Break On Through
(We chased our pleasures here, dug our treasures there, but can you still recall the time we cried? Break on through to the other side)
I’ve wanted to talk about the equity rally for a long time and now that the Dow Jones went off to reach new highs it seems like just about right. Last week when it broke the previous milestone (14164.5 points) Zerohedge published an interesting note comparing how other economic aggregates and prices stood in 2007. You can check them here:
Just a few highlights:
GDP Growth: 2.5% (2007); 1.6% (2013)
Unemployment (in Labour Force) 6.7 million (2007); 13.2 million (2013)
Size of Fed’s Balance Sheet: $0.89 Trillion (2007); $3.01 trillion (2013)
US Debt as % of GDP: 38% (2007); 74.2% (2013)
US Household Debt: $13.5 Trillion (2007); $12.9 Trillion (2013)
10-Yr T-note Yield: 4.64% (2007); 1.89% (2013)
Gold Oz: $748 (2007); $1583 (2013)
I think you’ve got the picture. The question is how can the price of equity be just about the same it was in the height of subprime careless joy? I mean, I don’t see any joy going round, not even in those investors that are actually making a nice return by holding on to equity (maybe because they are very few).
(When the still sea conspires an armour, and her sullen and aborted currents breed tiny monsters, true sailing is dead)
All indexes include a survival bias, meaning the worst performing shares get dropped out as their market cap diminishes and are replaced by the ones that see their market cap rise. But this can hardly account for the whole recovery, even because the small to mid-cap indexes (a sort of minor division to where these stocks would be relegated unless they are delisted or bankrupt) are keeping in line with the larger companies index (the S&P Mid 400 is even outperforming the S&P 500 posting 180% gains vs 130% from the lows of March 2009).
Disregarding survival bias, the first reply that comes to mind is expectations. Stock prices are always forward looking so people are discounting the end of our troubles. Yet, Consumer Confidence lies at 69.6, whilst in 2007 was at 99.5. Not that consumer confidence is a leading indicator but add GDP growth (another fallacious indicator), Unemployment (now we are getting somewhere) and possibly the size of Debt to GDP (future taxes) and the discrepancy between numbers is telling us something that should not be ignored. Expectations cannot be that bad or people would just head back to government bonds (like they have done so often during this rally, and in a hurry) but the answer is not there, or not there entirely.
The Dow Jones Index, or any other stock index for that matter, is a sum of a number of stocks from several companies, multiplied by their price and then by a divisor/multiplier that gives a number in points that is easy to visualize. So behind all technicalities we are measuring the exchange value between currency and a security that entitles his owner to part of the capital of a firm (and of the company’s profits). The companies are not the same and neither is what is used as currency. But, if the state of the economy (and its outlook) are worse than in 2007 then, it must follow that the value of the currency that is used in exchange is reduced, more of it being necessary to purchase the same amount of company shares of generally (perceived) worse quality.
Riders on the Storm
(If you give this man a ride, sweet family will die, killer on the road)
But if currency is worth less, then where is all the inflation that comes with depreciating currency? Too much money chasing too few goods? To start with it is up there, in the size of the Fed’s balance sheet (and all the central banks in the world). The prices of goods and services are not rising, or not very much, even taking into consideration that the CPI, by calculation method, underestimates consumer price inflation. But that is not the definition of inflation just one of its possible consequences. Inflation is the act itself of increasing the quantity of currency issued. The path it will actually take through the economy, although hinted, cannot be told in advance. And the inflation is chasing financial assets, namely stocks.
I’ve mentioned money but what we are actually talking about is credit. Money is not credit although credit can replace money in the present, fundamentally (but not only) against money in the future. But the modern world relies almost exclusively in fiduciary media as means of exchange, with each country (or a number of countries together like with the Euro) imposing a currency monopoly within their territorial limits. Money (defined as a commodity used to perform indirect exchanges) has long ceased to exist. This means debt cannot be extinguished without destroying that thing which replaces money while currency can be produced (technically) at will. So when the financial crisis hit, and investors tried to liquidate their assets for money, all they got was currency backed by central banks assets that consists almost exclusively of debt. Central banks bought existing assets or newly created debt (mainly government debt) to produce fiduciary money as fiduciary money was being destroyed by the flight to liquidity.
End of the Night
(Realms of bliss, realms of light, some are born to sweet delight, some are born to the endless night)
From the central bankers point of view all they were doing was replacing a less demanded “risky” assets for more demanded “less risky” assets by taking in whatever assets investors wanted to get rid of and giving them the assets they sought the most, namely, currency. Simple or at least that is what they want us to think. In the process, the central banks are increasing their balance sheets while reducing the quality of that same balance sheet and this, inevitably, depreciates the value of that currency. The only reason why this is not easily hinted is because to a greater or lesser extent all central banks are doing it, so the relative value of their currencies remains the same, but not their purchasing power. The devaluations are justified by the mantra of “making exports more competitive” which, as a long term strategy, is totally useless. It is invisibly made at the expense of domestic wealth and capital consumption. But that is not the point now. The point is that there is no other way around this.
The other important feature is that, in order to create as much currency as necessary to prevent asset prices from correcting the central bank has to buy ever more debt of decreasing quality and across the yield curve, forcing interest rates down. While fear of bankruptcy prevails, the low interest rates will not move investors away from the safe-havens (like in the Euro Crisis accepting negative rates for German short term bonds) but, moral hazard creeps into the system and the first to move is the one that gains the most. With low interest rates and scarce dividend payments, the only way to make high yields is by pursuing risky ventures, leveraging investments or, more likely, both.
Stage one came when Governments increased their deficits issuing debt that was discounted or directly purchased by the central banks. If we look at the total size of assets from 2007 until now we find out that, after the 2008 contraction, they add roughly to the same amount in USD
This was when private investors were deleveraging (by either saving or going bust) and the state was spending to offset the decreased “aggregate demand” like them Keynesians say. Stage two comes after private investors (or a significant part of these) have deleveraged and are ready to leverage again (look up the Household Debt number in 2007 and 2013 as evidence, or at least as a corroborating number). Nobody can tell in advance what assets are going to be bought as no one can tell in advance where inflation will show, but it seems like equity has been getting more than a fair share.
The Soft Parade
(All our lives we sweat and save, building for a shallow grave, must be something else we say, somehow to defend this place)
So what? Someone with a degree in Economics will ask. This is exactly what the Central Bank is there for, to keep the economy from entering a downward deflation spiral. But this is mistaking the disease for its symptoms. It is like taking pain-killers to cure an infection. The reduced amount of pain might allow the patient to endure abnormal activity for its condition, but will not make him healthier. The credit contracting deflation inevitably happens when entrepreneurs run to liquidate their mal-investments. Mal-investments are the disease. They don’t just go away.
Everybody can make an investment mistake that will then be forced to liquidate, but systematic errors across the economy happening simultaneously can only take place if capital goods were grossly mispriced in the market preventing a vast proportion of investors from performing accurate economic calculations. Not only that, but these market prices have to be in such way as to incentive those same investments. The distortion comes about because artificially lower interest rates (lower than the ones derived from actual savings) increase the present value of investment projects that, otherwise, would not have been made. When mistakes are discovered projects have to be restructured. But since most capital goods are not easily reconverted to different uses (some are so specific that they became useless) this stage is economically painful with massive unemployment that needs to find alternative ways to serve consumers. By preventing the recession from taking place the central banks are allowing those mal-investments to persist preventing the necessary, although necessary, liquidation.
This means that the now intended expansion will not go beyond the prices of assets, namely equity, into the so called real economy, where capital is still being directed to the production of things for which there is not sufficient demand while are costly to maintain. And there you have an economy where equity prices soar despite higher unemployment and lower economic activity. Those who live on wages are being forced to save to feed this expansion to nowhere. Because an over-indebted economy with capital goods set to produce things that are not required cannot grow itself out of the recession.