You would never know it listening to the market cheerleaders but asset prices, both real and financial, are, once again, at extreme valuation levels relative to the trend economy. The valuation reality coupled with the prevailing, but false, “don’t worry” market narrative sets us up for another major financial crisis.
A third major crisis in 20 years? These are only supposed to happen, once in every 100 or 1,000 or 10,000 years, so say the rocket scientists. Blame it on fat obese tails.
Asset Markets And GDP Growth
The chart below illustrates that household net worth, as measured by real and financial assets minus liabilities, which just hit a record high at around $102 trillion, is, once again, totally divorced from the economy. Note that one of the reasons why the highest level U.S. policymakers missed the last financial crisis is because they were too focused on this indicator, which also hit a record high in Q3 2007.
Their error was twofold: 1) not fully recognizing are believing the risk of asymmetric mark-to-market, where asset prices are variable, while liabilities remain fixed, and 2) not understanding the economy had morphed into a giant asset-driven feedback loop, where the wealth effect drives growth (both consumption and investment confidence), which drives asset prices, which drives the wealth effect. Wash, rinse, and repeat.
It’s clear from the chart which variable is leading the other. We find it laughable when analysts pontificate that asset markets have been driven by fundamentals and profits, and fail to understand the above feedback loop.
Asset markets have been inflated by the central banks, which has lifted economic growth and positively influenced the “fundamentals”, such as profits and consumer demand, and to, some extent, business investment. These same analysts are so self righteous they have gall to mock the global macro community, who have been trying to enlighten them.
We shall see who still has their family jewels when the tide goes out and asset markets regress to their long-term mean valuation. Even just a moderate bear market should have an outsized impact on the economy given are model. We suspect the monetary authorities understand this, and is the reason why they have been so timid about keeping stimulus and emerging levels for almost 10 years.
One thing is certain, however, it will be a mean regression to the mean. The question is when, not if.
The above chart also illustrates that a structural divergence of asset prices from the economy began around 1995. Before this, assets values fluctuated around trend nominal GDP growing on average about the same rate as real economic growth plus inflation for almost 50 years. The market trajectory made perfect theoretical sense.
So What Happened In The 1990’s?
We suspect mainly globalization.
This is the period of China, India, and Eastern Europe’s entry into the global labor force, the rise of the internet, and the beginning of large foreign capital flows into the U.S. financial markets, especially the U.S. Treasury bond market.
Furthermore, Mexico had just experienced an existential balance of payments and currency crisis, soon to be followed by the Asian financial crisis in 1997, and the Russian debt default in 1998. These countries learned the hard lesson that allowing short-term capital inflows to revalue their currencies causing unsustainable current account deficits was a recipe for economic collapse. The global shift in exchange regimes in the emerging markets during this period was a major factor in what former Fed chairman, Ben Bernanke, the rise of the global savings glut.
Emerging market central banks began to intervene in their foreign exchange market leading to a massive build in global currency reserves, which were then predominantly recycled back into the U.S. financial markets. The liquefaction of U.S. markets by the foreign private and official flows provided much of the fuel for the dot.com and housing bubbles.
The current economic and asset bubble has been driven, mainly, by central bank liquidity.
The End Of Globalization?
Now the President of the United States (POTUS) is the poster child of anti-globalization. Whether he sticks to his guns as the markets crumble remains to be seen. If we learned anything from 2008 crisis is that markets can get away from the policymakers and lead to nonlinear market dynamics. Once unleashed, it difficult to put volatility genie back into the bottle.
Asset Prices Are 40 percent Overvalued
We charted the difference between the net worth and GDP trend lines, which now estimates asset prices are overvalued by more the 40 percent. That is if you assume they should reflect economic fundamentals.
Regressing to the mean economic fundamental value will be an extremely painful event.
Justifying The Divergence
Some argue the divergence is sustainable, that margins will continue to expand, that asset prices can remain inflated, and price-to-earnings ratios are reasonable.
Traditional valuation metrics are so distorted and massaged, especially with the massive buybacks. We therefore ignore most of them, except the Buffet indicator, which measures market capitalization to nominal GDP, as reflected in the above charts.
How can stocks and housing be cheap if they trade at 180 percent of GDP? Is the stock market pricing infinite margin expansion and labor costs converging to zero? Good luck with those politics.
We also maintain the cheerleaders completely ignore the political reality that is now gripping world markets. The specter of anti-globalization and tribalism is now beginning to take hold. If not reversed, and quickly, the consequences will be disastrous.
The New Supply-Side Bubble
Finally, the unwind of this bubble should be more tortuous and take longer as it is driven by restricted supply and not leveraged demand. In stocks, the result of buybacks; and in housing, the result, among other things, private equity taking a massive supply of homes of the market for rentals.
Flash: Peter Navarro was out on CNBC into last night's close trying to calm the markets. Don’t you think our trading partners see this, that the administration fears a market downturn, and can play hardball until the U.S. caves? Let the game(s) theory begin!
As always, with the caveat we could be wrong.