Erstwhile “Dr. Doom” Becomes “Dr. Boom” – 1,000 SPX Points Too Late

From 2009 to sometime in 2012 when the stock market's echo boom rally was still in an earlier, less manic stage, Nouriel Roubini remained skeptical and bearish. We don't fault him for his skepticism: it was warranted, even if we didn't always agree with his reasoning. It could well be argued that with the exception of the 2009-2010 period, when prices were still fairly depressed, buyers of stocks took inordinate risk and were mainly gambling on the “Bernanke put”. They continue to do so, in what can only be termed an especially egregious manifestation of the 'potent directors fallacy' – a flight forward if you will, of the thundering herd. For Bob Prechter's view on this (he actually coined the term),  see here. 

It remains a good bet that all the gains that have accumulated since then will prove to be of the transitory variety, unless the economy tips over into a hyper-inflationary crack-up boom. In that case, the market may go bananas in nominal terms, similar to what has recently happened in Caracas, but in the words of Kyle Bass: “you will be able to buy three eggs with your profits”.

There are moreover very good reasons to expect that this won't happen, at least not at any point in the near future (say, the coming several years).  It is conceivable that there will come a time when the government must decide between outright default or indirect default through hyperinflation, but it is not knowable which path it will choose, or whether it will really come to that at all. Alternative paths definitely remain possible.

There is certainly more than a very good chance that the planners at the Federal Reserve will one day find out that they have trouble putting the genie back into the bottle. Their conception of inflation as rising consumer prices leaves a lot to be desired after all, and they are probably underestimating the powerful lagged effects that their massive boosting of the money supply will eventually exert.

However, in the event that 'price inflation' becomes noticeable at some future point in time and possibly a great deal larger than is currently expected, it certainly won't be good for stocks. Just consider what happened to stocks in the 'stagflation' era of the 1970s: their multiples were compressed to bear market lows in the single digits. In other words, if one expects higher rates of consumer price inflation, one should get out of stocks while their valuations remain near a historic extreme. The stock market is not 'cheap'; it is quite expensive in fact. For a detailed explanation as to why this is so, we refer you to these recent overviews at Advisor Perspectives: “Is the Stock Market Cheap?” and “Market Valuation Overview”.

Anyway, after watching the SPX rise by nearly 1,000 points from a low of about 670 points in 2009 (even larger percentage gains were recorded by mid and small cap stocks), Roubini is changing his tune. Now he's suddenly bullish. Here is is reasoning in a nutshell:

“Stock market prices will continue to rise for the next two years until the wealth gap between Wall Street and Main Street gets too high and reality sets in, economist Nouriel Roubini told CNBC.

Worry about the Federal Reserve backing off its historically unprecedented monetary easing is premature, Roubini said, as economic growth is too tenuous and the market too dependent on the $85 billion in monthly asset purchases from the central bank.

"Growth is not going to pick up and inflation actually is falling," the head of Roubini Global Economics and noted "Dr. Doom" told "Closing Bell." "So the markets are worried about tapering off sooner, but I think tapering off is going to occur later and therefore the market is going to rally."

(emphasis added)

In essence this could be called a good summary of what is today conventional wisdom. We are not referring to the contention that 'QE' will continue: we fully agree with it. All the recent belly-aching about the possibility that the Bernanke-led Fed might turn off the  spigot is actually rather mystifying. If there is one idea that unites Bernanke and his closest supporters at the Fed's board of governors, it is the notion that it is 'dangerous to end the stimulus too soon'.

We also have no problem with the idea that the economy will remain weak (we are less sure about what 'inflation', i.e., prices, will do). However, we believe it will remain weak precisely because the 'stimulus' is bound to continue.

What represents the conventional wisdom in Roubini's assertions is this part: “Because the Fed's money printing will continue, stocks will continue to rise.”

Liquidity and the Prices of Stocks

It is certainly not wrong to argue that stock prices have risen so much because there has been (and continues to be) extremely loose monetary policy. Excess liquidity in the economy is bound to go somewhere. With interest rates at rock bottom levels, it is not too surprising that titles to capital have increased in price. There is however nothing that says that this must continue. That would be tantamount to claiming that liquidity is the only factor driving stock prices. However, consider in this context the following chart of conditions in 1930 to 1931 (courtesy of Frank Shostak):

1930 to 1931: in spite of a huge expansion in the growth rate of free liquidity, the stock market collapsed. Investors bought treasury bonds rather than stocks.

As Shostak writes:

“We have seen that in some cases, such as the Great Depression of the 1930s, the time lag between the bottom in the growth momentum of liquidity and the beginning of a new bull market can be extremely long. An important factor that prolongs the lag is that an increase in liquidity on account of a collapse in the economy is not a great incentive to put money into stocks.

Despite massive increases in liquidity, as we had during the 1930s, the risk-adjusted return for being in stocks wasn't that attractive relative to some other asset classes, such as treasuries or just keeping money in cash or in short-term money-market instruments.

An increase in liquidity rather than entering the stock market in this case supports other markets. Note that by June 1931 the S&P 500 stood at 14.8, against 21.45 in December 1929 — a fall of 31%. This fall took place despite an increase in the rate of growth of liquidity from 4.7% in December 1929 to 21% by June 1931.

In contrast, the increase in liquidity was supporting Treasuries. The yield on the 10-year Treasury bond was in a gentle downtrend. The yield eased from 3.4% in December 1929 to around 3% by June 1931.”

(emphasis added)

Of course today's conditions are not similar to those in the 1930s. This is merely an example of an extreme case that illustrates that there are often very large time lags between increases or decreases in liquidity and the expected reaction of stock prices, and moreover that an increase in liquidity alone is not necessarily sufficient to drive stock prices up.

As John Hussman notes in his weekly update:

“One of the most strongly held beliefs of investors here is the notion that it is inappropriate to “Fight the Fed” – reflecting the view that Federal Reserve easing is sufficient to keep stocks not only elevated, but rising. What’s baffling about this is that the last two 50% market declines – both the 2001-2002 plunge and the 2008-2009 plunge – occurred in environments of aggressive, persistent Federal Reserve easing.

It’s certainly true that favorable monetary conditions are helpful for stocks, on average. But that average hides a lot of sins.

There are many ways to define monetary conditions using policy rates, market yields, and variables such as the monetary base or other aggregates. But given the strong relationship between monetary base/GDP and interest rates, these measures overlap quite a bit, and the results are quite general regardless of the precise definition. For discussion purposes, we’ll define “favorable” monetary conditions here as: either the Federal Funds rate, the Discount Rate, or the 3-month Treasury bill yield lower than 6 months prior, or the last move in the Fed Funds or Discount Rate being an easing. Historically, this captures about 52% of historical periods. During these periods, the total return of the S&P 500 averaged 13.5% annually, versus just 8.8% annually when monetary conditions were not favorable.

This is a worthwhile distinction, but it doesn’t partition the data enough to separate out periods where the average return on the S&P 500 was below Treasury bills. So historically, using this indicator alone would have suggested holding stocks regardless of monetary conditions. One might expect to do better by taking a leveraged exposure during favorable monetary conditions, and a muted exposure during unfavorable conditions, but this strategy would have invited intolerable risks. Strikingly, the maximum drawdown of the S&P 500, confined to periods of favorable monetary conditions since 1940, would have been a 55% loss. This compares with a 33% loss during unfavorable monetary conditions. This is worth repeating – favorable monetary conditions were associated with far deeper drawdowns.

If this all seems preposterous and counterintuitive, consider the last two market plunges. While investors seem to have forgotten this inconvenient history, the 2001-2002 market plunge went hand-in-hand with continuous and aggressive monetary easing.”

(emphasis added)

In short, investors are falling prey to the 'potent directors fallacy' if they believe that the Fed can keep stock prices rising under all circumstances. What is especially important and striking about all this is how deeply ingrained this belief has become. As we have argued in our recent comments on the 'tapering' issue, we agree with Peter Atwater that once faith in the omnipotence of central banks has become so pervasive, it is likely to be a contrary indicator. It cannot possibly become even more intense, so it is a good bet that it will eventually go the other way and crumble.

How will we know when that happens? We would suggest that the gold price is probably a very good indicator (among other things) of the faith market participants have in central banks and economic policymakers more generally. If the gold price were to begin to 'go parabolic', it would probably be a strong hint that the belief that policymakers have things 'under control' is finally  discarded. We don't know when this is going to happen, but we strongly believe that it will eventually happen.

As to Nouriel Roubini's new-found bullishness: it is always possible that even a blind squirrel finds a nut once in a while, but we think it would be best to regard is as yet another medium term warning sign.

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