Boom Times Compared

It has become abundantly clear by now that the late 2018 swoon was not yet the beginning of the end of the stock market bubble – at least not right away. While money supply growth continues to decelerate, the technical underpinnings of the rally from the late December low were actually quite strong – in particular, new highs in the cumulative NYSE A/D line indicate that it was broad-based.

 

Cumulative NYSE A/D line vs. SPX – normally the A/D line tends to deteriorate before the market peaks, as the advance narrows and fewer and fewer stocks participate in the rally. This did in fact happen shortly before the early October top.

 

To be sure, there are still technical warning signs as well – for instance, a number of divergences remain in evidence and several (but not all) measures of positioning and sentiment are back at extremes. On occasion of the two previous major market peaks in 2000 and 2007 the S&P 500 Index streaked to a marginal new high after an initial sharp correction and only began to decline in earnest thereafter. It is possible that such a retest of the highs will once again prove to be  the turning point, but this is of course not certain.

What prompted us to write this post was the highly unusual timing and ferocity of the decline in late 2018. We were wondering whether there were any comparable historical precedents – and lo and behold, there is one. When the boom of the 1920s entered its final stretch, the stock market did something very similar: it fell quite rapidly and precipitously at the end of 1928 and recovered just as quickly. It then went on to make new highs in 1929. Alas, as is well known, this happy state of affairs did not last very long. It was rudely interrupted by a crash that was ultimately followed by the most severe bear market in history.

 

The sharp correction of late 1928 was just as unusual in terms of its timing as the one of late 2018 – and the market recovered just as quickly. The DJIA fell from a high of 295 points on November 28 1928 to a low of 257 points on December 8 (down ~13%). By December 31 it was back above the starting point of the decline, ending the year at precisely 300 points.

 

Naturally, if the unusual December correction were the only parallel, it would not be worth mentioning. But there are several interesting parallels between the 1920s boom and today. Among them are valuations in terms of the Shiller P/E ratio or CAPE (cyclically adjusted P/E):

 

The stock market’s valuation is actually slightly above the level of 1929. This will be mitigated a bit when the 2009 data are no longer part of the calculation, but even then the market will remain close to the upper end of the long term valuation range. Moreover, today’s valuations happen to coincide with unusually high profit margins, which are traditionally mean-reverting.

 

There are still more interesting parallels. For instance, in a recent missive, John Hussman quotes Dow Theorist William Peter Hamilton, who remarked on the stock market’s advance in 1929 that while it was clearly in the last inning, one had to respect trend uniformity in the short term, i.e., the fact that the Industrial and Transportation Averages were confirming each other and the advance was still quite broad-based.

 

Interest Rates and Central Bank Intervention

Even more interesting to our mind are the moves in interest rates and the actions undertaken by the Fed. Below is a chart of the NY Fed’s discount rate from 1915 – 1934 with annotations. You may be surprised to learn that the huge securities purchases after the 2008 debacle were actually not a completely untried policy.

 

The Fed engaged in large securities purchases from late 1921 to mid 1922 and again from mid 1923 to late 1924 and in mid 1927. This was done with the intention of stabilizing consumer prices  (obviously, this price stabilization policy continues to be popular with central banks to this day – and it is just as dangerous today as it was then). Interestingly, the rate hike cycle was subject to a pause between mid 1928 and mid 1929, which is also eerily reminiscent of the current situation. Lastly, the Fed once again engaged in massive securities purchases between the fourth quarter of 1929 and the first quarter of 1933 – only this time it was unable to keep prices from declining.

 

The next chart shows a weighted average of interest rates in New York from 1919 to 1933 (it contains the average rate on stock exchange call loan renewals, the  rate on 4-6 month prime commercial paper, the rate on 90 day prime bankers’ acceptances, and the rate on 90 day stock exchange time loans). It is noteworthy that market interest rates kept rising during the Fed’s rate hike pause. As usual the Fed followed the market and was forced to “catch up” with it in mid 1929. By that time, the economy was already deteriorating.

 

Weighted average of NY interest rates from 1919 to 1933

 

The late stages of a boom are traditionally accompanied by rising interest rates. In essence, this represents a reassertion of time preferences, which are higher than previously thought. A distorted production structure ties up ever more final goods in production, and bottlenecks begin to develop. A scramble for scarce capital ensues, while still rising asset prices at the same time egg on speculative credit demand  (for additional color on this see also: The Capital Structure as a Mirror of the Bubble Era).

Eventually the distortion of relative prices that is a hallmark of the boom reverses (although this never leads to a restoration of the same price structure that prevailed on the eve of the boom) and a bust commences. The bust is actually a salutary event – it serves to realign the economy’s capital structure to the actual balance between savings and consumption.

This realignment takes time and is accompanied by numerous unpleasant side effects, but if the economy is left to its own devices it usually doesn’t take overly long. Unfortunately, the administrations of Herbert Hoover and his successor FDR were both extremely interventionist – hence the “Great Depression” (this was not the main reason for the severity of the bust in the short term, but it did deepen and above all lengthen it unnecessarily).

 

What Happens Next?

The parallels discussed above do not necessarily mean that the pattern of the stock market will continue to track that of the late 1920s boom period. It is certainly a possibility one should not dismiss out of hand, but as mentioned above, the two most recent major market peaks occurred in the context of retest highs.

There are also differences between the various boom-bust cycles; for instance, the 1920s boom was characterized by both malinvestment in the higher stages of the production structure and debt-funded over-consumption on the part of consumers. This time around the consumer spending has been comparatively muted, while the corporate universe has amassed truly staggering amounts of debt and is home to an unprecedented number of “zombie companies” which depend on extremely low interest rates (and careless investors) for their survival.

Obviously the Fed’s back-pedaling in the wake of the October-December swoon in stock prices and the concomitant widening of credit spreads has emboldened investors. After all, they were told that “QT” will end early, that there will be a pause in rate hikes, and that the Fed stands ready to reactivate QE “if necessary”. There are even discussions over expanding the range of securities the Fed might buy to ward off the next bust.

However, investors would do well not to ignore history. As long-time readers of this blog know, we are of the opinion that the extent to which loose monetary policy can affect the economy and markets depends largely on the state of the economy’s pool of real funding. As long as this pool is growing – which permits the diversion of scarce resources into bubble activities through money printing – boom conditions can be restored fairly quickly. This is not the case once damage to the pool of real funding has become so grave that it stagnates or even shrinks.

This was essentially the situation the US economy found itself in when the market crashed in 1929. New York Fed president Benjamin Strong was one of the foremost proponents of the disastrous price stabilization policy (see also “The Errors and Dangers of the Price Stability Policy” for additional information on this topic). Moreover, he pushed for the 1927 discount rate cut and the associated securities purchases, which ended up catapulting the stock market bubble into overdrive (Strong famously quipped that he was providing a “coup de whiskey to the stock market”). He did so mainly to help Great Britain, which suffered gold outflows at the time.

Strong died in October 1928. Other Fed members were reportedly a lot more concerned about the speculative fever that had gripped Wall Street and it stands to reason that the decision to hike rates again in mid 1929 was at least partly driven by this concern. What happened thereafter should stand as a warning to investors who have become convinced that the Fed will always be able to bail them out.

 

Year-on-year rate of change in securities held by the Federal Reserve System from 1929 to 1933

 

As the chart above illustrates, the widely believed assertion that the Fed did nothing to counter the post-1929 bust is simply wrong (Ben Bernanke once even apologized for the Fed’s alleged inaction at the time!). Strong’s “coups de whiskey” became a veritable flood of whiskey – it was QE on steroids. Within three quarters of the 1929 crash, the annual rate of change of securities purchases by the Fed reached almost 300%. A second wave of massive purchases began in early 1932 and by March 1933 the Fed’s securities portfolio had grown by a cumulative 404% from its level of October 1929.

And yet, the Fed was unable to keep the bust from unfolding. Admittedly, it has become easier for the Fed to boost the money supply in modern times (almost all commercial banks are members of the system nowadays and the FDIC helps prevent the disappearance of deposit money held at insolvent banks). We would contend though that in view of the effects the monetary pumping efforts of the 1920s exerted on the economy and markets and the failure of the same policies to gain any traction in the early 1930s mainly shows that the pool of real funding had indeed stopped growing by 1929.

 

Conclusion

The main take-away from this is that QE is not always guaranteed to “work”. It stands to reason that after an extremely long time of (too) low interest rates a lot of capital has been malinvested – and there are numerous indications that this is indeed the case. The danger that the economy’s pool of real funding is in trouble is accordingly elevated, in which case the Fed will be powerless to stop a major bust from unfolding once it begins (note that it is not possible to measure the pool of real savings – but one can certainly make educated guesses about its state).

Of course a central bank in a fiat money system can in theory always opt for hyperinflation. Venezuela is a recent example of a country in which one of the worst economic contractions in history is accompanied by soaring nominal stock prices as the value of the local currency collapses (since we last wrote about Venezuela in September of last year, the IBC Index has risen by another 2,705% in bolivar terms  – a roughly 28-fold increase – while the economy has contracted by 25% y/y and the unemployment rate has soared to 45%).

The Fed as it is constituted today will certainly refrain from deliberately pursuing such a policy (although it may well trigger accelerating price inflation by mistake); in fact, it is illegal for the Fed to fund the Treasury directly – and this makes a big difference in terms of potential money supply inflation.

The future is unknowable and it cannot be ruled out that the central bank will one day be stripped of its independence if there is a severe economic downturn. That would increase the risk that a policy leading to hyperinflation could be adopted, but that is a bridge we will cross when (if ever) we get there. Until then a major bust should be expected to result in sizable declines in asset prices.

 

Charts by: StockCharts, acting-man, multpl.com, Frank Shostak; data by Dow Jones, St. Louis Fed, NBER

 

 

 

Emigrate While You Can... Learn More

 


 

 
 

Dear Readers!

You may have noticed that our so-called “semiannual” funding drive, which started sometime in the summer if memory serves, has seamlessly segued into the winter. In fact, the year is almost over! We assure you this is not merely evidence of our chutzpa; rather, it is indicative of the fact that ad income still needs to be supplemented in order to support upkeep of the site. Naturally, the traditional benefits that can be spontaneously triggered by donations to this site remain operative regardless of the season - ranging from a boost to general well-being/happiness (inter alia featuring improved sleep & appetite), children including you in their songs, up to the likely allotment of privileges in the afterlife, etc., etc., but the Christmas season is probably an especially propitious time to cross our palms with silver. A special thank you to all readers who have already chipped in, your generosity is greatly appreciated. Regardless of that, we are honored by everybody's readership and hope we have managed to add a little value to your life.

   

Bitcoin address: 12vB2LeWQNjWh59tyfWw23ySqJ9kTfJifA

   
 

Your comment:

You must be logged in to post a comment.

Most read in the last 20 days:

  • As the Madness Turns
      A Growing Gap The first quarter of 2019 is over and done.  But before we say good riddance.  Some reflection is in order.  To this we offer two discrete metrics.  Gross domestic product and government debt.   US nominal GDP vs total federal debt (in millions of USD) – government debt has exceeded  total economic output for the first time in Q4 2012 and since then its relative growth trajectory has increased – and it seems the gap is set to widen further....
  • Bitcoin Jumps as Ordered -  Precious Metals Supply and Demand
      Digital Asset Rush The only part of our April Fools article yesterday that was not said with tongue firmly planted in cheek was the gold and silver price action (though framed it in the common dollar-centric parlance, being April Fools):   “Gold went down $21, while silver dropped about 1/3 of a dollar. Not quite a heavy metal brick in free fall, but close enough.”   Bitcoin, hourly – a sudden yen for BTC breaks out among the punters. [PT]   It also...
  • A Trip Down Memory Lane – 1928-1929 vs. 2018-2019
      Boom Times Compared It has become abundantly clear by now that the late 2018 swoon was not yet the beginning of the end of the stock market bubble – at least not right away. While money supply growth continues to decelerate, the technical underpinnings of the rally from the late December low were actually quite strong – in particular, new highs in the cumulative NYSE A/D line indicate that it was broad-based.   Cumulative NYSE A/D line vs. SPX – normally the A/D line...
  • Debt Growth and Capital Consumption - Precious Metals Supply and Demand
      A Worrisome Trend If you read gold analysis much, you will come across two ideas. One, inflation so-called (rising consumer prices) is not only running much higher than the official statistic, but is about to really start skyrocketing. Two, buy gold because gold will hedge it. That is, the price of gold will go up as fast, or faster, than the price of gold.   CPI monthly since 1914, annualized rate of change. In recent years CPI was relatively tame despite a vast increase in the...
  • Unsolicited Advice to Fed Chair Powell
      Unsolicited Advice to Fed Chair Powell American businesses over the past decade have taken a most unsettling turn.  According to research from the Securities Industry and Financial Markets Association, as of November 2018, non-financial corporate debt has grown to more than $9.1 trillion [ed note: this number refers to securitized debt and business loans, other corporate liabilities would add an additional $11 trillion for a total of $20.5 trillion].   US non-financial corporate...
  • Long Term Stock Market Sentiment Remains as Lopsided as Ever 
      Investors are Oblivious to the Market's Downside Potential This is a brief update on a number of sentiment/positioning indicators we have frequently discussed in these pages in the past. In this missive our focus is exclusively on indicators that are of medium to long-term relevance to prospective stock market returns. Such indicators are not really useful for the purpose of market timing -  instead they are telling us something about the likely duration and severity of the bust that...
  • The Liquidity Drought Gets Worse
      Money Supply Growth Continues to Falter Ostensibly the stock market has rallied because the Fed promised to maintain an easy monetary policy. To be sure, interest rate hikes have been put on hold for the time being and the balance sheet contraction (a.k.a.“quantitative tightening”) will be terminated much earlier than originally envisaged. And yet, the year-on-year growth rate of the true broad money supply keeps declining noticeably.   The year-on-year growth rates of...
  • The Effect of Earnings Season on Seasonal Price Patterns
      Earnings Lottery Shareholders are are probably asking themselves every quarter how the earnings of companies in their portfolios will turn out. Whether they will beat or miss analyst expectations often seems akin to a lottery.   The beatings will continue until morale improves... [PT]   However, what is not akin to a lottery are the seasonal trends of corporate earnings and stock prices. Thus breweries will usually report stronger quarterly earnings after the...
  • The Gold-Silver Ratio Continues to Rise - Precious Metals Supply and Demand
      Is Silver Hard of Hearing? The price of gold inched down, but the price of silver footed down (if we may be permitted a little humor that may not make sense to metric system people). For the gold-silver ratio to be this high, it means one of two things. It could be that speculators are avoiding the monetary metals and metal stackers are depressed. Or that something is going on in the economy, to drive demand for the metals in different directions.   As a rule the gold silver...
  • What Were They Thinking?
      Learning From Other People's Mistakes is Cheaper One benefit of hindsight is that it imparts a cheap superiority over the past blunders of others.  We certainly make more mistakes than we’d care to admit.  Why not look down our nose and acquire some lessons learned from the mistakes of others?   Bitcoin, weekly. The late 2017 peak is completely obvious in hindsight... [PT]   A simple record of the collective delusions from the past can be quickly garnered from...

Support Acting Man

Item Guides

Austrian Theory and Investment

j9TJzzN

The Review Insider

Archive

Dog Blow

350x200

THE GOLD CARTEL: Government Intervention on Gold, the Mega Bubble in Paper and What This Means for Your Future

Realtime Charts

 

Gold in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Gold in EUR:

[Most Recent Quotes from www.kitco.com]

 


 

Silver in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Platinum in USD:

[Most Recent Quotes from www.kitco.com]

 


 

USD - Index:

[Most Recent USD from www.kitco.com]

 

Mish Talk

 
Buy Silver Now!
 
Buy Gold Now!