The Biggest Bubble Inside The Biggest Bubble Ever
Chapter 11, Part I
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.
Figure 1
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.
Figure 2
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 “produce” 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.
Figure 3
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 US. 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.
Figure 4
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, mortgages rates at that level would be considered usurious in Europe!
In The Wealth of Nations, published the year of America’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.
Figure 5
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.
Figure 7
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.
Figure 8
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.
Figure 9
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 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.
Section II To Be Released March 3rd
[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 the 17th century, 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.