Reflections upon the past few years bring out valid criticisms about “being wrong.” I have made no secret that I favor the bearish interpretation of eventually the stock market, but immediately the economy. The erosion and attrition I describe does not look like anything seen before, except the months and years immediately preceding the Great Recession. But that inevitably brings back the rejoinder that there is no such immediate danger right now, as bad as the economy may be there is nothing financially equivalent to the conditions that existed prior to August 9, 2007; with the further inference that a floor exists, economically speaking, today where a trap-door was present then.
What we are really describing, as investors, are the risks to the asset case as it exists now. The optimistic view, which is represented by almost every mainstream economist and policymaker, is really the basis for what they would like to believe is a monetary panacea and thus bull market. The economy is promised to be as a full recovery each and every year, to no ultimate avail. As Stanley Fischer put it recently:
Year after year we have had to explain from mid-year on why the global growth rate has been lower than predicted as little as two quarters back. Indeed, research done by my colleagues at the Federal Reserve comparing previous cases of severe recessions suggests that, even conditional on the depth and duration of the Great Recession and its association with a banking and financial crisis, the recoveries in the advanced economies have been well below average.
Even reading that acknowledgement you realize what the bull case actually is – it is not the recovery or the economy as it exists, it is the promise of one and the plausibility for that promise. Under that paradigm, the market doesn’t care whether orthodox economists are “right” as much as I may be “wrong”, only that there is always next year.
Other places in the world, however, are running out of “next year.” The same assumptions have fueled the trajectory of asset prices in Europe, with much the same vigorous results. Those that have expressed doubts about Europe’s positive numbers and the durability of any recovery were met with the same howls of being “wrong” as stocks rose exponentially (it seemed) alongside the sovereign debt prices of every nation that appeared desperately or even fatally broke only two years ago.
Given what has taken place recently with regard to economic projections and confidence in Europe, does “next year” still hold the same regard as far as stock and bond prices? Again, as in the US, the description and analysis of European economics as it may be outside of the overly optimistic recovery narrative is the difference between seeing a bull market take shape and a monetary-driven asset bubble.
The same can be said of Japan, though the unraveling there has been far quicker than anyone thought (except everyone who was “wrong” doubting Abenomics and the Nikkei).
That is the context into which we provide this analysis. The economy and the market are not the same, as Joe Calhoun regularly points out, but they do bear resemblance over the longer-term. At some point, given any large disparity, there has to be convergence and reckoning. Identifying these divergences not only colors the interpretations of market prices, it allows investors to identify risk.
The greatest risk in investing under these conditions is the Greater Fool problem. Anyone using mainstream economic projections and thus expecting a bull market will, if I and those like me are eventually proven correct, be that Fool. That was what transpired in 2008 as the entire industry moved toward overdrive to convince anyone even thinking about mitigation or risk adjustments that it was “no big deal.” Read through the 2008 FOMC transcripts, as I have done, and get a feel for what was taking place then and how it related to identifying the divergence of the economy with various markets (just as housing had done almost two years earlier, and where the same actors proclaimed the same “don’t worry” nothingness to the imbalance as it imploded in slow motion).
For the mainstream, there was not to be recession in 2008 until it became too obvious to ignore.
The risk that the economy has entered a substantial downturn appears to have diminished over the past month or so.
Federal Reserve Chairman Ben Bernanke, June 9, 2008.
Bernanke was not alone in that “confidence” as it filtered throughout economic projections and even what brokers and investment advisors recommended and said to their clients. For the most part, retail investors sat out 2008, passively watching as their 401(k)s became 201(k)s as the joke went. They did so because optimism ruled where it did not belong, because the cracks in the dollar system were not apparent outside of the technical complexity upon which the whole mess relied, a condition wholly different from those same faults never being presented.
But 2008 was 2008, and 2014 is a different circumstance. Or is it? We see the same types of cracks appear and widen, dysfunction continues on a global scale and the economy even here never lives up to those promises. So even evaluating on the individual circumstances here leads to the same framework – identifying the possibility that the economy may not be providing the support markets are expecting. Further, the potential trajectory of that may be such that “next year” never actually comes, and at some point “markets” become too aware.
It’s not as if mainstream orthodoxy has proven itself in that regard, regardless of anyone’s feelings about the current case. They have even invented a highly academic cover story to try to explain why we have yet to see “next year”; secular stagnation is both an implicit admission that economists have been wrong of their own accord, but yet, curiously, markets never adjust to that or how that might shade these same projections year after year.
I have serious doubts that the running theme of secular stagnation penetrates the rationalizations that currently anesthetize stock investors, for if they actually understood what it was about there would be very likely be far, far different results.
“I think we do need to try to identify asset bubbles in real time,” Dudley said today at the Bloomberg Markets Most Influential Summit in New York. “You can’t have an effective monetary policy if you have financial instability.”
…
Chair Janet Yellen acknowledged the risk in July, telling Congress that financial-market valuations appeared stretched in some sectors, including lower-rate corporate debt, and that policy makers were monitoring developments closely.
The Fed’s semi-annual Monetary Policy Report to Congress also discussed “substantially stretched” valuations for smaller firms in the social media and biotechnology industries.
The combined account of what was reported above with the idea of secular stagnation is bubbles as far as they eye can see. It also means exactly this kind of disconnect between markets and the economy, one that is opened up on a regular basis as a matter of policy. At Jackson Hole this year, Janet Yellen’s speech was devoted, in part, to the basic idea I paraphrased at the time as:
We had to blow bubbles because that’s the only way to get the economy to grow, and now we have to start thinking about the inevitable consequences of that.
Investments are about two facets, as Doug Terry is fond of reminding: returns which are all very apparent right now, and risk. Risk is defined as keeping those positive returns for more than just numbers on a long ago discarded custodial statement. You can generate all the positive return you want on the upside, but you better have a solid handle on risk of a downside that buries the returns wherever and whenever it may show up. An economy that never lives up to the hype set against rapidly rising prices is simply a highly increased probability of that.
The Fed is practically begging in that direction because they do not want to be Bernanke/Greenspan’s deer in the headlights for a third time. However, that doesn’t mean there won’t be a third time, only that they are on record now trying to “do something” about it. Will markets listen, or is the cloak of rationalizations about “next year” too densely packed?
How you handle the interim period before that time is determined by your own comfort with various analyses of divergences, and whether you feel you can accurately gauge the Greater Fool problem. No matter the desire for return, you better understand the context. Evne
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For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, contact us at: jhudak@alhambrapartners.com
