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By Adam English 2013-12-31
Here we are, at the last day of a year that has defied all the odds.
The Dow and S&P 500 have posted out-sized gains in spite of what can generously be called tepid economic growth.
The regional governors and economists over at the Fed are undoubtedly enjoying the afterglow of their resounding success with the latest tapering announcement a couple weeks ago.
Investors, banks, and policymakers are most likely enjoying their holiday vacations while planning what to do with the fat bonus checks that are en route.
Of course, the disenfranchised poor are worse off than ever. Millions just lost their only source of money for food, and millions more are stuck in a downward spiral of debt traps and part-time work.
But these downtrodden masses don’t have any money to pour into the markets to boost gains. To the market and policymakers, they were only included when it came time to package self-enriching schemes in populist rhetoric.
Tomorrow, it’ll be time to start thinking about the next set of yearly returns, and none of the big players are worried.
Next year promises more of the same in their eyes. The Easy Money Battle of 2013 was won.
Unfortunately, many of them don’t see that it was a Pyrrhic victory. The cost is already too high to succeed in the end.
A Terrible Record
Clearly, the temptation in the market is to take the latest Fed announcement and ensuing rally as a call to double down on wildly bullish sentiment as 2014 starts.
I have little doubt that we’ll see this shaken out of the market sometime in the first half of next year. When you take a look at the Fed’s record on tapering announcements, it doesn’t look good.
By my count it has one win, one tie, and five losses.
The first mention of winding down QE programs came back on May 22nd. Hints of a reduction in stimulus measures in the Federal Open Market Committee (FOMC) minutes caused an immediate 1% drop in the Dow and a volatility spike.
On June 19th, there were no taper hints. Ben learned his lesson. However, the markets still knew it was imminent. The Dow closed down 1.3% while the S&P 500 fell 1.4%.
July’s announcement caused a 0.7% drop for the Dow and another volatility spike.
September was an aberration and a virtual tie because the government shutdown distracted everyone.
October saw no date set for a taper. There was some volatility and a slight dip in the markets for the afternoon.
Then on December 18th, the November FOMC minutes were released, causing a 290-point gain in the Dow and exuberant front-page headlines.
It’s clear the Fed’s record is pretty abysmal, filled with fumbles and confusion. But the trend appears to suggest that the markets have made peace with the idea. At least on the surface.
So what changed over time?
The overall tone of the statements and Bernanke’s remarks suggests that the Fed is still very “dovish” and willing to err on the side of caution. That helped, but it isn’t enough on its own.
In reality, the folks at the Fed spent the last half-year scratching their heads trying to figure out how to make a taper palatable to the markets. The result was a massive concession in how the taper would proceed.
The Fed now intends to hold interest rates at historic lows past the point when the unemployment rate falls to 6%. This is a large adjustment — over 1% lower than in earlier statements.
The flow of easy money into corporations has been extended through most — if not all — of 2014.
Wall Street could take or leave the $10 billion per month trimmed from bond purchases as long as the virtually free money guaranteed by low interest rates keeps flowing with no real end in sight.
Corporate Cash Cow
The rate banks pay on overnight loans, or the federal funds rate, was at 4.5% in late 2007. As the recession bit into the economy, it was slashed to 0.25% and has stayed there ever since.
Long-term rates quickly followed suit and fell from over 5% in 2007 to record lows near 1.5% in the second half of 2012. Since the beginning of 2013, 10-year Treasuries have crept back to 3%, still well below normal levels.
Corporations capitalized on the low interest rates by issuing $18.2 trillion of bonds worldwide since 2008. Currently outstanding corporate debt has risen over 50% to $9.6 trillion over the same period.
Many of these loans were simply created to push corporate debt obligations out as far as possible. Instead of using them to create growth, it just delays loans from maturing until 2017, 2018, or 2019.
Interest paid by U.S. businesses peaked in 2007 at $2.83 trillion, and then it fell sharply to $1.34 trillion in 2011, the last year data is available from the St. Louis Fed.
At the end of the recession in 2009, companies listed on the S&P 500 paid roughly $4 a share in interest per quarter. Now, they are paying around $1.50 a share in interest on average.
These dramatically lowered interest rates account for an estimated 50% of total profit growth, not including indirect savings from lower leasing or rental costs.
Stock buybacks using debt-fueled funding have also been very popular and have provided quick boosts to stock prices and created earnings per share increases that are not based on growth or performance.
In fact, earnings have tripled since 2000, back when the economy was in far better shape.
The Fed has created a massive boom for corporate America through historically cheap debt and that is what the markets wanted to keep most of all. The Fed capitulated and the markets rejoiced.
Meanwhile, the EBITDA margin (earnings before interest, tax, depreciation, and amortization divided by total revenue) operating profitability peaked at 25.6% in late 2007 and recently fell below 20%.
Of course, this can’t possibly last in perpetuity. Debt will become more expensive, and payments will eat into profit margins.
We have not seen the last time the Fed will disappoint markets, create a volatility spike, and ultimately drive losses for investors.
Still On Shaky Ground
Going forward, the Fed and anyone in the market have a handful of things to remember that should temper the irrational exuberance we’re seeing in the market.
First, Fed policy is overly dependent on creating artificially high asset prices to alter economic behavior for investors and companies. The economy has not substantially improved enough to subsist on meaningful corporate growth, consumer spending, or housing sales.
Secondly, the impact of easy money through abnormally low interest rates is hard to quantify, especially in the short-term. Bullish markets that overextend their gains on very uncertain stimulus will inevitably see very disruptive corrections.
Finally, the Fed is not the only central bank that is actively pushing asset prices higher and fighting to maintain economic and financial stability. China, Japan, and Europe are all using extraordinary measures to intervene.
If any of these major economies see demand that is too weak, experience corporate or bank liquidity and credit crunches, or fail to juggle sovereign debt, the domestic economy will take the full brunt of the blow.
The Fed has fully deployed all of its tools to spur growth while expanding its balance sheet by about $4 trillion with little real effect. Economists put the total return for the Fed’s intervention as low as 0.25% of GDP.
As we close the books on 2013 with large gains for the markets and on a high-note for the Fed, we know what to expect for now. The Fed will have to continue pushing you to put your wealth into the market, and the big players will keep holding the rallying market hostage as they rake in massive profits.
However, the cost has been too high. The Fed may push the day of reckoning well into 2014 or beyond, but there is no way around the correction and burden it will place on us all.
I didn’t study business before I became a business reporter. I studied architecture, and of all the knowledge I acquired the most important was that I was not destined to be an architect.
Journalism was a lucky accident, born of necessity, and business journalism even more so. The underdog paper that would hire me in 1994 was the Financial Post and so I dove into the world of business.
From the beginning, I admired the untidy elegance of the way an economy functions. I believed in and even came to revere the importance of markets — that is, well-oiled machines whose only real job is to set prices.
Markets work to ensure that resources are allocated efficiently. Accurate prices are at the heart of that efficiency and the result isn’t some remote or arcane thing, it is prosperity and happiness for humans. Well-priced markets are essential. Fairness is essential.
‘Whenever it is possible to fix a price for personal gain, someone is doing it’
Over time, I watched a number of changes take place aimed at levelling the playing field. From the long ago days when stocks were traded by a group of men who met under a buttonwood tree in lower Manhattan, to a game that is pitched to grandmothers — “Manage your own money! You too can be wealthy!” — the rules have changed.
In the late 1990s, as technology stocks bubbled to a temperature that would burn some investors for a decade or more, rules about fairness of pricing were implemented. The point of the most important such rule, known as Regulation Fair Disclosure, was that insiders — or the “smart money,” as professional money managers are sometimes called — shouldn’t have an unfair edge in the form of access to information. Prices are only perfect if all information is priced in and the more participants there are to that process, the more pristine the outcome. Or so the thinking went.
How naive that view now seems. How innocent. Because for the last two years, as the globe staggered back to its feet in recovery from the body blow delivered by fast moving investment banks that lost sight of basic risk management policies, the number of examples of ways in which the markets are rigged are too numerous to count.
Each one seems more shocking than the last.
Insider trading, as old as the hills, is now a billion-dollar enterprise at certain investment funds and part of the culture of many. Investment banks may be gaming the price of some commodities, with a subsequent cost that reaches every corner of the planet. Currency traders collude with each other to make tiny profit on their trades, writ large over billions of executions.
The system is rigged
Then the most shocking of all, a key international interest rate used to set trillions of dollars of prices, is being manipulated. LIBOR, the London Interbank Offered Rate, is like the foundation of a house that holds billions of people. If that foundation is askew — as we now know it was — what does that say about huge parts of the markets and those prices we thought were based on real information? A mirage.
For this business journalist, the shock of that was intense. There will always be fraudsters — smooth-talking snake oil pitchmen — and regulators are on the lookout for them. But the evidence is mounting that whenever it is possible to fix a price for personal gain, someone is doing it.
That’s not just a disappointment; it undermines the entire system. Tiny price distortions get magnified across the global economy. We all pay, even if we don’t really know it. Most important, if market participants — from a sophisticated bond trader trying to price a bond based off a benchmark rate, to your grandmother putting her life savings into a stock — don’t believe in its fundamental soundness, don’t believe that prices are as fair as prices can be, the entire thing falls apart.
It happened in Holland in the 17th century, when tulip bulbs became an irrational bubble. It has happened often in fact, in tiny pockets, from land in Florida to London Bridge. The outcome of those incidents is distrust and an unwillingness to invest there again.
So what is the outcome if those kinds of mispricings are everywhere? That’s a thought too stark to contemplate. Better that investors — the “dumb money” that is you and me — sit up and take notice before it’s too late. If indeed it isn’t already.
Whether the light at the end of the economic tunnel represents sunshine or an on-coming train depends on whom you ask. I am of the opinion that it is a train a comin’. Economic matters cannot get better until we hit bottom and rebuild from the ashes. That need not be except government policies drive us there.
Government, especially the current one, has incented people to not work by providing overly long and generous benefits. Society has an obligation to take care of its less fortunate, but it does not have an obligation to encourage people to join that group and then make it comfortable enough that they have little incentive or ability to leave. The dole should not be a safety net, not a career choice!
One political party in particular has interest in seeing dependency grow. It forms a substantial part of their support and power. The creation of more dependents is the creation of more voters and more electoral success. No society can grow or recover when government deliberately undermines the need to work. That path leads to poverty and destruction.
Printing money is no substitute for effort. It does not create things or wealth. The myth of Keynesian economics is not the answer to a society that declines in labor force participation and has fewer productive people supporting more dependents. Incentives at the individual level must be changed in order to make work more desirable and attractive than welfare.
A society whose workforce is in decline is one that can pretend to live at former levels only by consuming the wealth and capital created by previous generations. This behavior is equivalent to the man who used to make $250,000 per year in a job and now is unemployed. To save face, he continues to live as if he is still earning at his previous rate. He achieves this short-run living style only by consuming the capital that he built up from years of hard work. At some point, he runs out of capital and must live as a pauper (or the modern equivalent of one).
Our economy and government both behave like this formerly rich man. Both are consuming the seed corn in order to maintain the appearance of well-being. Politicians will continue this behavior until the music stops. Hopefully when that happens there is enough left of society and freedom to allow a rejuvenation.
Many believe that government and its partner the Federal Reserve are wise and strong enough to avoid this crash. If printing money and spending money were a solution, there would be no poverty anywhere in the world. Even the poorest country has a government and can afford a printing press.
Thus far there has been no collapse. However, that is equivalent to the man who jumps off the Empire State building and is heard to say as he flashes by the fortieth floor: “So far, so good.” His fate was sealed when he jumped. Similarly, so is our economy’s. Economics has its own gravity. It is as powerful and immutable as that of physics.
“So far so good” is not acceptable for an economy. There has been no economic recovery since one was falsely declared in June of 2009. The distortions and mis-allocations imposed on the economy for the last several decades are cumulative and have finally reached that stage where they can no longer be covered up. The myth of a recovery is getting harder to maintain.
A complete cleansing of the mal-investments, distorted incentives and regulatory burdens must occur before a true recovery can take place.
Can the economy flutter around is some kind of air pocket at the fortieth floor for a year or even several before resuming its destiny with terra firma? Perhaps, but it cannot fly without wings and these have been removed by regulatory interference and economic interventions over the course of decades. They can re-grow, but not before a complete and total cleansing.
A major crash is coming. The dot.com bubble and the housing bubble were not crashes, at least as I imagine a crash. They were the beginnings of corrections that were aborted by government economic intervention. The country survived these two major bubbles, but only at the cost of making the next one bigger. Government did not save us from these two events. They created them and by deferring their correction assured the next one would be bigger and more painful.
The video below shows a train moving down a track. It struck me as a reasonable metaphor for our economy. The train represents market forces, slow but powerful. The train does not appear threatening. But, like markets, it represents a massive force. That the video is in slow motion exaggerates the surprise and the force.
Government may believe it is in control of the economy, but it is not. It may think it is influencing and controlling outcomes. To some degree it is and has. However the forces that have built up over decades of these interventions cannot, at some point, be controlled. The mismatch between Ben Bernanke, Barack Obama, the Federal establishment and all their dollars and regulations is about to be run over by the train that represents decades of suppressed market forces.
No government is a match for hundreds of millions of citizens who are represented by markets. Suppressing markets is suppressing the will of citizens. At some point markets dig in their heals and say enough. Then government is helpless.
While the world of mainstream media stock pundits would like investors to believe that there is a wall of money on the sidelines waiting anxiously to go all-in on stocks (bear in mind there’s a seller for every buyer and where does the cash on the sidelines go when it is handed over to the seller in return for his stock?), as none other than Charles Schwab notes in this brief Bloomberg TV clip, “investors are less rattled” than most believe, “and have stayed invested” in large part. “There hasn’t been a wholesale movement away from stocks,” he goes on, busting myths asunder, adding that “investors want to see market-driven conditions, not Fed manipulated ones.”
So perhaps – just perhaps – Schwab is right, if the Fed stepped away and let markets be markets once again, maybe real capital would flow once again?
Schwab goes on to discuss how the Fed’s policy has hurt the older generation – “it has been a terrible thing”
Beginning at around 50 seconds, Schwab calmly dismisses one of the biggest market myths and raises a few red flags – “we see the market go up or down depending on which Fed member is speaking…”
Draghi introduced additional ease into Europe this morning.
A surprise rate cut (67 of 70 economists did not see it coming, which provides a proxy IQ test for these geniuses) created turmoil in markets.
What this means by noon today is unknowable. What it means in a larger context is not:
- Europe is not in good shape. Anyone who believed they were, should be disabused of such notions.
- The forcing down of interest rates once again further exacerbates the longer-term mis-allocation of resources. Such actions may buy time, but only at the cost of greater problems down the road.
- Maco-economics is failed witchcraft which should be apparent to anyone paying attention. Yet it will continue to be used to justify “remedial” actions out of desperation.
- Governments around the world have only this hammer (liquidity/stimulus). They will hammer away even though that cannot solve the problem(s).
- Liquidity and stimulus will not end in the US or Europe until markets end it. The market ending will be either an implosion or a crack-up boom. Either is possible at this stage.
- Governments are in full pretend mode. They have no control over the situation other than to fool people into believing that things are getting better.
- The policies employed by governments ensure the destruction of economies and themselves. Governments spiral downward toward defaults and bankruptcy that will take economies with them.
- Currencies are being destroyed in terms of purchasing power.
- Nothing is being done to correct economic problems. Politics has deemed true remedies too severe. They are off the table, replaced by extend and pretend actions.
- The shelf-life of this government fraud is limited. Economic Armageddon is coming.
The frustrations of watching this play out are huge. So too is the knowledge that this entire scheme jeopardizes more than living standards and economies. It threatens the very future and quality of civilizations themselves.