“Most valuation parameters are either the richest ever or among the highest in history. In the past, levels like these were followed by downturns. Thus, a decision to invest today has to rely on the belief that ‘it’s different this time.’ I’m convinced the easy money has been made.” (Howard marks, Oaktree Capital, WSJ, 1/29/18).
The legendary investor, Baron Rothschild famously said, “I got wealthy never waiting for the peak.”
There is no bell that rings at the top of the market. And, when today’s market does turn down, liquidity is going to be a big problem. Till now, liquidity from worldwide central bank accommodative policy, has poured into the investment markets. Vanguard, alone, took in a record amount of cash in 2017, with most of it going to passive index funds. That trend continued in January, as individual investors put $33+ billion into ETFs and mutual funds the week ended January 24th, the biggest inflows for a seven-day period looking at data going back to 2002. The question is, what happens when something does cause a correction? Who will be the buyers? Will the ensuing rush for the exits exacerbate the correction? Won’t those who have salted away some cash be able to take advantage?
Markets rise like an escalator, but fall like an elevator. Once an investor realizes that the peak has already been put in, it is too late. Remember the Wall Street saying: “the public buys the most at the top and the least at the bottom.”
The narrative on Wall Street is that the tax package will spur the economy. There is fierce debate as to how strongly the economy will respond. That remains to be seen, and I won’t debate that in this blog. What is clear, however, is that, given current valuations, the market has already priced in a significant growth premium from the tax legislation. In past blogs, I have discussed why the long-run growth path for the economy is 1%-2%. Those demographic and business conditions (low savings rate, high debt, pulled-forward demand) still exist. But, today’s equity market is priced for significantly higher economic growth rates. Studies of mean reversion and historical returns after significant market melt-ups all point to long periods of low returns that follow.
Monetary Policy History
“Inflation is always and everywhere a monetary phenomenon.” (Milton Friedman)
As a student of monetary history, it appears that, in the post-WWII period, the Fed has had its thumb prints on every expansion and on every recession. This includes the bull and bear markets that accompany those. Sadly, this expansion and bull market are no exception. The accommodative policies of the Fed and the world’s other major central banks (Bank of England, Bank of Japan, and European Central Bank), policies that expanded their combined balance sheets by 16% in 2017 (markets rose 20%) are the primary cause of the sky high equity market valuations.
There appears to be little “inflation” in today’s economy, but only if it is measured as the prices of consumer goods and services (using the CPI or the PCE (Personal Consumption Expenditure index)). The fact that “inflation” hasn’t shown up in the limited world of consumer goods and services doesn’t mean it didn’t occur. The money created by the central banks has to go somewhere. It has gone into the prices of investments (stocks and bonds), raising equity valuations and crimping bond yields. It is my view that central bank accommodation has long overstayed its usefulness as an antidote for recession and has now become a bubble machine. Consider the following:
• The economy has been officially performing below the “full employment unemployment rate” of 4.6% for nearly a year; that rate is called NAIRU in economic parlance (Non-Accelerating Inflation Rate of Unemployment). It means that at an unemployment rate below 4.6%, the economy is subject to an accelerating inflation rate. While we haven’t seen inflation appear in the official definition of consumer goods and services, I and others contend that is has appeared as upward pressure on the prices of investment assets. (David Rosenberg measured the 2017 rate of inflation using the performance of the various stock market indexes assigning the same weights as in the CPI – the rate of inflation was calculated as 35%!)
• The output gap (the difference between where the economy has been performing and its potential) has been closed for the last two quarters.
Despite the above, Fed policy has never been as accommodative at this stage of an expansion as it is today. The real rate of interest (the Fed Funds Rate less inflation) is still significantly negative, between -0.75% and -0.25%. (The Fed Funds target rate is between 1.25% and 1.50%, and inflation running near 1.75%-2.00%.) The reason for the continued accommodation is, ostensibly, that inflation (measured by CPI or PCE) is too low. The Fed’s target is 2%, an annualized level that hasn’t been seen in any month for more than 5 years, and not for 90% of the time over the past decade. The economy has been operating at full capacity for nearly a year, and the Fed is moving more gradually today than it did in 2005-06.
What is Magic About 2%?
That 2% inflation target was set in 1996 and hasn’t been altered for more than 20 years. Meanwhile, the economy has undergone a significant metamorphosis (demographic, competitive, attitudinal, technological…). The inflation target appears to be inappropriate. What is really magic about 2%? If the target had more appropriate been moved lower as the economy morphed, to say 1% or even 0%, then the Fed would have, long ago, moved rates higher and significantly reduced its bloated balance sheet.
The only rational conclusion is that inflation has occurred somewhere – just not in the consumer sector. But, the investment markets are clearly in a bubble.
Of course, Wall Street doesn’t want the Fed to take the punch bowl away, and markets are behaving as if they never will. Why not? The Fed was late in removing it at the turn of the century (dot.com) and in the housing bubble. But, remove it they did, and each time there was a significant and powerful reaction in the investment markets. Ignore history at your own peril.
The Fed Chairs
On December 5, 1996, when he uttered those famous words, “irrational exuberance,” then Fed Chair Greenspan was excoriated by the financial media. He quickly backed off and continued accommodative policies. The result was the dot.com bubble.
Bernanke, now infamous for telling us that sub-prime mortgages weren’t an issue just a few months before the financial meltdown, also relied on the “wealth effect” to support the economy. The wealth effect occurs when the prices of real and financial assets rise, making the owners of such (usually the more well off) more confident and more willing to spend. The wealth effect has long been recognized in economic theory, but it was always considered a much weaker policy tool than deficit spending or tax cuts because the marginal propensity to consumer of the wealthier class is much lower than lower classes in the social strata.
Yet, Quantitative Easing (QE) was a policy whose ultimate objective was this very “wealth effect.” There were three QEs, the last one coming long after the ’09 financial melt-down was in the rear view mirror, but clearly Bernanke used this to shore up Wall Street and financial asset prices. In fact, Bernanke penned an op-ed in the New York Times in the immediate aftermath of QE1 stating this.
It also appears that the Janet Yellen Fed has been a Wall Street supporter. Like Greenspan, Yellen had concerns early in her tenure as Fed Chair which began in February, 2014. In July of that year, she said “valuation metrics in some sectors do appear substantially stretched.” At that time, the S&P 500 stood near 1975 and the trailing PE ratio was 18x. In her last press conference, December 13, 2017, she said (incredibly) “…when we look at other indicators of financial stability risks, there is nothing flashing red, or possibly even orange.” Wow! Today, the S&P 500 is near 2870 and the trailing PE ratio is 23x! But nothing is even flashing orange!
The Jerome Powell Fed
Because he has said very little that could be interpreted as policy input during his nomination period, and, thus, nothing controversial, Wall Street has assumed that Powell is a clone of Yellen, Bernanke, and Greenspan, and that monetary policy will continue to be accommodative even as the economy operates above potential and as some inflation inevitably appears in the drum tight labor markets. Whether he is such a clone, or not, remains to be seen. Perhaps, though, we should look at his background and past statements. Unlike Yellen, Powell is not an economist by training, nor has he been a long-time Fed employee.
• October 2012 (S&P 500 = 1400): “I think we are actually at a point of encouraging risk taking and that should give us some pause.”
• April, 2015 (S&P 500 = 2085): “I would be … concerned… that more-accommodative policy could lead to frothy financial conditions and eventually undermine financial stability.”
• January 2017 (S&P 500 = 2270): “It is not the Fed’s job to stop people from losing (or making) money.”
Will Powell, like Greenspan and Yellen, back off from these statements about market valuation? That remains to be seen. But his statements should give investors some pause.
In fact, there is already talk in the Fed Watcher club about a change in the way policy is viewed. Instead of the 2% inflation target, there is discussion of a wider range, say 1% to 3%, which would give the Fed much more flexibility. Had such a policy been in place for the past half decade, perhaps the Fed would not have remained as uber-accommodative, and wouldn’t be faced with the prospect of having to play “catch-up,” with dire implications for Wall Street and ordinary investors.
Just to reiterate, one year ago, at the meetings of the American Finance Association, today’s new Fed Chair, Powell said: “It is not the Fed’s job to stop people from losing (or making) money.” If he believes this and the Fed now carries out policy without regard to investment markets, Investors – beware!
Robert Barone, Ph.D.
Robert Barone, Ph.D. is a Georgetown educated economist. He is a financial advisor at Fieldstone Financial. www.FieldstoneFinancial.com .
He is nationally known for his writings and Robert’s storied career includes his having served as a Professor of Finance, a community bank CEO and a Director and Chairman of the Federal Home Loan Bank of San Francisco. Robert is currently a Director of CSAA Insurance Company (a AAA company) where he chairs the Finance and Investment Committee. Robert leads the investment governance program at Fieldstone Financial, is the head of Fieldstone Research www.FieldstoneResearch.com, and is co-portfolio manager of the Fieldstone Financial Fixed Income ETF (FFIU).
Statistics and other information have been compiled from various sources. The facts and information are believed to be accurate and credible, but there is no guarantee as to the complete accuracy of this information.