Excess Begets Excess … and Market Downturns
WHY YOU SHOULD CARE
Because, after a 10-year bull market, this is a great time to exercise caution.
Do you remember what caused Japan’s market dive in 1989? What about the Nasdaq in 2000? How about all global markets in 2008? The answer for all three is excess. If you look further back, you find excess preceding most market plunges, such as the crash of 1929 that marked the end of the Roaring ’20s (the name says it all).
If excess is often the harbinger of trouble, why don’t we stop before the insidious side effects topple markets? Simply put, because excess generates lofty forecasts that fuel more excess — what George Soros terms as reflexivity. Herein lies the problem.
When economies are growing, it’s easy for investors to focus on forward-looking indicators such as Price-to-Forward Earnings. But trust me, nobody was looking at such variables when Lehman Brothers went bankrupt. Instead, when panic arises, investors rely on the past: backward-looking indicators.
As debt has increased, the intertwined financial health of lenders and borrowers has come to precariously depend on rosy economic forecasts.
So to assess our current state of affairs, the first question is: Are we experiencing excess? And if so, and panic catches us wrong-footed, how do current market valuations look relative to the past? Let’s start with excess.
On October 8, 2008, the Federal Reserve released a “Joint Statement by Central Banks” announcing that it and six other central banks were lowering interest rates in an effort to alleviate the then-worsening credit crisis. The Fed eventually lowered its rate to 0 percent and kept it there between 2009 and 2015; today it stands at a still relatively low 2 percent. The European Central Bank currently has its deposit facility rate at -0.4 percent, and Japan is at -0.1 percent — negative rates!
Low rates were not enough, and Quantitative Easing (QE) became necessary. As a result, between 2009 and 2017, the monetary base (a proxy for available money in an economy) for the United States, Eurozone and Japan — which represent a combined 50 percent of world Gross Domestic Product (GDP) — all rose to all-time highs. To top it off, the U.S. government recently engaged in expansionary fiscal policy (tax cuts) at the height of a bull market.
Bottom line: The world has never had so much money at such low rates. Let’s assess how this has influenced behavior:
- U.S. personal savings as a percentage of disposable personal income (DPI) has dropped from 11 percent in December 2012 to 3.2 today, the lowest since January of 2008.
- U.S. consumer credit has skyrocketed to $3.88 trillion, an all-time high in absolute terms and relative to GDP (19.3 percent), most of it in credit cards and auto and student loans.
- Credit to U.S. nonfinancial corporations stands at $14.26 trillion; on an absolute basis, this is 34 percent higher than it was in 2008, while relative to GDP this represents an all-time high of 73.5 percent versus a peak of 72.5 percent in 2008.
- Outstanding leveraged loans and high-yield debt are at $1 trillion and $1.1 trillion respectively, nearly double the amount outstanding in 2007.
- Oversubscribed issuances last year of U.S. dollar-denominated debt from Ivory Coast (16-year bond, 6.125 percent coupon), Argentina (100-year bond, 7.125 percent coupon) and the Maldives (five-year bond, 7 percent coupon) depict the relaxed enthusiasm that exists to lend to entities with tenuous economic foundations and fluid political situations.
As debt has increased, the intertwined financial health of lenders and borrowers has come to precariously depend on rosy economic forecasts gliding along a path of predictable tranquility, in the hope that over time consumers, companies and countries reduce their debt load.
But what if problems were to arise in the bloated universe of consumer, corporate or emerging market debt? As trouble spreads and the future begins to look hazy, investors would turn quickly to history for guidance. Here are some indicators investors often rely on:
- The S&P 500 index trailing 12-month Price to Earnings (P/E), or how many dollars an investor is willing to pay for each dollar of corporate earnings, is 25; the historical mean is 16.
- S&P Shiller P/E (which uses inflation-adjusted earnings) is 32; the historical mean is 16.8 (the only time Shiller P/E has been higher than today was in the year 2000).
- S&P Price to Sales, or how many dollars an investor is willing to pay for each dollar of corporate revenue, is 2.2; the historical mean is 1.5.
- Buffet’s Market Cap (Wilshire 5000 Index) to GDP, which compares the market valuation relative to what a country produces, is 142 percent; a “fairly valued market” is considered to be in the 75 percent to 90 percent range.
These indicators are 40 percent or more above their historic averages, making it very tempting for panicked investors to sell.
Ironically, in attempting to solve the crisis of 2008, central banks have rendered the system more fragile. An unprecedented amount of cheap money has fanned across the world, plenty of it accumulating in high-risk pockets. It’s almost certain many of these borrowers and lenders have engaged in questionable practices that are untenable in the long run — it’s human nature.
The U.S. economy continues to perform well, but it’s imperative to remember to separate the system (consumers, investors and corporations) from the performance of the system (overall economic indicators). For example, consumer spending (which represents about 66 percent of U.S. GDP) has been high and thus generating growth; but much of this spending has been fueled by debt, causing many consumers to overextend. The performance of the economy is not necessarily reflective of the health of the underlying system.
It’s impossible to predict how millions of consumers, investors and businesses will collectively behave, and surely things can continue like this for a while, supported by additional debt and rosy forecasts that fuel reflexivity. But now that the Fed has ended QE and is raising rates, unknown ramifications are beginning to spread, and the debt-laden system will be tested. As things stand today, the probability of a significant market correction is high.
- Alonso Garza, OZY Author Contact Alonso Garza