The Greatest Bubble Ever: Why You Better Believe It - Part 1

Authored by David Stockman via Contra Corner blog,

During the 40 months after Alan Greenspan's infamous "irrational exuberance" speech in December 1996, the NASDAQ 100 index rose from 830 to 4585 or by 450%. But the perma-bulls said not to worry: This time is different----it's a new age of technology miracles that will change the laws of finance forever.

It wasn't. The market cracked in April 2000 and did not stop plunging until the NASDAQ 100 index hit 815 in early October 2002. During those heart-stopping 30 months of free-fall, all the gains of the tech boom were wiped out in an 84% collapse of the index. Overall, the market value of household equities sank from $10.0 trillion to $4.8 trillion----a wipeout from which millions of baby boom households have never recovered.

Likewise, the second Greenspan housing and credit boom generated a similar round trip of bubble inflation and collapse. During the 57 months after the October 2002 bottom, the Russell 2000 (RUT) climbed the proverbial wall-of-worry----rising from 340 to 850 or by 2.5X.

And this time was also held to be different because, purportedly, the art of central banking had been perfected in what Bernanke was pleased to call the "Great Moderation". Taking the cue, Wall Street dubbed it the Goldilocks Economy----meaning a macroeconomic environment so stable, productive and balanced that it would never again be vulnerable to a recessionary contraction and the resulting plunge in corporate profits and stock prices.

Wrong again!

During the 20 months from the July 2007 peak to the March 2009 bottom, the RUT gave it all back. And we mean every bit of it----as the index bottomed 60% lower at 340. This time the value of household equities plunged by $6 trillion, and still millions more baby-boomers were carried out of the casino on their shields never to return.

Now has come the greatest central bank fueled bubble ever. During nine years of radical monetary experimentation under ZIRP and QE, the value of equities owned by US households exploded still higher----this time by $12.5 trillion. Yet this eruption, like the prior two, was not a reflection of main street growth and prosperity, but Wall Street speculation fostered by massive central bank liquidity and price-keeping operations.

Nevertheless, this time is, actually, very different. This time the central banks are out of dry powder and belatedly recognize that they have stranded themselves on or near the zero bound where they are saddled with massively bloated balance sheets.

So an epochal pivot has begun----led by the Fed's committement to shrink its balance sheet at a $600 billion annual rate beginning next October. This pivot to QT (quantitative tightening) is something new under the sun and was necessitated by the radical money printing spree of the past three decades.

What this momentous pivot really means, of course, is ill understood in the day-trading and robo-machine driven casinos at today's nosebleed valuations. Yet what is coming down the pike is nothing less than a drastic, permanent downward reset of financial asset prices that will rattle the rafters in the casino.

This time is also very different because there will be no instant financial market reflation by the central banks. And that means, in turn, that there will be no fourth great bubble, either. Here's why.

PART 1

In the first instance, the market is not merely complacent; it is insouciant-----indulging in an eye-wide-shut orgy of recklessness that truly has no parallel, not even the mania of 1927-1929.

That's implicit in Wall Street's dismissal during 2017 of two fundamental policy messages that emerged from Washington officialdom. These signals strike at the very heart of the current stock market mania and scream-out "rising yields ahead" to a casino that has "priced-in" ultra-low interest rates as far as the eye can see.

To wit, the Fed is now on automatic pilot---set to drain cash from the canyons of Wall Street at a $600 billion annual rate by Q4. At the same time, the political goulash known as Trumpian government has thrown fiscal caution entirely to the winds, and has essentially now enacted the most asinine fiscal borrowing spree known to history.

As we have recently pointed out, ground zero of the impending bond market conflagration is FY 2019, which incepts exactly 276 days from now during the same window of time (Q4) as the Fed hits full stride on its bond dump-a-thon. Yet on top of CBO's most recent but now obsolete FY 2019 deficit deficit projection of $700 billion, the Trumpian GOP is adding $200 billion for defense, disasters, border control, ObamaCare insurance bailouts and other domestic boodle; and on top of that, now comes its vaunted front-loaded tax cut, which will rip $280 billion out of Uncle Sam's revenue collections in the same year.

Then, throw in $100 billion extra for interest on the higher debt and off-budget borrowing (e.g. $80 billion for student loans). What you get is Uncle Sam fixing to sell $1.28 trillion of debt---equal to 6.2% of projected GDP---at the same time the Fed is dumping another $600 billion of existing treasury and GSE paper.

Folks, they most assuredly did not repeal the laws of supply and demand. Indeed, as we stumble toward this FY 2019 public sector debt tsunami, the household savings rate has plummeted to virtually a pre-crisis low at 2.9% of disposable personal income. Accordingly, we have every reason to believe that consumers will use their temporary tax cut windfall to pay-down their own debt, not accumulate the bills and bonds Uncle Sam will be dumping on the market.

So where else is the financing supposed to come from if the Fed and households are out of the picture? Surely, not the corporate sector, which is being induced by $262 billion of FY 2019 tax cuts (the 21% rate plus "bonus" depreciation) to undertake an orgy of CapEx.

To be sure, we rather suspect that whatever investment orgy happens with this $262 billion gift from Uncle Sam, it is likely to occur via stock buybacks and M&A deals in the canyons of Wall Street, not on plant and shop floors on main street. But regardless, slurping-up paper from the incipient tsunami of new treasury debt is likely to be the last place it goes.

The only other category left is foreign buyers---private investors and central banks alike---but that source of "demand" for Uncle Sam's emissions is fixing to dry-up, as well. And that will be especially true for private European and Japanese investors---who have poured into the dollar bond markets in search of yield and to escape their own yield-free local currency alternatives.

The fact is, this off-shore rescue brigade of the last few years depended upon radical central bank easing in their home markets, which drove these investors and speculators into the dollar markets in search for yield; and, crucially, it also required a yield differential in favor of dollar securities sufficiently wide to cover the carry cost including the inherent FX hedging expense.

Alas, those artificial props are falling by the wayside. The ECB will be out of the bond-buying business by the fall of 2018, the PPBOC is now desperately trying to drain liquidity from its own booming credit Ponzi and even the bank of Japan is slowing down it purchase rate---perhaps because its balance sheet is already approaching absurdity at 100% of  GDP.

In all, what was a $1.3 trillion central bank bond purchase rate earlier this year will fade to nearly zero in 2019; and then it will become a large cash drain as central banks shrink their balance sheets in the context of hyper-bloated global financial markets.

Stated differently, what is "priced-in" to the world's risk asset markets is central bank footings of $22 trillion-----not the $6 trillion level prior to the financial crisis or the $17-18 trillion level now being targeted for the end of the QT/normalization campaign.

What is worse, however, is that on top of this epochal central bank pivot to QT (quantitative tightening), there also comes the abrupt change of the corporate tax regime now enacted into law. That is, the switch from a worldwide income to a territorial income based levy will throw a giant monkey wrench into the works---causing dollar funding costs in FX and swap markets to soar as the trapped cache of un-repatriated earnings of US corporations are brought home.

On the one hand, the  resulting reflow of some $2.8 trillion of off-shore dollars does not exactly count as a new source of financing for the domestic US treasury market. Uncle Sam intends to take an average 13.5% level from any repatriated funds, and that $130 billion in FY 2018-2019 (and $339 billion over the decade) is already built into the net cost of the tax bill.

Moreover, the untaxed portion of these allegedly "trapped" off-shore funds were not exactly stuffed into a corporate shoe-box. More often than not these assets functioned as collateral for dollar borrowings in the domestic US markets---with Apple (APPL) being the obvious poster boy case.

Yes, APPL has $275 billion of cash-like assets parked abroad in Ireland and other tax havens, but even as it floated on a sea of cash, Apple has also borrowed $115 billion to fund domestic investments----mainly investments on Wall Street in the form of stock buybacks.

So after-tax reflows of corporate cash are likely to finance the unwinding of previous tax law arbitrages like Apple's or be applied to funding current financial engineering maneuvers including stock repurchases and M&A deals.

In short, the mandatory one-time repatriation tax grab of $339 billion over the next decade by Uncle Sam will likely cascade in many complex directions, but the first use will almost certainly not be to buy US government debt at today's 2.43% yield on the 10-year benchmark issue.

But what is certain is that the mandatory repatriation tax just passed by Congress will reinforce the global off-shore dollar shortage that is inherent in the Fed's normalization and QT campaign. That means hedging costs will rise and the currency-adjusted returns on foreign-investor owned US treasury paper will fall---and could actually disappear entirely if the basis swap becomes increasingly negative.

For instance, the Japanese financial institutions tend to use 3-month FX forwards when they invest in hedged foreign bonds. Annualized hedge costs have recently risen to 2.33%, which means that yen-based investors in 10-year US Treasuries at today's yield of 2.43% would end up with virtually no return.

In short, this time is truly different because the impending, spectacular late-cycle collision of US fiscal and monetary policies is sure to rock the $100 billion global bond market with severe, cascading ripples of downward pricing adjustments (i.e. higher yields and wider spreads). Yet the entire price structure of the equity market incorporates the previous era of drastically repressed yields.

In our judgment, a large share of the $15 trillion of US stock buybacks and M&A deals over the last decade would not have happened---save for the ultra-low after-tax cost of debt. For instance, mega-M&A deals by investment grade companies always look accretive to earnings because they have been 85% cash/debt financed at a weighted average after-tax cost of under 2.0%.

Likewise, the scramble for yield has funded a massive revival of the junk loan and bond markets---with combined outstandings now pushing $4 trillion or more than double the 2007 level. On the margin, virtually every dollar of that $2 trillion gain went into the liquidation of corporate equities via LBO's and leveraged recaps.

In a word, a huge chunk of the over-valuation in today's stock markets reflects the cheap debt fueled financial engineering "bid" for stocks that will be literally monkey-hammered by the central bank pivot to QT---compounded by the fiscal insanity of the Trump-GOP debt binge.

In that context, the insouciant complacency in today's casino is all the more remarkable---and dangerous. The VIX index average during 2017 came in at 11.1. That is the lowest reading ever — by more than one and a half points — since the VIX inception in 1986. By way of comparison, the daily average for all years since then was over 20.

Likewise, the maximum level reached by the VIX in 2017 was 17.3. That's the lowest maximum level attained in any year since inception----and 60% lower than average.

 

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And that's what ultimately makes this time so very different.

Valuation levels have never been higher relative to income and forward prospects. Central banks have never been on the precipice of a multi-trillion cash extraction and pivot to QT. And nine years of central bank fostered bubble inflation and fake recovery have never rendered the casino so complacent.

In all, we'd say Wall Street is calling the sheep to the final slaughter. At the moment, in fact, the bleating is so loud that the gamblers are seriously debating whether the 50X gain in bitcoin in just 22 months is sustainable. But that's surely derangement at Tulip Mania scale, as we will further consider in Part 2.

Comments

Oldwood Stackers Fri, 12/29/2017 - 10:00 Permalink

We have all read articles of impending doom for many years now, all well written and researched with graphs and rational deductions, yet here we still sit....waiting, our risk adverse investments stinking to high heaven.

I have NO fucking idea.

What I do know is that many of the higher income business people believe this tax plan will result in real economic growth, even while it may have negative impact on our tax liabilities.

The economy is NOT reality based. It reflects the attitude of it's participants. If those participants, especially those who actually have money to spend, believe it will grow....it will grow.

I believe the reason the economy sunk so low in 08/09 was due to the pessimism that the Obama presidency induced in middle income business owners who saw it for what it was....knowing that nothing good would come from Obama's presidency that they would not have to BUY.

Nothing is really in this economy except our personal fates. The overall is simply a reflection of hope or pessimism of those who spend or invest.

Trump understands this and sees our only salvation coming from hope, from optimism, because our realities are far too grim to provide anything beyond deepening depression.

In reply to by Stackers

Stackers Oldwood Fri, 12/29/2017 - 10:40 Permalink

Oldwood, debt doesn't matter until suddenly all at once, it does. Venezuela is a perfect recent case study. Everything was fine until suddenly everything wasn't fine and in the space of 18-24 months you go from a strong middle class economy to people dumpster diving for dinner. The problem is you can't tell where the tipping point is until you're already past it... then all the hope and promises and optimism in the world wont save you.

In reply to by Oldwood

Ethelred the Unready Oldwood Fri, 12/29/2017 - 10:51 Permalink

J.M. Keynes (may his name be blessed) called it "animal spirits".   A demographer such as myself would call it too many boomers who already have too much shit and too many childless young adults  who either do not want children or who cannot afford them.  The only consumers left are the third-world hoards who get their required  spending power from the government.  

 

That is, the latest "consumers of the last resort" are impoverished migrants.  Maybe the Deep State knows this (the GOPe certainly does) and that is why it chose to to open our borders.   Rock and a hard place.  Healthcare seems the only source of future demand - so encourage your youngins to become a health tech or something.  Of course there is also moar war - which has the added bonus of bringing in more refugees and having to provide life long medical care for our badly wounded.

In reply to by Oldwood

troubadourcapital Ghost of PartysOver Fri, 12/29/2017 - 09:40 Permalink

This is not the greatest bubble ever.

 

1. Tech companies nowadays are actually profitable, unlike during the 1990s.

2. Valuations aren't at a historical maximum. Look at Tobin's Q

3. real estate prices in the u.s. just exceeded 2007. But it's been 10 years, and at 2-3% inflation a year real prices are lower.

 

http://bullmarkets.co/stock-market-on-december-29-2017-outlook/

In reply to by Ghost of PartysOver

Herdee Fri, 12/29/2017 - 09:30 Permalink

Lots of printing left to be done. If Japan can do it so can the Master of Debt. I like the round number of $50 Trillion. Let's just get on with it and let'r blast wide open.

Fantasy Free E… Fri, 12/29/2017 - 09:37 Permalink

Stockman is brilliant. Unfortunately he is still in the trap of believing the bubble will end as it logically should.

http://quillian.net/blog/warm-fuzzies-of-democracy/

This particular bubble is a political agenda. Are the laws of economics suspended? Not at all, incentives are not the same as in a free market.  For sure the effort to sustain the bubble will not end just because statistically the market is overpriced.

 

roadhazard Fri, 12/29/2017 - 09:38 Permalink

Gosh I really love the "show all content" prompt I have to refuse EVERY TIME I click. Thank you SO much ZH. And I thought having to click on every page to get to the last one was bad. It's a fucking click epidemic on ZH.

asteroids Fri, 12/29/2017 - 09:40 Permalink

Sounds to me the politicians will sacrifice anything to keeps stawks up. I suspect the bond boys won't be too happy about that. They are after all the smartest guys in the room.

Cassandra.Hermes Fri, 12/29/2017 - 09:48 Permalink

So NJ residents volunteerly stripped themselves of 10B liquidity to prepay property taxes, I presume the amount is much larger in NY, CA and MA. So Trump has tax refund will be unexpectedly large and can foresee trouble ahead, also many taxpayer families have interest to file separately their taxes in order to claim 20,000 state and property tax deduction instead of 10,000 something not calculated in Trump estimation. I think debt will be 2-3 times higher than have been projected.

honestann Fri, 12/29/2017 - 09:58 Permalink

Wrong.

The Federal Reserve will continue to crash the markets they wish when they wish (after telling their members and allies to load up on short positions).

Then they will create astronomical quantities of fiat, fake, fraud, fiction, fantasy, fractional-reserve ponzi debt bits to blast the markets they wish higher when they wish (after telling their members and allies to load up on long positions).

And... as always... the Federal Reserve tells no one how much fiat they created or what they did with the vast, vast, vast majority of the newly created fiat.

To say there is "no dry powder" is INHERENTLY FALSE unless you are talking about gold and/or silver in a vault that is thoroughly physically audited independently by several honest, non-mainstream auditors.  To say "no dry powder" with regard to fiat, fake, fraud, fiction, fantasy, fractional-reserve ponzi debt bits is a blatant contradiction in terms.  Not only that, but a notion that has proven wildly false several times in recent history.

The Federal Reserve and predators-that-be will continue to create more fiat, fake, fraud, fiction, fantasy, fractional-reserve ponzi debt bits and leverage that up 10, 50, 100, 500, 1000 times or more, and manipulate competitors of their fiat ponzi fraud (gold and silver) as well as conventional markets...

UNTIL THE WORLD REFUSES TO ACCEPT US DOLLARS... or at least greatly raises the prices in dollars of their goods.

Since the predators-that-be and central-banksters have absolutely ZERO honor, honesty or scruples of any kind whatsoever (to put it super mildly), the current fraud of the top 1% (and especially top 0.001%) stealing everyone else blind (and enslaving them) will continue, and probably continue to accelerate until just before the collapse, which will almost certainly be caused by [some] of the rest of the world refusing to sell the products they create for US dollars (or for anywhere near current prices).

Crypto-currencies will not be the undoing of the US dollar.  Producers and fictitious governments in other fictitious nations will collapse they US dollar when they demand gold or other real, physical, valuable goods for the goods and goodies they produce.

Oldwood honestann Fri, 12/29/2017 - 10:11 Permalink

The government's dry powder comes in the form of a desperately leveraged population that will agree to ANYTHING to save their ass. For markets to fail, for money to leave, it needs somewhere to go. How many perceive cash as a safe place? Bitcoin an isolated aberration?

The market is UP because there is no place else to go.

This is a captured market that with each minor downturn only creates another buying opportunity.

It will end but no one knows when or how or where to be standing when it goes down. Likely a world ending event like an asteroid strike.

In reply to by honestann

wdg honestann Fri, 12/29/2017 - 12:42 Permalink

Honestann...everything you have stated is correct. David Stockman is disingenuous at best for treating the Fed as anything other than a criminal system of theft and fraud run by the evil and largely alien Deep State. We should not be discussing the Fed, Greenspan, Bernanke or Yellen except in the context of a criminal entity that must be brought to justice and the stolen wealth recovered from this thieving network. I want justice and retribution for these gangsters and hanging is much too good for them. 

In reply to by honestann

wdg honestann Fri, 12/29/2017 - 12:43 Permalink

Honestann...everything you have stated is correct. David Stockman is disingenuous at best for treating the Fed as anything other than a criminal system of theft and fraud run by the evil and largely alien Deep State. We should not be discussing the Fed, Greenspan, Bernanke or Yellen except in the context of a criminal entity that must be brought to justice and the stolen wealth recovered from this thieving network. I want justice and retribution for these gangsters and hanging is much too good for them. 

In reply to by honestann

wdg Fri, 12/29/2017 - 10:02 Permalink

What David Stockman did not say is that the unconstitutional and privately owned Federal Reserve is a Trojan Horse inserted by international bankers into the heart of our monetary, financial and political system with the objective of controlling and destroying our system of free enterprise and ultimately the American people. This is not happening by ignorance or stupidity on the part of the Fed but by a well thought out and clear design. The bubbles driven by suppressed interest rates and the creation of unearned (and therefore immoral) trillions of dollars out of thin air also serve to plunder wealth from honest savers and workers, thereby enslaving Americans with unimaginable debt. Another benefit of Fed policies is to make housing unaffordable thereby limiting the capacity of Americans to form families and livable communities. To be blunt, central and fractional-reserve banking is a diabolical system that must be banished from the western world. The first step is to bulldoze the Fed and indict the occupants of this Satanic Temple, past and present, for high treason.    

redbird Fri, 12/29/2017 - 10:18 Permalink

Ya know. ... I remember the first time I heard about this Stockman fellow.  It was on national public radio.  I was driving cross country and happened to stumble upon an interview.  I agreed with everything he had to say and thought, wow, this guy knows his stuff.  He was talking about what we all know now.  National debt.  Government corruption.  Inflation, bla bla bla.   I think most here know his M.O..    

That was December 2011.   Frustratingly, I still agree with his thesis.  It hurts.

Bemused Observer Fri, 12/29/2017 - 10:24 Permalink

When this thing finally turns, and goes bad, there is going to be some epic wailing and gnashing of teeth!

But no one, and I mean NO ONE, can claim with a straight face, that 'no one could have seen this coming...'

They ALL see it coming, and we get warnings everyday. So many that they have become a kind of joke now. And even someone with no background in finance can see that something is very, very wrong with this economy, even if they can't articulate just what it is...(this is the reason behind the over-complexity of modern finance...if someone can't understand it, they can't pinpoint where it is going wrong, and you can baffle them with bullshit more easily.)

But when this thing turns, I will LOL, long and hearty. And I will NOT be kind to those dumb fucks who will lose it all for a THIRD time in as many decades. And that is because dumb fucks like them are the REASON we all get to relive this shit every few years now. The conservatives are convinced this is because of 'welfare payments', and the liberals blame it on 'crony capitalism'...both are dumb fucks who can't properly identify the enemy, because they are BOTH part of that 'enemy'.

The only thing that will finally defeat them is for an historic crash, a wealth destruction that at last CANNOT be papered over this time. THAT might be the gauntlet that finally slaps them out of their slumber.

Next time, no one gets to claim ignorance. Everyone funneling in knows where this is going, they just hope they can get back out in time. And most will be tragically wrong, again. No sympathy, not this time.

brewing_it Fri, 12/29/2017 - 11:05 Permalink

Sorry, but this Homie don't play that game. I got sheared once, learned my lesson, got most of my money back. Never trust a broker unless you have know him for a long, long time. Like he went to your dad's funeral, or made sure your Grandmother had enough income.

KrazyUncle Sat, 12/30/2017 - 15:53 Permalink

It seems Stockman assumes that the Fed will do its QT just because they plan too. What if like some are suggesting, market rates shoot up faster than the Feds plan and torpedoes bonds/stocks? IMO QT will end immediately, and the printing press will once again take over. Will it matter?