The Cost Of Delusion - Asset Prices & Monetary Policy In An Irrational World

Tyler Durden's picture

Authord by Chris Whalen via The Institutional Risk Analyst,

Almost as soon as it started, the excitement surrounding earnings for financials in Q3 2017 dissipated like air leaving a balloon.

Source: HedgeEye

Results for the largest banks – including JPMorgan (NYSE:JPM), Citigroup (NYSE:C) and Wells Fargo (NYSE:WFC) – all universally disappointed, even based upon the admittedly modest expectations of the Sell Side analyst cohort.

Bank of America (NYSE:BAC), the best performing stock in the large cap group (up 60% in the past year), disappointed with a $100 million charge for legacy mortgage issues.  Despite strong loan growth, year-over-year BAC's net revenue is up about 5% but actually fell in the most recent period compared with Q2 '17.

As with many other sectors, in large-cap financials there was little excitement, no alpha -- just slightly higher loss rates on loan portfolios that are growing high single-digits YOY.  Yet equity valuations are up mid-double digits over the same period.

The explanation for this remarkable divergence between stock prices and the underlying performance of public companies lies with the Federal Open Market Committee.  Low interest rates and the extraordinary expansion of the Fed's balance sheet have driven asset prices up by several orders of magnitude above the level of economic growth, as shown in Chart 1 below.

Meanwhile across the largely vacant floor of the New York Stock Exchange, traders puzzled over the latest management changes at General Electric Co (NYSE:GE), the once iconic symbol of American industrial prowess.  Over the past year, GE's stock price has slumped by more than 20% even with the Fed's aggressive asset purchases and low rate policies.  Just imagine where GE would be trading without Janet Yellen. 

To be fair, though, much of GE’s reputation in the second half of the 20th Century came about because of financial machinations more than the rewards of industry.  A well-placed reader of The IRA summarizes the rise and fall of the company built by Thomas Edison:

“For years under Welch, GE made its money from GE Capital and kept the industrial business looking good by moving costs outside the US via all kinds of financial engineering.  Immelt kept on keeping on. That didn't change until it had to with the financial crisis.  No matter what, untangling that kind of financial engineering spaghetti is for sure and has been a decade long process.  No manager survives presiding over that.  Jeffrey Immelt is gone.”

Those transactions intended to move costs overseas also sought to move tax liability as well, one reason that claims in Washington about “overtaxed” US corporations are so absurd.  Readers will recall our earlier discussion of the decision by the US Supreme Court in January not to hear an appeal by Dow Chemical over a fraudulent offshore tax transaction.

The IRS also caught GE playing the same game.  Indeed, US corporations have avoided literally tens of trillions of dollars in taxes over the past few decades using deceptive offshore financial transactions.  Of note, the Supreme Court’s decision not to hear the appeal by Dow Chemical leaves offending US corporations no defense against future IRS tax claims.

Like other examples of American industrial might such as IBM (NYSE:IBM), GE under its new leader John Flannery seems intent upon turning the company into a provider of software.  Another reader posits that “they’re going to spend a decade selling the family silver to maintain a dividend and never make the conversion they would like and never get the multiple they want.  GE is dead money at a 4% yield, which given some investors objectives – retirees and the like -- might not be such a bad thing.”

The question raised by several observers is whether the departure of Immelt signals an even more aggressive “value creation” effort at GE that could lead to the eventual break-up of the company.  Like General Motors (NYSE:GM), GE has been undergoing a decades long process of rationalizing its operations to fit into a post-war (that is, WWII) economy where global competition is the standard and the US government cannot guarantee profits or market share or employment for US workers.

GE's decision this past June to sell the Edison-era lighting segment illustrates the gradual process of liquidation of the old industrial business.  Henry Ford observed that Edison was America’s greatest inventor and worst businessman, an observation confirmed by the fact that Edison’s personal business fortunes declined after selling GE.  In fact, the great inventor died a pauper.  And of the dozen or so firms that were first included in the Dow Jones Industrial Average over a century ago, GE is the only name from that group that remains today.

But the pressure on corporate executives to repurchase shares or sell business lines to satisfy the inflated return expectations of institutional investors is not just about good business management.  The expectations of investors also reflect relative returns and asset prices, which are a function of the decisions made in Washington by the FOMC.  Fed Chair Janet Yellen may think that the US economy is doing just fine, but in fact the financial sector has never been so grotesquely distorted as it is today.

Let’s wind the clock back two decades to December 1996.  The Labor Department had just reported a “blowout” jobs report. Then-Federal Reserve chairman Alan Greenspan had just completed a decade in office. He made a now famous speech at American Enterprise Institute wherein Greenspan asked if "irrational exuberance" had begun to play a role in the increase of certain asset prices.  He said:

“Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy? We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy. But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy.”

In the wake of the 2008 financial crisis, the FOMC abandoned its focus on the productive sector and essentially substituted exuberant monetary policy for the irrational behavior of investors in the roaring 2000s.  In place of banks and other intermediaries pushing up assets prices, we instead have seen almost a decade of “quantitative easing” by the FOMC doing much the same thing.  And all of this in the name of boosting the real economy?

The Federal Reserve System, joined by the Bank of Japan and the European Central Bank, artificially increased assets prices in a coordinated effort not to promote growth, but avoid debt deflation.  Unfortunately, without an increase in income to match the artificial rise in assets prices, the logical and unavoidable result of the end of QE is that asset prices must fall and excessive debt must be reduced.

Stocks, commercial real estate and many other asset classes have been vastly inflated by the actions of global central banks.  Assuming that these central bankers actually understand the implications of their actions, which are nicely summarized by Greenspan’s remarks some 20 years ago, then the obvious conclusion is that there is no way to “normalize” monetary policy without seeing a significant, secular decline in asset prices.   The image below illustrates the most recent meeting of the FOMC.

The lesson for investors is that much of the picture presented today in prices for various assets classes is an illusion foisted upon us all by reckless central bankers.  Yellen and her colleagues seem to think that they can spin straw into gold by manipulating markets and asset prices.  As Chairman Greenspan noted, however, “evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy.”

While you may think less of Chairman Greenspan for his role in causing the 2008 financial crisis, the fact remains that he understands markets far better than the current cast of characters on the FOMC.  Yellen and her colleagues pray to different gods in the pantheon of monetary mechanics.  As investors ponder the future given the actions of the FOMC under Yellen, the expectation should be that normalization, if and when it occurs, implies lower returns and higher volatility in equal proportion to the extraordinary returns and record low volatility of the recent past. 

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yogibear's picture

"Yellen and her colleagues seem to think that they can spin straw into gold by manipulating markets and asset prices..."

So far it's worked.

Many people believe gold is a worthless relic and that you create wealth by printing and BS.

Kidbuck's picture

More like stripping the middle classes' purchasing power and turning it into loot for the banksters.

Stuck on Zero's picture

Companies used to be ranked by their number of employees, the quality of products they made, social responsibility, and industrial might. Now companies are ranked by stock price only. Yech.

runnymede's picture

We are in the looting stage of the operation. Legal, institutionalized government protected theft. Bankers are the greatest criminals in history. 

And there's no one to restrain them.......

A. Boaty's picture

"Henry Ford observed that Edison was America’s greatest inventor and worst businessman, an observation confirmed by the fact that Edison’s personal business fortunes declined after selling GE. In fact, the great inventor died a pauper."

Ford and Edison had a joint venture to build electric cars. A mysterious fire at Edison's battery factory ended that idea.

nscholten's picture

The Edison battery last 100 years

Mcguyver's picture

I disagree. Ford played checkers Edison played chess.

 

While ford relied on patents (look how that worked out) prior to releasing his technology Edison staked mining claims where minerals needed to build his revolutionary findings were found. There are mine shafts still in use that Edison was behind - in other countries.... 

Stan Smith's picture

In other news, water is wet.

taketheredpill's picture

GE's decision this past June to sell the Edison-era lighting segment illustrates the gradual process of liquidation of the old industrial business.  Henry Ford observed that Edison was America’s greatest inventor and worst businessman, an observation confirmed by the fact that Edison’s personal business fortunes declined after selling GE.  In fact, the great inventor died a pauper. 

 

No. He was worth $12 Million when he died in 1931.


cheech_wizard's picture

Must have been thinking of Tesla who died a pauper.

Edison, not so much...

 

ffed's picture

DELUSIONAL Las Vegas Shooting Witness says he was in the 1st row of the aldean concert.  BULLSHIT!!!!!!!

https://www.youtube.com/watch?v=3qeJ-nJMXSc&lc=z22guzxhiu35hbn1zacdp43bc...

asteroids's picture

The twin forces of demographics and debt will eventually catch up with these jokers. You can't print your way out of what's coming.

GunnerySgtHartman's picture

We're going to see more large companies break themselves up - er, "unlock value" - to satisfy the inflated expectations of certain investors.  There is a plethora of rumors that Daimler will break itself up in the not-too-distant future given its announcement that it will make Mercedes and Daimler Trucks freestanding units.

Bottom line: everyone else gets screwed (surprise, not!).

runnymede's picture

Everything is skewed by fiat money and fractional reserve banking.

The altar bankers worship at is a professional counterfeiting operation. And the God they worship is debt. And don't they just love to give us their God.

Maybe their God will save them when its piano wire time.