of this criticism most clearly.
Source: John Goode, Morgan Stanley
Somehow, the Fed managed to convince most of America that 2% inflation was desirable. But, as noted earlier, even that modest level caused about a 45% decline in the dollar’s purchasing power over 30 years. And, most bizarrely, the Fed under three of the four chairmen enshrined in Figure 2 above — Ben Bernanke, Janet Yellen and, of course, Lord and Savior Jay Powell — developed an obsession with 2% inflation. Unlike the Maestro (the far-left image on the mythical Mount Rushmore), who had a much more relaxed, and realistic, attitude toward inflation, oscillating between 1% and 2%, the other three Fed-heads were determined to keep the CPI up at 2%.
In fact, they were willing to expend trillions of dollars the Fed didn’t have to attain what became their elusive “2% Solution”. In the decade after the GFC, it mostly failed in this regard, with the exception of a few truly transitory prints around that magical number. Somehow, 1.7%, or so, simply wasn’t high enough.[iii]
As recently as the summer of 2020, at the Fed’s annual shaker and mover convocation in Jackson Hole, Wyoming, Mr. Powell was begging for higher inflation. Here’s what he had to say:
“Many find it counterintuitive that the Fed would want to push up inflation. After all, low and stable inflation is essential for a well-functioning economy. And we are certainly mindful that higher prices for essential items, such as food, gasoline, and shelter, add to the burdens faced by many families, especially those struggling with lost jobs and incomes.”
The old saying “Pride goeth before the fall” comes to my mind as I reflect on the words by Chairman Powell, and so does another: “Be careful what you wish for; you may get it good and hard.” It’s remarkable that, in such short order, Mr. Powell could go from rooting on higher inflation to becoming among its most prominent victims.
As one of my favorite sources on financial trends, Mike O’Rourke, Jones Trading’s Chief Market Strategist, wrote in November 2021 about these bizarre comments: “In his attempts to micromanage price stability, Powell created price instability and undermined three decades of stable prices.” Accordingly, this is another example of how quickly long periods of prosperity, stability, and sound policies can be undone by government officials pursuing politically expedient objectives or even seemingly well-meaning, but ill-advised, goals.
Mike has also brilliantly referred to the Fed’s rinse-wash-repeat modus operandi as “The Afghanistan of Monetary Policy”. The parallels between the U.S. military’s management of the “Good War” and the Fed’s response to Covid are tight, in his view: “In response to a grave crisis, the powers that be responded swiftly and strongly garnering impressive early results. Despite the success, the leadership did not know when or how to end the emergency intervention… Instead, those powers-that-be erred on the side of caution, resulting in greater and greater investment and entrenchment in their policy response. In both scenarios, the frequently flawed Government logic that bigger is better was repeatedly applied.”
Certainly, when it comes to the Fed’s balance sheet, it has gone big rather than gone home. (Recall that it increases the size of its balance sheet by purchasing bonds with fake money from its Magical Money Machine.) Since the GFC, the Fed’s synthetically acquired holdings have grown by $500 billion per year, an 18% compound rate. This is in comparison to an economy that has grown about 2% per year in real terms or roughly 4% including inflation (nominal GDP). No wonder we had rampant asset price inflation despite a lackluster economy in the 2010s. And then, in 2021, we had a flashback to 1970s-like CPI reports.
As noted at the outset of this chapter, these measures, which we were assured by Ben Bernanke were, in fact, temporary, over a decade ago, have become a permanent fixture. However, their ability to fix anything is highly questionable. In fact, at this point they are likely making a bad inflation situation far worse.[iv]
Yet another irony was that Jay Powell had been beseeching Congress to open the spending — aka, fiscal stimulus — floodgates. He got that one good and hard, too, which is greatly aggravating his inflation problem. The progressive Democratic caucus in Congress and the Biden administration are striving mightily to inject even more trillions of “stim” into an economy that’s already hopped up like the German army was on crystal meth during WWII. (That’s a true factoid, by the way, and, for a time, it fed the myth of the Germanic “super-race”.)
As Gavekal Intelligence Software’s Head of Research, Didier Darcet, has noted, America’s Covid fiscal response has been 30 times the size of the Marshall Plan, in constant dollars. Unfortunately, in this case we didn’t rebuild a war-torn Europe. These staggering outlays have merely been to get our economy a bit ahead of where it was two years ago.
The Fed, of course, has been right up there in the hyper-stimulation department. One quarter of all money created in America’s history came into being in 2020 alone. M2, the primary money supply measure, is at 90% of GDP versus the normal just under 60% ratio. This amounts to over $6 trillion of high-octane money that the Fed has injected in a very short time. Incredibly, despite the “taper” it announced in November of 2021, it was continuing to pump over 100 billion per month into the system at that point. Again, this is all fake money from its… well, you know by now, Magical Money Machine, its very own 3M (not to be confused with the Fortune 100 company known by the same acronym).
Yet, through most of 2021, the Fed assured the world that the string of shockingly high inflation prints seen early in the year were the now-infamous “transitory”. If this was just an uncharacteristic bad call, that would be excusable. The reality, as I’ve brought up earlier, is that it is standard operating procedure for the Fed. Putting aside its aforementioned inability to forewarn of a single recession, and the monstrous miscalculation it made with regard to the housing market in the early 2000s, it consistently overestimated economic growth through the last decade. It also mis-predicted inflation — back then, on the downside. Again, to me, that was a happy event, but the Fed disagreed… and they’re the ones with the printing press!
Courtesy of data-sleuth extraordinaire David Rosenberg, one of North America’s preeminent economists, over the last decade, which includes 110 major economic datapoints, here’s how “well” the Fed has done in the forecasting department:
On its own fed funds rate, it has been correct 37% of the time.
With what it calls core inflation, 29% of the time.
On the unemployment rate, 24% of the time.
Regarding real GDP, 17% of the time.
Clearly, the Fed needs to spend some of its enormous budget on a dart board. Based on the fact that the Fed sets the fed funds rate (hence the name) that one strikes me as particularly pathetic.
David also created the following table showing its forecasting track record around the time of the last six recessions prior to Covid. (In the case of March 2001, the recession started before then, but the Fed missed that one, too.) This takes either some really bad luck or, perhaps, an extreme inability to call a spade a spade. Figure 4
Source: Haver Analytics
Complicity or duplicity?
While the above is embarrassing and confidence-shaking — especially, for an institution which politicians continue to grant ever higher levels of responsibility — what I’m going to cover is far worse. It concerns the Fed’s credibility and, frankly, its honesty.
Yes, I know those are harsh words (though not quite Edward Griffin harsh) but let’s consider the evidence. First off, there is the Fed’s preferred measure of market valuation, what it calls the equity risk premium. Don’t worry — it’s not as esoteric as it sounds. What it does is compare the prevailing yield on long-term treasury bonds to the earnings yield of the stock market. While I’ve covered this before, it’s worth a recap: If the P/E on the S&P 500 is 25 then the earnings yield is 4% (if, as in days of yore, the P/E was 10, the earnings yield would be 10%, an admittedly easier calculation). As I’ve mentioned before, an earnings yield in the stock market is like a “cap rate” in real estate.
The Fed has repeatedly batted away concerns that the stock market is in another bubble by pointing out that the earnings yield is much higher than the interest rate on long-term treasuries. Here’s a typical response to a reporter’s question about overheated market conditions from Lord and Savior Jay Powell, as the mania in meme stocks was raging in early February of 2021: “If you look at P/Es, they’re historically high, but, you know, in a world where the—where the risk-free rate is sustain—is going to be low for a sustained period, the equity premium, which is really the reward you get for taking equity risk, would be what you’d look at. And that’s not at, at incredibly low levels, which would mean they’re not overpriced in that sense.”
Considering that this is Chapter 16 of this book, I’m confident readers can detect a slight flaw in this logic: the risk-free rate, as in the treasury interest rate or the fed funds rate, is set, or at least manipulated, by the Fed! In days gone by, it only controlled the fed funds, or overnight, rate, but, in the wake of more than a decade of repetitive QEs, it also exerts considerable control over longer term interest rates. After all, the roughly $8 trillion of pseudo-money it has whipped up from its MMM since the Global Financial Crisis has primarily gone into treasury bonds. Thus, the Fed doesn’t just have its thumb on the scales, it’s leaning on one side with the full weight of its printing press.
Wait, it gets worse. Later in the same press conference, Mr. Powell threw out this line: “So if you look at what’s really been driving asset prices really in the last couple of months, it isn’t monetary policies. It’s been expectations about vaccines.” His last point is a fair one, except that he uttered these words during the previously mentioned meme-stock insanity that saw GameStop, AMC Entertainment, and BlackBerry ripping 2,385%, 842% and up 326%, respectively, in a few weeks. This was in addition to a litany of other lottery-ticket stocks that experienced moonshot trajectories. To believe that type of hyper-speculative behavior was a result of vaccines, rather than trillions of free money sloshing through markets, is either extremely naïve or exceedingly disingenuous.
But here’s the real clincher — a few sentences later he had the chutzpah to say: “And I think, you know, I think that the connection between low interest rates and asset values is probably something that’s not as tight as people think, because a lot of different factors are driving asset prices at any given time.”
Really? Just a few minutes earlier, Jay, you dismissed fears that this is one of the biggest equity bubbles of all-time, which this author absolutely believes to be the case, by saying prices are justified by low rates (that you created). And then you say it’s not as tight a connection as people think? Oy vey, this is some serious double-talk, even for a politician, which the head of the Fed has clearly become.
There have also been some serious contradictory utterances by Mr. Powell when it comes to what has obviously become the Fed’s number one priority, the unemployment rate. In a July 2021, “presser” he stated that the jobs market was “some ways off from substantial further progress.” Then, a few minutes later, “we’re clearly on a path to a very strong labor market with high participation, low unemployment, wages moving up across the spectrum. That’s the path we’re on and it shouldn’t take long.”
He was right, it didn’t take long. Despite the Delta Variant’s drag on the U.S. economy through the summer of ’21, by October there were a remarkable 500,000 new jobs created. The unemployment rate fell to 5.9% by 6/30/21, 5.1% by 9/30/21, then to 4.2% by 12/31/21%. Coming out of the Great Recession, it took over five years to get down to a 5 ½% jobless rate. Lower unemployment is wonderful but when “we’re clearly on a path to a very strong labor market” and the Fed continues to maintain deeply negative real interest rates, as well as maintaining money manufacturing at a $120 billion monthly rate, an inflation problem is almost a certainty. And, sure enough, as summer turned into fall, the world — and, even, the Fed — began to realize that inflation was not exiting stage left anytime soon. Workers started waking up to the disquieting reality that despite hefty pay increases they were often losing ground to a CPI that was outrunning their raises.
It was more of the same at Mr. Powell’s November 2021 “meet the press” event. Here’s what he said: “If we do conclude it’s necessary to do so (raise rates), we will be patient, but we won’t hesitate.” The Fed is supposed to ooze credibility and gravitas but statements such as that non-sequitur move in exactly the wrong direction.
In a November 2021 Washington Post Op-Ed, former Obama administration Treasury Secretary Larry Summers pointed out that in Mr. Powell’s August 2021 Jackson Hole speech (again, this is one of the Fed’s most important gatherings), he made a “comprehensive and authoritative statement”. It was based on five pillars ranging from his belief that inflation was limited to a few sectors to citing global deflationary trends still being in place. As Mr. Summers methodically addressed, all five turned out to be disproven by subsequent developments.
However, possibly the worst example of the Fed’s increasingly fast and loose relationship with the truth might be related to that highly charged acronym, MMT. First, for those who doubt America is actually engaged in this once fringe economic model, consider the views of billionaire investor Howard Marks, co-founder of Oaktree, as far back as 2020, when MMT was in the early stages of policy implementation: “Possibly without serious vetting and a conscious decision to adopt it, Modern Monetary Theory is here. Whether we like it or not, we’ll get to see its impact much quicker than I thought.”
Like Howard Marks, I thought MMT was coming, but not nearly this soon. For sure, Covid brought on a full-blow version but, as I noted earlier, a stealth version began as early as September 2019. Thus, it started under the Trump administration, but it hit a crescendo in 2021 under the Biden administration and its repetitive multi-trillion-dollar spending programs.
Because, as I explained earlier in this book, there is no way the bond market can absorb all of this supply — unless rates were freely set by profit-seeking investors at much, much higher rates. As a result, the Fed has to fill the role as primary buyer. Of course, this amounts to the debt monetization process previously described in multiple chapters and, hence, de facto MMT.
When MMT was attracting considerable media attention in 2019, two Fed economists stridently warned CNBC of its dangers. They correctly observed that history has taught such policies lead to high, even hyper-, inflation and economic ruin. Yet, U.S. policymakers not only resorted to MMT during the worst of the virus crisis they maintained it even as the U.S. economy gathered significant momentum.
In fact, Chairman Powell himself in early 2019 denounced MMT as “just plain wrong”. If it was wrong in 2019, why did the Fed do $5 trillion of it from 2020 through 2021?
Despite the observations of heavyweights like Howard Marks that MMT is the economic order of the day, there are those who say it’s not really happening. But, as I alluded to early in this book, the most high-profile advocate of MMT is Stephanie Kelton, Bernie Sanders’ economic advisor in his 2016 presidential campaign. She approvingly told Barron’s in July 2020 that the U.S. is behaving in a “more MMT way”. Since then, of course, it’s been acting in way, way more of an MMT way.
Interestingly, as even MMT advocates like Ms. Kelton have conceded, you keep pressing the “More” button until inflation shows up. Well, that certainly happened in 2021 and yet what has been the Fed’s reaction function? Just like the old Saturday Night Live skit with Christopher Walken: “More cowbell!”. In other words, for an economic theory the Fed not long ago held in disrepute, it certainly became an avowed convert and an even more enthusiastic practitioner.
While it’s fashionable these days to turn a blind eye toward MMT and its escalating threats to our nation’s finances, if not its very existence, I refuse to cave into that reckless mindset. This MMT implementation is going to end not just in tears but in anguished sobs, at least for those who don’t recognize it for what it is and prepare accordingly.
Arguably, the finest Fed chairman in its history was Paul Volcker, the great inflation slayer. Long ago, he uttered some words this Fed would be well advised upon which to seriously reflect. “The truly unique power of a central bank, after all, is the power to create money, and ultimately the power to create is the power to destroy.” There is no doubt in my mind Mr. Volcker would believe the institution whose reputation he once rescued is now employing a highly destructive power.
Yet, back on the dissembling topic, Mr. Powell has repeatedly assured us that should inflation become an issue he is prepared to act. As of late 2021 that action, thus far, amounted to the slightest dialing back of the easiest monetary conditions in American history. The reality is that, at this time, the Fed continues to be in the most extreme stimulus mode in which it has ever engaged, other than a few months back. How that squares with anything remotely related to inflation vigilance is a question that perhaps only Mr. Powell — who has repeatedly proven he can maintain two contradictory thoughts simultaneously — can attempt to answer.
What we are witnessing is a gain of function, monetary policy style. In virology, this refers to researchers doing experiments to make a pathogen more contagious and, potentially, more virulent. The Fed’s great experiment with trillions of dollars of debt monetization is already proving to be extremely infectious and increasingly harmful.
Once the dark side of its MMT investigative trial has emerged, the Fed’s predicament became glaringly apparent. David Rosenberg estimated that based on its nearly $9 trillion dollar balance sheet (again, nearly all acquired via its Magical Money Machine), the effective fed funds rate was minus 10%. That number might be overstating how deeply negative its key interest rate was, but it was likely in the general vicinity of accurate.