Financial Potemkin Village

A rising stock market has the illusory effect of masking the economy’s warts and blemishes.  Who cares if incomes are stagnant when everyone’s getting rich off stocks?  Certainly, winning wealth via the stock market beats working for it.

 

Learning from history, 2018 style [PT]

 

Without question, the pleasure that comes when opening an inflated quarterly brokerage statement is much more satisfying than a lackluster biweekly paycheck.  But not only does paper wealth grow when the stock market rises, implied intelligence grows too.  The quarterly statements, with growth lines moving up and to the right, prove it.

Why grumble over a labor participation rate that’s at a 40 year low when Netflix is up over 6,000 percent?  The abundance of cheap, frivolous, and on demand content, more than makes up for the lack of well-paying jobs.  Indeed, there has never been a better time in the history of the world to be a couch potato – particularly when 75 inch flat screen televisions can be bought on credit.

On Wednesday, with much celebration, a generally meaningless milestone was notched. U.S. stocks, as measured by the S&P 500, marked their longest bull market run in history.  They have gone 3,453 days without a 20 percent decline…  though there have been several close calls (i.e., mini bear markets) along the way.

Those who profited most over the course of this bull market, were those who ignored the many potential disaster scenarios that presented themselves, and blindly bought an S&P 500 Index Fund or shares of Facebook and Amazon.  Buy and hold.  Dollar cost average.  Buy the dip.  These were the strategies that delivered big over this bull market. What to make of it?

 

Winners and losers… it was a one-way street for a very long time. We know it is hard to believe, but that is going to change. [PT]

 

One of the higher callings to aspire to in life is that of finding meaning in the meaningless.  Hence, we’ll take the stock market’s historic, yet meaningless, achievement and use it as a source for meditation and reflection.

“The bigger they come, the harder they fall one and all,” observed Jimmy Cliff during the bear market of the early 1970s.  Taking this simple insight, what follows is a scratch for perspective on one of the suspicious cornerstones of this bull market.

 

Promise of the Gospel

The zealous belief in the tea leaves of data have confidently driven trading decisions via the rear view mirror over the course of this bull market. The rationale of the ardent promoters seems to be that with a long enough time series of data and a well-tested rules-based algorithm, tomorrow’s trading decisions can be made today.  The answers to tomorrow’s trading questions, according to these data models, were already uttered in the past.

Young economists, with much more data and much less understanding than 19th  century homesteaders holding a dog-eared copy of the Old Farmer’s Almanac, operate with remarkable confidence.  They believe they know the answers to tomorrow’s questions while their feet are firmly planted in today and their eyeballs are glued towards yesterday. Massive data sets are plotted and projected out with the promise of delivering the gospel.

 

The models have found a definitive answer to successful investing! For the very first time in history stock market strategists are able to come up with truly profound insights such as the one above, thanks to technological progress and the general increase in intelligence and market acumen imparted by rising stock prices. A new era has undeniably arrived. If you want to gain greater understanding of the situation, try to picture a permanently high plateau… [PT]

 

These statistical prophets dial in their cutting-edge computing power, place their faith in automated decision making, and pre-program future trades that will, no doubt, make them rich. With enough data, and enough regression analysis modeling, there is not a fraction of a dip that cannot be exploited for high frequency trading profits.  What could possibly go wrong?

One of the potential hazards of being über-smart is that it puts one at greater risk of being über-stoopid.  Just ask Nobel Prize economists Myron Scholes and Robert Merton.  In 1998, Scholes and Merton – and their investors – learned an expensive and humbling lesson about the limits of data modeling.

 

Evidently, LTCM should have used the much cheaper and more effective Dilbert model, which is supported by 87 studies. [PT]

 

In just four months, their hedge fund, Long Term Capital Management, hemorrhaged $4.6 billion.  Before the bloodbath was over, financial intervention  by the Federal Reserve was required to prevent a panic of mass liquidation.

Apparently, the Nobel Prize-holding duo’s quantitative models failed to predict the 1997 Asian financial crisis and 1998 Russian financial crisis.  In short order, Long Term Capital Management’s highly leveraged interest rate convergence trades did what was held to be statistically impossible – they diverged.

At that precise moment, the reputations of Mr. Scholes and Mr. Merton also diverged from their previous path.

 

As the Credit Cycle Turns

The experience over the last nine years – and also over the last 35 years – presented by the stock market, is one of near uninterrupted upward progress.  The experience over the last 35 years presented by the debt market is one of ever declining interest rates.

We suspect the next 35 years will look quite different from the preceding 35 years.  Yesterday’s market data will no longer be a good predictor of tomorrow’s market movements. Rather, it will be a source of trouble for quantitative analysis.

Presently, the risks of a financial crisis are also increasing.  After a decade of cheap money policies, which resulted in a flood of credit from American and European investment funds to emerging market borrowers, the credit cycle has turned.  The Federal Reserve, albeit slowly, is shrinking the Fed’s balance sheet and tightening the federal funds rate.

 

Brewing storm 101: total assets held by the Fed continue to decrease, while the FF rate keeps marching higher. Emerging markets were the first to feel the pinch, but it is eventually going to migrate to the center. [PT]

 

As the dollar’s value increases, emerging market borrowers are finding it more and more difficult to repay their debts with income in their depreciating national currencies. Turkey’s been the latest emerging market to feel this pinch.  Tomorrow it will be South Africa or Brazil or Russia or Mexico.

The consequences of an emerging market debt and currency crisis show up in the most unexpected places. The 1997 Asian financial crisis and 1998 Russian financial crisis resulted in the blowup of Long Term Capital Management. The 1994 Mexican peso crisis resulted in the bankruptcy filing of Orange County.

Given the length and breadth of credit that has been extended over the last decade, and the ever more risky search for yield, it seems likely the next blowup will find its way into a wide range of unsuspecting American investment portfolios.

 

Chart by: St. Louis Fed

 

Chart and image captions & editing by PT

 

MN Gordon is President and Founder of Direct Expressions LLC, an independent publishing company. He is the Editorial Director and Publisher of the Economic Prism – an E-Newsletter that tries to bring clarity to the muddy waters of economic policy and discusses interesting investment opportunities.

 

 

 

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2 Responses to “As the Credit Cycle Turns”

  • utopiacowboy:

    I keep reading articles like this all saying the same thing. In fact gold and silver will soon be worthless and the Dow will pass 100,000 on its way to infinity. This time it IS different!

  • RedQueenRace:

    “The Federal Reserve, albeit slowly, is shrinking the Fed’s balance sheet and tightening the federal funds rate.”

    I don’t know if this is an exact quote but Rudiger Dornbusch once said “In economics, things take longer to happen than you think they will, and then they happen faster than you thought they could.”

    The way the Fed is going about this (increasing the rate of shrinkage as the balance sheet decreases, rather than starting with higher run-off rates when it was bigger and “tapering the taper”) makes me believe that his quote could be easily modified to describe what will happen to this market.

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