Comstock Partners, Inc.October 01, 2015
THE CENTRAL BANK BUBBLE II
We would be hard pressed to name an event where the outcome was more closely watched than the 9/17/15 Fed meeting. That was the meeting that was finally supposed to be liftoff from the zero interest rate policy (ZIRP) of the Fed. The Fed held steady, which was dovish, and the market’s reaction was up…for about an hour. Post announcement, the market rallied about 1.7% from low to high before closing down on the day. In the text of the Fed’s announcement was reference to world economic conditions, specifically China, as a reason to remain at zero. That sounded pretty far from the traditional “full employment and low inflation” mandate and the market didn’t like it one bit. One week later Janet Yellen gave a speech where she said that liftoff was likely this year. That more hawkish statement, which came after the close on Thursday 9/24, caused the market to be strong through a good part of the day on Friday…until the market decided it didn’t like it and closed lower. There were also statements from present and former FRB members both for and against liftoff. It seems the market can’t make up its collective mind for good reason, since the members of the FRB and Chairman Yellen can’t seem to make up their minds. In short, the Fed is nearing the end of its credibility “rope”.
Though our viewers are certainly familiar with ZIRP and our thoughts on it, for purposes of historical perspective we have provided a chart (see chart 1; each vertical box = 5%), courtesy of Bloomberg, that shows the upper bound of the Fed Funds target range going back to 1971. Apart from the times in the 70’s and 80’s that the rate rose above 10% and as high as 20% (recall stagflation and Paul Volker’s tough love cure) the vast majority of the time was spent between 3% and 10%. In fact, the rate did not drop below 3% until well after the bursting of the “Dot Com Bubble” in March of 2000. But there is nothing in memory, recent or otherwise, that can match the length or low absolute level of the Bernanke/Yellen ZIRP.
To state in the simplest of terms, our view has been and remains that ZIRP has grossly distorted the allocation of capital investment by supplying credit, in large amounts, to borrowers at the wrong prices (interest rates). Equally importantly are “down the line” savers, who are being punished by zero interest rates and thus have turned to taking risk and speculation. We know people with the attitude that at zero interest rates, to quote several directly, “where else am I going to put my money”, referring to the stock and bond markets. The flip side of chasing yield is to take too much risk and in our view the market is much riskier than it is at normal levels of interest rates because investors have moved farther out on the risk curve as part of a self-re-enforcing process that now depends on the Fed to “keep the party going”.
“Going” is the operative word here. Because where we are going, unfortunately, is into a perfect storm. That storm is what we have referred to as “The Central Bank Bubble”. To be sure it has taken a long time and making of poor decisions by people at many levels, both public and private. This started in our country and now has spread more broadly to both other developed and emerging world countries. Those countries have emulated us by following the lead of our central bank and implementing quantitative easing programs designed to stimulate their economies, but in the final analysis doing nothing but inflating financial assets to bubble levels.
In theory, QE was supposed to work in the following way: Quantitative easing would cause financial assets to go up in price. Then people that held those assets would feel and actually be wealthier and they in turn would spend more. By those wealthy people spending more the economy would grow, jobs would be created, wages and employment would rise and we would all be better off. It was all good except for one thing…it didn’t work. The only thing that happened is that financial assets, real estate and art have gone up to bubble levels.
As we have stated many times, the US and economies around the world are in a secular period of deflation. The deflation has been caused by excess credit provided to governments, corporations and individuals that has grown to levels that are so large that they have become THE headwind for economic growth. In the US, government debt alone is nearing $19 trillion (T) and is over 100% of the last reported $17.9T GDP. When corporate and personal debt is added in, the figure grows to $56T. If that situation were not bad enough when you add in $75T or so for Social Security, Medicare and other unfunded liabilities it is hard to see where this money will come from other than printing, higher taxes and lower spending.
The situation is in fact worse in the rest of the world. World total credit market debt in the past 20 years has grown from $40T to $200T, a 500% increase. In contrast world GDP has grown by a total of $40T in that same time frame. So debt has grown at 400% of GDP on a worldwide basis. Also, included in that number are things like $130 billion (B) of Petrobras debt; which may never be repaid! So like in the US, around the world this deflation will continue as taxes rise, spending falls, defaults rise and financial assets deflate.
Let’s consider our own stock market. It is widely acknowledged that corporate share repurchases have been a major factor in the demand for equities. According to Factset Research S&P 500 trailing 12 month (TTM) share repurchases in Q2 stood at $555.5B, a 1.3% increase YOY. However, TTM free cash flow fell 28.6% to $514B YOY. In other words, not withstanding the fact that energy and financials were main contributors to the shortfall, S&P 500 companies spent more (108%) on buybacks than their free cash flow!
It is also true corporate borrowing has never been higher. Four years ago, corporate bond issuance set all-time records; and has gone up 15% a year since. Said another way, share repurchases have in large part been funded by borrowing. That this debt will need to be repaid is another reason that we believe growth headwinds will persist far into the future.
Normally, debt used to purchase an undervalued asset is not a bad thing but in our view (for many of the reasons above) the US stock market is extremely expensive. Consider the S&P 500 price/sales indicator that we believe shows good correlation to subsequent returns. (See attached charts courtesy of Ned Davis Research). Whether looking at the S&P 500 as a whole (chart 2) or the median company (chart 3), price to sales is at or not far from historical extremes. As can be seen in the charts, those extremes in the past have been at or near significant market tops.
In conclusion we reiterate, as we have in the past, we are in a “Central Bank Bubble”. Actions by the US, Japanese, European, Chinese and lesser central banks have created a worldwide bubble in financial assets that has begun and will continue to deflate in a calamitous manner. Deflation is here. It was precipitated by government and central bank actions and caused prosperity almost exclusively for holders of financial assets only. Many commodities are crashing or have crashed. Countries are devaluing their currencies in a race to the bottom. Companies have bought back over a trillion dollars in stock at high valuations and borrowed the money to do it. Capital investment has suffered and investors have piled into risky assets. As of this writing, 231 companies of the S&P 500 are more than 20% from their highs of the last year while 277 made all time highs in the last year. The markets have started their decent and we expect that drops along the way will be quick and steep. The effect of 80 months of zero interest rates and mountains of debt will not be corrected in a few weeks. We expect equities to remain under pressure for some time before the excesses are corrected.