Will the Bubble Pop?
Recent days have seen eerie parallels to the late Summer of 1987, when one Alan Greenspan – viewed then with suspicion as a political placeman – took the helm of the Federal Reserve at a time when international tensions were high, the U.S. was in the grip of a speculative orgy of stock buying and takeover activity, and when the Greenback was falling sharply, driven down by a loss of confidence on the part of those foreign investors who had fuelled the go-go ethos of the booming Reagan years.
Recent years have seen eerie parallels with the Japanese bubble of the same era when innovations in financial engineering allowed companies access to seemingly costless capital, giving rise in turn to prodigies of investment and promoting aggressive expansion overseas. Then, equity derivatives were harnessed to raise cheap funds directly for the firm via the attachment of warrants to debt issues: today, equity derivatives are harnessed indirectly by their widespread use in keeping employee contributions out of the bottom line (and, incidentally, out of aggregate measures of unit labour costs).
Recent years have seen eerie parallels with the 1920's when world overcapacity forced down the prices of traded goods made ever more abundant by the applications of striking and exciting advances in technology and communications and the Strong-Norman duumvirate at the pinnacle of the world monetary order kept credit easy to offset the tensions generated thereby. The disruptions to international lending which followed, the pattern of over-consumption, heavily reliant on aggressive marketing of the new installment credit techniques, the fascination, turning to obsession, with the value of the stock market are all well known and all have their counterparts today.
For all the acres of newsprint expended on glowing talk of the New Paradigm and all the post-hoc musings of the gerontocrat technophile, Greenspan, on the potentialities of the laser beam (sic) and the silicon wafer, economists of the Austrian School cast a more sceptical eye on proceedings. Devotees of von Mises, Hayek and Rothbard would recognise events of the last four years as nothing more than a classic, interventionist, credit expansion and would warn of the inevitable consequences when the process stutters to a halt.
Over the long history of the U.S. stock market, price/earnings ratios have averaged somewhere in the mid-teens. Today the broad market is twice that, while the NASDAQ enjoys a mind-boggling multiple 10 times the norm. The derived steady earnings growth factor on even the first, given expanding corporate spreads and generally rising bond yields of late, is some 3.6% in perpetuity. Given that the economy has shown few signs of being able to grow at greater than around 5.0-5.5% in nominal terms in the last several years--the world economy, indeed, growing at an even more sedate pace--this allows a mere 1.5-2.0% economic risk premium, probably less than a third of the typical safety margin historically demanded.
Moreover, with dividend yields a paltry 1.2% on the broad market, stock returns are now more dependent than at any time on capital returns, not the income stream derived therefrom. Given that one can currently lock in a compounded, risk-free return of 6.8% semi-annually for 20 years by buying a US Treasury strip, or zero coupon bond, it is evident that there is little room for any accidents on either earnings growth or the end multiple the baby boomers will have to command from their demographically-fewer working age grandchildren when they come to cash in.
Stock returns of late have been such as to banish all rational calculations from the mind of the public. Indeed, earnings have risen in the period such that the return on book value has moved from 17% in late 1994 to range between 20-23% since. Granted, corporate profits after tax have risen as a percentage of GDP from around 4% to nearer 6%, though some (including both those at the SEC and the likes of Warren Buffet who recently compared company reports to dubious golf scores) would wonder how much of this is simply due to an ever more aggressive exploitation of FASB loopholes.
The real crux here though is that profit growth has slowed, if not stagnated, since the middle of 1997 and returns on equity have been maintained largely through leveraging the balance sheet, issuing relatively cheap debt to retire equity. This has been effected not so much to secure long term capital at favourable rates, but to make the quarterly numbers and thus maintain favourable stock price momentum. Nothing to do with CEO stock option packages, you understand. The scale of this trend can be seen from the flow-of-funds accounts; non-financial businesses retired $305 billion of equity and issued $418 billion in debt, effectively raising gearing $723 billion, or a twelfth of GDP, in the last four quarters, a total which has hit over $2 trio in the bubble years.
So whence other have the phenomenal stock returns originated? Multiple expansion, or, in plain English, a heady combination of the inflation of the present price attached to the future value of earnings and the estimated trajectory of those earnings. It is all a long way from the cautionary words of Graham and Dodd who asserted in their investment bible, Security Analysis, "Value based on a satisfactory trend must be wholly arbitrary and hence speculative, and hence inevitably subject to exaggeration and later collapse."
Yet here is the paradox: the unprecedented rise in the multiples, both of earnings and book value, suggests, in isolation at least, a decline in time preference, ie a greater willingness to forego consumption today for the command over resources which will allow consumption at some later date. How then are we to reconcile this with an economy which has seen the personal savings rate decline from 6% of income when Greenspan assumed the chair to a negative 1.4% today? This suggests an extreme degree of time preference – or in less anodyne language - a voracious demand for the satisfaction of immediate wants such that the ‘originary' rate of interest (the intrinsic discount rate applied to future satiety) is in fact infinite!
Less academically, America is a nation which has so outstripped its own productive capacity that it has seen the current account balance deteriorate from a deficit of around 1.5% of national product just four short years ago to 3.7% today. It is a nation where household debt has risen from two thirds of income in 1987 to over 82% today, where the level of mortgage debt as a proportion of income has been raised to a new height of 62% from 38%, where consumer credit is well over a trillion dollars, where over a third of "savers" borrow against their 401(k) retirement nest-egg. Americans are consuming capital on a vast scale. They have become a nation of Tomorrow Eaters.
So how do we square the circle? In part the strong dollar policy of the Rubin years sucked in capital from abroad. The four quarters to June alone have seen $573 billion flood into the States on the capital account, with less than half that being recycled, such that the net inflow of $322 billion has more than covered the $208 billion deficit on goods and services racked up in the period. So far, so good. If Americans collectively wish to rearrange their balance sheets in the pursuit of the greatest degree of the satisfaction of their wants, that is their privilege. The darker side is the debt explosion and here we can blame none other than the Monetary Messiah himself, Alan Greenspan.
Like his predecessor in the Twenties, Ben Strong, Greenspan has not noticed that his much-vaunted supply-side revolution should have depressed prices throughout the period. The fact that the rate of increase has merely slowed shows that the supply of money, broadly defined, has been too rapid and thus masked this. Furthermore, he has been so pre-occupied with international events since his own salutary encounter with the mild debt deflation of the early 90s domestic "credit crunch" that--staggering from Mexico to Thailand to Korea to Russia and back to Brazil, pouring in liquidity at every juncture--he has since foresworn the hard decisions necessary to restore monetary order at home.
In the last four years, commercial paper outstanding in the U.S. has doubled while commercial bank assets as a percentage of GDP have burgeoned from roughly 55% to over 60%. Repurchase agreements (a subtle way to monetize government debt if there ever was one - cf the German Reichsbank in the Great War) have increased 50% in two years. While supposedly tightening these last few months, the Fed has in fact been involved in the generous provision of high powered money, taking its own holdings of treasuries to new records weekly at a 10.8% annual rate.
At the apotheosis of this process in the past year as the sluices were opened to offset the LTCM debacle, domestic financial debt increased a mind-boggling $1.1 trillion, or fully 20% of the total existing debt stock. When Greenspan took up the reins, financial debt was 95% of non-financial corporate debt: today, the ratio is 174%. Then, it represented some 39% of national income: today, the figure is 80%. Concomitant with this credit inflation has been the inexorable rise of the stock market's Q-ratio – its own proportion of GDP – from an unexceptional 54% to today's towering 155%, or its expansion from under 30% of the world market capitalization to a shade under a half now.
Monetary pumping on this order, as the Austrians will tell you, leads to serious distortions in the price structure of an economy which cannot be captured in crude, aggregate, index numbers. These distortions between the value of goods, present and future, lead to mal-investments and a clustering of false decisions. Factories built and productive processes put in train based on a market rate of interest artificially lowered by the effulgence of fiduciary media are not backed up by real savings and thus become misaligned with a propensity for consumption which has, if anything, intensified. A raft of ‘entrepreneurial errors' lies ahead.
This means not only the prospect of half-finished malls, hotels and offices (factories are deliberately omitted since we have also witnessed a secular shift in the amount of construction dollars spent on premises devoted to redistributing wealth, rather than generating it in the first instance), but also completed, but now distinctly sub-par undertakings: businesses and plant which cannot possibly earn the returns projected at inception. Less visible, though more widespread, such an overhang will depress returns on capital where they do not wipe it out completely. The credit expansion, once it draws to its inevitable end, will impoverish everyone, everywhere.
Recently, this realization has begun to dawn on the world's fiat money kings. BOJ Governor Hayami said in a speech a few months ago that credit was not capital and that while he could provide the first, economic recovery required the second. The holy of holies, the BIS itself stated bluntly in its annual report that much of the malaise in the world financial and economic system could be put down to the fact that the cost of capital in at least one major centre had been artificially low for too long this decade. Step up to the winners' rostrum, Mr Greenspan, 3%, Mr Hayami, 0.2%, and Mr. Duisenberg, 2.5%.
Savings ratios are declining sharply in the Anglo-Saxon world and are likely to follow elsewhere as consumers stir anew: term premia in interest rates are rising accordingly. Inflation premia, measured by the yield differential between straight and index-linked government bonds, have gone up by over 1% in the last six months in the UK, the US and Europe as the world begins to fret on another bout of central bank inflationism. Credit spreads have exploded as entrepreneurial risk (and debt and derivative worries about the financial sector) have come to the fore once more. All these are driving yields up sharply and inflicting punishing capital losses, not to mention making equities look ever more anomalous. An over-leveraged system with high concentrations of assets in over-priced stocks is a recipe for disaster.
Since the BIS report, there has been a certain sentiment shift towards long-overdue restraint. Most notable was the Bank of England, for all the ill-considered outrage among wrong-footed analysts which greeted its recent rate rise. Others too, the RBA, the RBNZ, the SNB and the Riksbank among them, have talked of possible rate rises ahead. The ECB, disappointingly is moving here at a self-confessed ‘snail's pace'. The Fed has started, but half-heartedly and amid a flurry of conflicting comment, some of it too sanguine, some downright irresponsible and uncomprehending, such as remarks by NY Fed boss McDonough that stocks were not overvalued and the dollar was of no concern.
The problem now is that the flood of capital into Japan, partly a defensive retreat on the part of domestics smarting from another currency debacle, partly an aggressive foray on the part of foreigners hoping finally to catch the Nikkei's lows, is threatening to short-circuit hopes of making this an orderly process. When the Almighty Dollar, de facto totem of the world monetary order, can fall 18% in two months against the unit of a country which gives its currency away essentially for free, has severe demographic problems, no natural resources, a grid-locked and speculative political structure and a near-bankrupt fiscal position, we know that the end is near. These are worrying times indeed and, given the self-reinforcing nature of capital markets, another sharp dislocation may be imminent.
Credit-led business expansion has always ended in one of two ways; depression – which used to be a sharp, cathartic affair before the Keynesians and New Dealers and their successors at the MOF contrived to institutionalize it by preventing market adjustment--or hyper-inflation and a collapse of the existing monetary order. As Roger Garrison has put it, paraphrasing von Mises, "the Central Bank can print itself into trouble, it cannot print itself out."
Ask not for whom the bell tolls, Alan. It tolls for thee.
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Sean Corrigan is a London-based stock analyst.