Submitted by Joe Calhoun of Alhambra Investment Partners,
I think sometimes, with the stock market doing its best imitation of the Energizer bunny, we forget just how extraordinary are the times in which we live. We’ve been lulled to sleep by the relentless and mesmerizing march higher of stocks and all manner of risky assets. Maybe it’s just that having lived through two booms and busts already that people have come to believe that another boom in risky behavior is not just the new normal but the old one as well. And having survived the last two busts, none the wiser apparently, everyone figures we’ll survive the next one too. Maybe. Or maybe people just don’t realize how truly weird things are right now.
I’m guilty of this type of thinking too but it seems like every week I get some kind of reminder that snaps me back to reality. Last week it was an article on MarketWatch about a convicted murderer passing out investment advice while serving a 54 years to life sentence. The article detailed some of his stock picks which included a healthy dose of social media stocks and other tidbits such as his affinity for penny stocks. When the stock market mania has reached all the way to San Quentin, one can’t help but think maybe things have gotten a bit frothy. Stocks are not, as I’ve said more than a few times recently, cheap by any measure but as the market has demonstrated repeatedly in this bull phase, that is no reason prices can’t continue to go higher. The supply of greater fools however is not unlimited and at some point reality and rationality will return, likely with a vengeance.
It isn’t just stock markets that are acting extraordinarily. If anything, debt investors have gone even more bonkers than stock buyers. Leveraged loans, junk bonds and the sovereign debt of governments just about everywhere are trading at prices that incorporate no margin of safety. Banks are lending to companies to buy back stock, an action that increases the risk to existing bondholders (a lot of the bank debt is secured) who seem oblivious to the leverage being taken on to keep the junior part of the capital structure happy. Private equity deals are being struck at unprecedented prices with bonds issued at unprecedented low yields. Merger Monday is back with companies announcing takeover deals struck over the weekend, trying to buy the growth they can’t generate on their own. Having wrung all the excess out of their own operations the only path left for higher earnings and bonuses is to combine with another company, eliminate the duplications and reduce taxes through international tax arbitrage. That is not good news no matter how much it excites existing shareholders and the talking heads of CNBC.
The extraordinary extends to the economy and economic policy as well. The Fed has kept interest rates at zero for 6 years now and their expectations setting forward guidance says 7 is in the bag. For all those who worried that the US might turn into Japan, well worry no more, that ship has sailed. Over a half decade of zero interest rates says we already have become Japan, with the same demographic, productivity and structural problems so well documented. High taxes, a shrinking workforce, offshored production, protection of large incumbent firms, political gridlock, a falling savings rate, a growing xenophobia and an affinity for sushi all point to America as the economic kissing cousin of the land of the setting sun. Turns out the Vapors were not just one hit wonders but keen eyed economic forecasters as well.
The US economy isn’t acting normally, now in the 6th year of an anemic expansion the likes of which we haven’t seen since, well, never. The temptation is to compare this period with the Great Depression but even the recovery from the early part of that self inflicted economic wound was better in some respects. The unemployment rate has fallen but the path of improvement has been a road less traveled in economic history. No matter the reason, full time employment has become an unreachable dream for too many Americans. Multiple part time jobs and underemployment have made debt a way of life, starting with the ubiquitous student loan and throughout life as a way to achieve the perception, the illusion, of success, if not the real thing.
Companies aren’t investing for the future, preferring to spend on the present through stock buybacks and dividends that in many cases exceed their current cash flow, the difference being plugged with debt. Balance sheets are seen as sound by investors who see cash on the asset side of the ledger, forgetting apparently that there is a liability side as well. Where we have seen investment, the returns have left much to be desired. The capital sunk into extracting high cost oil and gas is staggering, approaching $1 trillion per year and $5.5 trillion globally since 2008. What we got for that staggering sum is not a single field that can produce profitably at less than $80/barrel and $4.5 per foot of gas. In some cases, the search for oil has gone to such extremes the breakeven prices are well over $100/barrel. You don’t have to be an Austrian to see that as malinvestment.
I think this acceptance of the extraordinary as usual is just the normal human desire, after the shocks of the last 15 years – economic, social and geopolitical – for, as Warren Harding put it, a return to normalcy. We want to believe that the Fed’s policies will eventually work their magic and bring back the good old days. Recently, the metric upon which everyone has seized as evidence that normal is right around the corner is the renewed uptrend in borrowing, particularly via credit cards. The optimistic explanation is that it is confidence in their future that allows individuals to go out and spend money they don’t have to fulfill desires they didn’t know they had. There are alternate explanations of course – people borrow on credit cards because they don’t have the income to maintain their lifestyles – but we latch onto the one that allows us to continue enjoying the mass delusion of debt fueled prosperity.
A return to normalcy would mean a rejection of the idea that debt is the sine qua non of economic growth. A return to normalcy would mean a recognition that the Fed’s monetary gnomes are the ones who got us in this mess and are therefore wholly unsuited in their role as the economy’s knight in shining armor. A return to normalcy would mean rewarding and recognizing savers as the unsung heroes of economic growth. A return to normalcy would mean a shared prosperity for all rather than just the privileged few with access to the Fed or the ear of their congressional representative.
Achieving the goals of the Fed’s extraordinary policies – full employment and low inflation – would require an extraordinary set of conditions to develop. The economy would have to achieve a rate of growth that has escaped it for years while the Fed would have to extricate itself from a policy regime they barely – and that is generous – understand. I see no reason other than wishful thinking to believe those conditions can be met.