“Investing” in the 2020s
Written Apr 15, 2021
Spring has sprung and the stock market continues to make record highs. Life is good!
Most investors mistake the spectacular gains they’ve enjoyed as the result of other investors buying stocks. They are wrong, and probably unfamiliar with Exter’s Pyramid. The following diagram is outdated but gets the point across. Top of this inverted pyramid, which ranks global financial asset classes by size and risk, is the biggest and riskiest “asset” class — Derivatives. These are financially engineered paper products (essentially “betting contracts” with huge leverage but no collateral) bearing no direct relationship to the physical economy. Warren Buffet coined them “financial weapons of mass destruction”.
Global derivatives currently total $640T, 18X the size of the world’s current total stock holdings at $34.8T, and 7X current global GDP at $87.55T. The world’s 11th-ranked Deutsche Bank alone has $47T of derivatives currently on its books, 12X Germany’s current GDP at $3.8T. (By the way, thanks to inter-banking transactions in a globalized world, if Deuteche Bank blows up, Goldman, JP Morgan et al are all at risk, — just like the situation in 2008.)
These ludicrous numbers that defy common sense illustrate how rampant financialization since the 1980s created a financial sector several times the size of the physical economy (thanks to the removal of previous regulations which curbed such growth, notably repeal of the Glass-Steagall Act during Bill Clinton’s administration). The financial sector produces nothing but financial paper “products” (especially exotic derivatives). Its activities no longer result from, or even reflect, economical activities. Yet, growth in the financial sector figures into GDP numbers, leading to the fallacious conclusion of economic growth.
Now let’s dive a little into the mechanics that drove the spectacular stock market rise since 2009.
Since 2009, the Fed has artificially kept interest rate at near zero, taking away the option of risk-free investment in Treasury bonds. Conservative portfolios traditionally 60% in stocks and 40% in Treasuries now had to go 100% in stocks. Elsewhere, pension and mutual funds must make a minimum of 7.5% return to meet redemption requirements. Without yield from Treasuries, they now had to take chances in the stock market.
The way managers of these portfolios attained extraordinarily high returns was to engage in esoteric computer algorithm-driven strategies (like “short volatility”, “gamma hedging”, and “risk parity”) that combine the trading of derivatives and stocks in hedged (but highly leveraged) portfolios. These strategies are all “trend following”, i.e. all betting on one direction, — UP. The self-reinforcing nature of such strategies thus triggered the automatic buying of stocks in an incessantly rising market.
Why were money managers so emboldened with these algorithm-driven strategies? Because the Federal Reserve Bank (“the Fed”), over 3 regimes of chairmanship (Greenspan, Bernanke and Yellen), had guaranteed, through their incessant money printing, the stock market would simply “not be allowed to go down”. This guarantee became explicit after the 2008 market crash from the Global Credit Crisis.
The following chart (shaded area = official recession) amply illustrates this:
- Any honest economic growth from (industrial) job creation and making of products ceased in the 1980s with Reagan’s “de-industrialization”. Growth of the financial sector took off rapidly in the 1980s, aided by money printing that started with Greenspan in 1987, in response to Black Monday.
- The main effect of financialization is serial asset bubbles. Both the market peaks in 2000 and 2008 were the result of asset bubbles. All asset bubbles eventually burst (causing boom-bust cycles). Both the 2000 and 2008 bubble bursts were “uh-oh” moments having less to do with specific bad actors (Worldcom, Enron, Healthsouth; and Lehman, Bear, AIG) but more to do with realization of systemic toxicity in the financial sector. Yellen made sure there would be no more “uh-oh” moments under her watch by keeping the pedal to the metal, printing like there was no tomorrow. Notice the stock market rise was at a steeper angle under her “financial engineering”. (I detailed the mechanics in my other article Global Economy in the 2020s.)
- Since 1987, the established pattern by the Fed in response to any asset bubble burst has been blowing a bigger bubble by creating more money out of thin air and funneling it into the financial markets. The 2020 Covid global shutdown gave Powell the perfect excuse to outdo all past Fed chairmen with “Whatever it takes” money printing, — with no limit or end date. The stock market is now in a spectacular VERTICAL CLIMB.
- A rising stock market propelled by money created out of thin air is a statement of the money’s debasement. (The same principle applies to real estate: A $60K house in 1970 is now worth $1M not because the house is 1,500% more valuable, but because the currency is only 6% of what it was previously worth.)
The current asset bubble, labeled the “Everything (equities, bonds, housing) Bubble” by Wall Street insiders, is the longest running (12 years and ongoing since 2009) and the biggest by far. This following (pre-Covid) chart should alleviate any remaining doubt about the irrefutable correlation between central bank money printing and rising stock market(s) (ECB=European Central Bank; BOJ=Bank of Japan):
This is why I put “Investing” in the title in quotes. Are the financial markets even invest-able for the rest of this decade, without first “correcting” (a bubble burst)?
All bubbles eventually burst. But when and how this bubble bursts critically depends on policy makers (the Fed and the Treasury)’ actions within this year.
In my other article Global Economy in the 2020s, I detailed how long-bond rates are now rising, for the first time in 12 years, in anticipation of already palpable consumer price inflation. Since reaching a 40-year low on 7/31/2020, the 10-Y Treasury yield has more than doubled from 0.528% to now 1.55%. Rising rates have a particularly profound effect on the current stock market, which is propped up by artificially suppressed interest rates running for 12 long years. The mechanics of how rising rates can burst the bubble is best explained by “Price Discovery”.
“Price Discovery” is the discovery of the Fair Market Value of any asset. It is a function of supply, demand, risk, and intrinsic value of that asset. Since the 2000 Dot Com bust, the Fed has explicitly reaffirmed its guarantee of incessant stock market rise via unlimited creation of money. This guarantee (termed the “Fed Put”) turned the vast majority of fund managers “passive” (buy the whole market via an index fund, rather than discriminate good from bad companies via stock picking). This consequently destroyed Price Discovery. And this is what happens to those who got this message too late.
Meanwhile, interest rates play a critical role in the bond market (which leads the stock market) because they set the cost of money by being the barometer of risk. By artificially keeping interest rates at near zero, the Fed eliminated risk-signaling (similar to performing root-canal to kill off the pain signaling mechanism). Intrinsic value thus became irrelevant. Nothing is overpriced anymore; the “Everything (equities, bonds, housing) Bubble” simply kept inflating (hence “Yellen’s Wonderland” and “Powell’s Vertical Climb” in the preceding chart).
Rising rates (demanded by the bond market against the Fed’s will) now signal elevated risk of insolvency of heavily indebted corporations and their lenders (banks), and increased difficulty for the heavily indebted federal government to continue its deficit spending through ever more Treasury bond issuance. I detailed the mechanics in my other article Global Economy in the 2020s.
This perception of elevated risk, in turn, makes intrinsic value matter again in the stock market. Those actively monitoring the stock market may have noticed capital rotating of late into and out of the same sectors/stocks (i.e. one day, money flows out of technology stocks into renewable energy stocks, only to have the process reverse the next day). This is in fact Price Discovery at work. Capital is trying to decipher which are overpriced sectors (discrimination is more at the sector, rather than individual company, level) and which not. The poster-boy of this rotation is the Cathie Wood’s best performing ARKK fund in 2020, now rapidly selling off in 2021.
The overriding question at this junction is: “Will there be more fiscal stimulus (automatically financed by Fed QE) to come from the Treasury?” The answer is almost certainly “yes”. Therefore, we can expect continued pressure on long-bond rates to rise in anticipation of inflation. The next question becomes “Will the Fed try to suppress long-bond rate rise with ‘Operation Twist’ (aka Yield Curve Control, — the selling of short term bonds and buying of long term bonds)”? The answer to that is less certain because consumer price inflation caused by global shortage will likely persist. The bond market may insist on higher rates beyond the Fed’s ability to suppress.
If indeed rates trend up beyond the Fed’s control, then:
- The US dollar will go up, which means emerging economies’ growth will be sub-par, and capital will flow into the U.S.
- “Growth” (such as Tech) stocks will languish because discounted cash flow at higher rates will render them overpriced.
- “Cyclical”/”Value” (such as consumer discretionary) stocks will benefit because of pricing power from shortage.
- Bank stocks will rise with a steepening yield curve.
- Treasury bonds will tank.
On the other hand, if the Fed succeeds in suppressing long bond rates, then:
- the US dollar will go down, which means emerging economies’ growth will outperform, and capital will flow out of the U.S.
- the yield curve will flatten (remember inverted yield curve signals recession)
- Gold, commodities, cryptocurrencies and some foreign currencies will benefit.
In the highly unlikely event that fiscal stimulus actually ceases, then inflation will subside for lack of purchasing power. The economy will revert back to dis-inflation (eventually deflation) mode, and one should hold
- Treasury bonds.
Of course, politicians, desperate to extend the 12 year long asset bubble already long in the tooth, want to sell you this narrative: Governments around the world are working in concert toward rebuilding after the devastating Covid shutdown, specifically via “The Green Initiative”, — a series of environmental-friendly mega-projects which creates millions of jobs and make the earth greener at the same time. What can be greater than mom and apple pie? Or is it a pie in the sky (it is still far more expensive and far less reliable to go “all green”)? Even if you buy this “infrastructure build with a green tint” narrative, renewable energy stocks had already gone up 300% since the 2020 March bottom. Commodities prices already doubled and even conventional energy stocks had already gone up 80%. Investors now seem to be in “wait and see” mode on “The Green Initiative” narrative. The vertical climb is sustained by money sloshing in and out of speculative plays, rather than accumulation of committed capital in a secular theme (such as “The Green Initiative”).
Physical spring has sprung but we are still in financial and economic winter. A 12-year long stock market bubble, now in vertical climb, is not a sign of spring. Winter will end only when that climb runs out of nuclear fuel, and the bubble becomes so big that it cannot withstand its own gravitational force and explodes into a supernova. One may do well to remember “history rhymes”:
What will the supernova look like? There are two possible scenarios. One: Current inflation is transitory until supply catches with demand generated by “stimulus” and the economy returns to disinflation. Discounted future values bet reassessed and investors realize that a 30+ PE is way too overpriced. The stock market crashes, money rushes into long term Treasuries, driving rated rapidly down and creating deflation. This is 1930s-like “deflationary bust” that can last a decade or so. The following century long cyclical view supports this scenario. The message of this chart is: Think Mean Reversion (around long term trend line); or, “Nothing goes straight to the sky”. The upcoming “correction” will most likely overshoot on the downside (most probably to the 2009 low) before reverting to the long term trend line.
The other scenario is more nuanced. The reason why the stock market has not been allowed to even moderately correct (never mind crash) is that a dropping stock market will take the Treasury market (deepest market globally) with it. Since foreign sovereigns (especially China) stopped buying Treasuries to fund our deficit spending in the mid-2010s, the Fed is the only significant marginal buyer. all other “smart money” is shorting the U.S. dollar (borrowing U.S. dollar to buy other assets like commodities, gold, cryptocurrencies and even NFTs). If a highly leveraged stock market (circling back to Exter’s Pyramid at the beginning of this article) falters, portfolios will sell off Treasuries (“sell what you can”; — this is unlike 2009, when money fled the stock market into the Treasury market). The Fed, the lone buyer of Treasuries, will go into hyper-print in order to cap the yield from rising (as a result of Treasury sell off). What we will see then is negative real yield, — like when WW-2 ended. This will be the moment when already existing global sovereign insolvency becomes obvious to all (a la Warren Buffet’s proverbial “when the tide goes out you’ll see who are without swimming trunks). This is what the “Great Reset” (mentioned in my other article Is “The Great Reset” the agenda of heroes or villains?) kicks in.
What will the stock market look like then? Here’s a clue: