Thursday, November 19, 2015

It Is Not Different This Time............

It Is Not Different This Time

Investors don't like to acknowledge bubbles. 

And because they've been so prone to deny them, bubbles and their consequences, they have become a recurring part of the financial landscape over the past two decades. During the late-1990's technology/dot-com bubble, debt-financed malinvestment was mainly directed toward internet-related companies. The end result was a collapse in the Nasdaq 100 of -83%, while the S&P 500 lost half its value. By the 2002 low, the entire total return of the S&P 500 — in excess of Treasury bills — had been wiped out, all the way to back May 1996.

It has taken yet another full-fledged multi-year speculative bubble to get the Nasdaq back to even (most likely only temporarily), and to bring the total return of the S&P 500 since 2000 to even 4% (again, most likely only temporarily). By the completion of the current market cycle, we fully expect that the total return of the S&P 500 since the 2000 peak will fall to zero or negative levels for what will then be a roughly 17-year span, and that the S&P 500 will have underperformed Treasury bills all the way back to roughly 1998; what will then be a nearly 20-year span.

As a reminder of how unwilling investors are to acknowledge bubbles, one must remember that in 2000, even before the S&P 500 even reached its final bull market high on a total-return basis, a broad range of dot-com stocks had already collapsed by about 80% from their own 52-week highs. Investors were finally willing to acknowledge that bubble only after it collapsed, but somehow continued to believe that the bubble was contained only to dot-com companies, and continued to push the S&P 500 higher. Consider this gem from the Wall Street Journal, which appeared in July 2000 with the title "What were we THINKING?"

"For a while it seemed that risk was dead. Now we know better... Why didn't they see it coming? Arrogance, greed and optimism plus fear of being left out blinded people to the risks. After all, the dot-commers embraced risk. They prided themselves on their willingness to gamble and used it to justify their lucrative stock-option plans. Unfortunately, at the extreme far end of the risk curve, people lose perspective."

All of that apparent learning, stated in the past tense, might have been well and good were it not for the fact that the S&P 500 was still at record highs, at the most extreme valuation in history, and the broader collapse had not even started. The tech-heavy Nasdaq 100 was down -14% from its March 2000 high, but would go on to lose another -80% by its October 2002 low. Many of those companies were, and remain, outstanding businesses. But just as a parabolic stock price advance is no assurance that the underlying business is sound, having a sound underlying business does little to prevent an overvalued stock from collapsing once investors lose their taste for speculation. Investors have a habit of pointing to past bubbles as if they have actually learned something, even when they are in the midst of another one.

By 2007, the S&P 500 had again reached record highs, though the market's total return from the 2000 peak was still only about 2% annually. The preferred object of speculation during the housing bubble was mortgage debt. With the Federal Reserve suppressing yields to just 1% in 2003, yield-seeking investors found higher returns in mortgage securities, Wall Street jumped to create new "product," credit standards were lowered, debt was "financially engineered" to bundle it in ways that could get a rubber stamp from ratings agencies, and unsound debt filled the portfolios of insurance companies, banks, and hedge funds. By the March 2009 low, the entire total return of the S&P 500 — in excess of Treasury bill returns — had been wiped out all the way back to June 1995. Investors, analysts, and economists look back on that bubble, and the global collapse that followed, as if they have actually learned something.

So here we are, in what in hindsight will likely be called the "QE Bubble" — a moment in history where the most reckless and intentional encouragement of speculation by central bankers actually came to be viewed as not only acceptable but welcome.

The preferred objects of speculation, and the greatest casualties of the 2000 bubble, were technology and dot-com companies. The preferred objects of speculation, and the greatest casualties of the mortgage bubble, were housing and the financial companies that held those mortgages. Recognize that because QE provoked such indiscriminate speculation, the recent extremes in the median price/earnings and price/revenue ratios, across all stocks, actually surpassed their 2000 peaks. Make no mistake: the preferred objects of speculation during the QE bubble have been low-grade debt and the entire stock market, indiscriminate of industry, sector, quality, or capitalization. We are now beginning to observe internal divergences that signal increasing risk aversion among investors. The greatest casualty of the QE bubble will also likely be low-grade debt and the entire stock market, probably just as indiscriminately.

The economy is increasingly likely to roll into a recession at the same time the equity market rolls into a rather severe bear market decline. If the Fed raises rates in that environment, the FOMC will likely be blamed for losses that are actually already inevitable as a result of the Fed's much earlier recklessness. If the Fed fails to raise rates in that environment, after having conditioned investors to expect a rate hike, it will likely be taken as a vote of no-confidence in the economy, and the FOMC will likely be blamed for losses that are actually already inevitable as a result of its much earlier recklessness. Ultimately, the only way to avoid near-term losses is to make the prospect of longer-term losses that much worse.

Investors don't like to acknowledge bubbles. Yet somehow we have little doubt that a few years from now, they will look back at the present moment and ask that tragic question: "What were we THINKING?"


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