The Implosion Is Near: Signs Of The Bubble’s Last Days

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The central banks of the world are massively and insouciantly pursuing financial instability. That’s the inherent result of the 68 straight months of zero money market rates that have been forced into the global financial system by the Fed and its confederates at the BOJ, ECB and BOE. ZIRP fuels endless carry trades and the harvesting of every manner of profit spread between negligible “funding” costs and positive yields and returns on a wide spectrum of risk assets.

Moreover, this central bank sponsored regime of ZIRP and money market pegging contains a built-in accelerator. As carry trade speculators drive asset prices steadily higher and fixed income spreads steadily thinner—- fear and short interest is driven out of the casino, making buying on the dips ever more profitable and less risky. Indeed, the explicit promise by central banks that the money market rate will remain frozen for the duration and that ample warning of any change in rate policy will be “transparently” announced is the single worst policy imaginable from the point of view of financial stability. It means that the speculator’s worst nightmare—–suddenly going “upside down” due to a sharp spike in funding costs—-is eliminated by central bank writ.

Stated differently, ZIRP systematically dismantles the market’s natural stability mechanisms. One natural deterrent to excessive financial gambling, for example, is the cost of hedging a speculator’s portfolio of “risk assets” against a broad market plunge. In an honest market environment, hedging costs consume a high share of profits, thereby sharply limiting risk appetites and the amount of capital attracted to speculative trading.

By contrast, an extended regime of ZIRP, coupled with the central banks’ perceived “put” under risk assets, drives the cost of “downside insurance” to negligible levels because S&P 500 put writers are emboldened and subsidized to pick up nickels (i.e. options premium) in front of a benign central bank steamroller. This ultra-cheap downside insurance, in turn, attracts ever larger inflows of speculative capital to the casino.

This corrosive game has been underway ever since the Greenspan Fed panicked on Black Monday in October 1987 and flooded the stock market with liquidity. It is now such an endemic feature of Wall Street that it is falsely assumed to be the normal order of things. But, then, would anyone have been picking up nickels in front of the Volcker steamroller?

This dynamic is evident in the chart of the S&P 500 since the March 2009 bottom. The dips have gotten shallower and shallower as ZIRP and other pro-risk central bank policies have eroded the market’s natural defenses against excessive speculation. As of mid-2014, therefore, it can be fairly said that fear and short interest have been extinguished almost entirely. The Wall Street casino has thus become a one-way market that coils dangerously upward, divorced completely from the fundamentals of earnings and cash flow and real world economic conditions and prospects.

 

 

The inverse side of this coin is disappearance of volatility in the equity markets. As shown below, the current readings are at all-time lows, even below bottoms reached on the eve of the 2008 financial crisis. Needless to say, this dangerous condition does not appear by happenstance: its is the inexorable and systematic result of ZIRP and the associated tools of monetary central planning.

But all of this is ignored by the central banks because their Keynesian economic plumbing models contain a fatal flaw. These models purport to capture capitalism at work, but they contain no balance sheets and hardly any proxy for the financial markets which are at the heart of modern capitalist economies. As a result, central banks pursue ZIRP in order to inflate the plumbing system of the macro-economy with more “demand”—and hence more jobs, income, investment and GDP—-while ignoring the systematic destruction of financial stability that results from these very same policies.

As a consequence, Keynesian central bankers are bubble-blind. Whereas they monitor immense amounts of “in-coming”  high-frequency macro-economic data that is trivial and “noisy” in the extreme, they ignore entirely “in-coming” financial market data that points to monumental troubles just ahead.

At the present time, for example, 40% of all syndicated loans are being taken down by sub-investment grade issuers. This is materially higher than the 2007 peak, and is accompanied by an even more virulent outbreak of “cov-lite” credit terms. Indeed, upwards of 60% of these junk loans have no protection against debt layering and cash stripping by equity holders—-notwithstanding their nominal “senior” status in the credit structure. The obvious implication, of course, is that the Fed “easy money” is being massively diverted into leveraged gambling and rent stripping by the LBO houses. Three times since 1988 this kind of financial deformation has led to a thundering bust in the junk credit market. Why would monetary central planners, who allegedly watch their so-called “dashboards” like a flock of hawks, think the outcome would be any different this time?


40pc of syndicated loans are to sub-investment grade borrowers

The monetary politburo remains unperturbed, of course, because they are not monitoring the composition and quality of credit. Their models simply stipulate that aggregate business loan growth will lead to more spending on capital assets and operational expansion including hiring. That assumption is manifestly wrong, however, because it is plainly evident that most of the massive expansion of business credit since the last peak has gone into financial engineering—-stock buybacks, LBO’s and cash M&A deals—-not expansion of productive business assets. Indeed, total non-financial business credit outstanding has risen from $11 trillion in December 2007 to $13.8 trillion at present, or by 25%, yet real business investment in plants and equipment is still $70 billion or 5% below its pre-crisis peak.

And that is “gross” spending for plant and equipment as recorded in the “I” term of the GDP accounts.  The far more relevant measure with respect to economic health and future growth capacity is “net business investment” after accounting for depreciation and amortization allowances. That is, after accounting for the consumption of capital that occurred in the production of current period GDP. As shown below, that figure in real terms is 20% below the peak achieved two cycles back in the late 1990s.

In short, the combination of faltering investment in real plant and equipment juxtaposed to peak levels of leveraged loan finance should be a warning sign of growing financial instability. Instead, the central bankers bray that valuation multiples are not out of line and financial institution leverage is reasonably well-contained.

Real Business Investment - Click to enlarge

Real Business Investment – Click to enlarge

The “valuations are normal” line proffered by Yellen and her band of money printers, however, is simply an adaptation of the Wall Street hockey sticks based on projected earnings ex-items. That is to say, the kind of “earnings” estimates that omitted on average 23% of actual P&L charges over the course the 2007-2010 boom and bust cycle owing to non-recurring write-downs of goodwill, plants, leases and restructuring costs, among countless other real expenses—all of which ultimately consume corporate cash and capital. As I demonstrated in “The Great Deformation”, cumulative S&P 500 “earnings less items” over that four-year period amounted to $2.42 trillion compared to GAAP reported earnings—-that is, the kind that you don’t go to jail for reporting to the SEC—of only $1.87 trillion.

Consequently, the Fed fails to see the in-coming data on financial instability because it isn’t looking for it, and is simply tossing out Wall Street sell-side propaganda as a sop.  The disappearance of volatility in the S&P 500 chart shown at the beginning, for example, is nearly an identical replica of the run-up to the 2007 stock market peak. Yet the appearance of a proven warning sign of a bubble top has been resolutely ignored.

The fact is, PE multiples are far above “normal” based on GAAP earnings in historical context. During the LTM period ending in Q1 2014, S&P 500 earnings amounted to $100 per share after adjustment for a recent change in pension accounting that is not reflected in the historical data. Accordingly, even the big cap “broad” market is trading at 19.6X reported earnings—a level achieved historically only at points when the stock market was on the verge an implosion.

Moreover, today’s $100 per share of earnings are highly artificial owing to massive share buybacks funded by cheap debt and by deep repression of interest carry costs. The S&P 500 companies carry upwards of $3 trillion in debt, but were interest rates to normalize— earnings per share would drop by upwards of $10. Likewise, profit margins are at an all-time high, indicating that the inevitable “mean-regression” will chop significant additional amounts out of currently reported profits.

In other words, at a point which is month #61 of the current business cycle, and thereby already beyond than the average cycle since 1950, why would any one in their right mind say a market is not bubbly when it’s trading at nearly 20X reported earnings. Indeed, in a world where interest rate and profit rate normalization must inevitably come, the capitalization rate for current earnings should be well below normal—-not extended into the nosebleed section of historical results.

And this applies to almost any other measure of valuation in risk asset markets. The Russell 2000, for example, still stands at the absurd height of 85X reported earnings. The cyclically adjusted S&P stands at 24X, or six turns higher than its half century average. The Tobin’s Q measure is also far more stretched than in 2007.

Likewise, emerging markets have piled on $2 trillion in foreign currency debt since 2008. This makes them far more significant in the global financial scheme than they were in 2008 or even at the time of the East Asia crisis of the late 1990s. And that is not even considering the massive house of cards in China, where credit market debt has soared from $1 trillion at the turn of the century to $25 trillion today.

At the end of the day, the Fed and its fellow traveling central banks have systematically dismantled the natural stability mechanisms of financial markets. Accordingly, financial markets have now become dangerous casinos in which speculative bubbles are guaranteed to build to dangerous extremes as the central bank driven financial inflation gathers force.  That’s where we are now. Again.

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25 comments
econophile
econophile

David, this is really a fine analysis. Very insightful. I've been passing it around. Jeff H.

droubal
droubal

I don't know that a crash is imminent, but I think it certainly is going to happen, at some point.  If we get another 20 or 30% return in stocks, this year, that would probably do it.  It seems the world is becoming more reckless and unstable as time goes on.  That will have to be resolved at some point.  When is does resolve, have some cash, the opportunities will abound.

pauleade
pauleade

Everything is going to hell. I get it. But let's have an article about what will happen when the crash comes. How do we prepare? Will there be inflation? Deflation? Should i buy gold? Should I avoid dollars? Should I put money overseas?

Lostinaword
Lostinaword

But in the final analysis, all of this anti-Keynesian concern is really rather theoretical. Would you rather indulge in some post-hippie rejuvenated sense of outrage, or simply invest for your retirement? Millions upon millions have chosen the latter, correctly. Listening to the diatribes found in the articles written here, there is a strong tendency to merely wallow in imagined grievances in support of America's economic well-being. Actually, the evidence shows that America is not doing too badly at all.

PeterPaul2
PeterPaul2

This is the pyramid scheme played out to the bitter end.  Buying time for the elites and their friends to unwind all their investments and hide them safely before they drop the big one on the middle class.  This is the ultimate pump and dump which will strip all the meat from the bone leaving a holocaust of gnashing teeth.  But what follows will be the cold, relentless madness which seeks God's vengeance and wont stop until those Wall Street robber barons are hanging from all the trees between San Francisco and New York City.  Revenge will be sweet.  The middle class folks the Wall Streeter's held in such complete contempt, will now show what happens when the trust of the People is defiled.

halfkidding
halfkidding

The only way the financial system implodes is if it looses liquidity. There is no reason why  liquidity should falter as long as banks do not have to recognize losses. Which is exactly the case and it is the case because to a large extent economists, regulators and central banks don't care about the asset side of bank balance sheets. 


I ask and it isn't a rhetorical question, if everyone who is someone only cares about more credit and more money and not about recognizing losses then why does loss matter?  By what mechanism will balance sheet losses on the asset side make any difference at all? (Sooner or later even central bank balance sheets will not matter. No longer even buying assets, just printing, as per Modern Monetary Theory)


The emperor with no clothes analogy barely begins to express the nature of the system.  


DavidYoung2
DavidYoung2

Will it be another debt collapse in a Submerging Market or China that triggers the 2014-2015 Collapse?  Hard to tell what the trigger will be, there are so many Goose Eggs ready to rise to the surface, but it will be a whopper of a decline in global financial markets.  Will Gold and Silver follow other assets south as they did in Fall of 2008?  After a 3-year bear market during a super-cycle Bull Market for Real Money, both PM's will probably only suffer a temporary hiccup due to futures traders liquidity problems in especially the Bond market, and then head north like a scalded cat!  Most American investors will be left in the dust scratching their chins, but the East is accumulating both Gold and Silver for the inevitable Yellen Sellin'.  Obama Economy already in Recession Phase II on way to Greater Depression.  I would argue that based on understated GDP Deflators that we haven't had any positive GDP growth since 2007.  Inflation running at 9% to 10% for us Commoners who pay their own bills and shop for gas, food, healthcare.  Bad times ahead, America.  DIG YOUR FINANCIAL FOXHOLE NICE AND DEEP AND LINE IT WITH GOLD, SILVER, AND DIAMONDS.  Firearms and plenty of ammo also suggested.

dylanbernstein
dylanbernstein

i consider myself an austrian school heretic.  while i believe in a hard money and sound-banking philosophy, there is a new money system controlled by those who can change the rules whenever it suits them best.  that new money is called 'credit'.  the fed can expand it as much as it desires, especially knowing that there is no place else for the rest of the world to put their dollars safely, except for in the US.  inflation from all those currency units?  yes, in equities.  will it implode and when?  no one knows.  but, while those currency units come back into the US, the fed is mopping it all up like water in a desert with neat policy tools; and, if there is a correction within the markets, the rest of the world will pour even more dollars into US equities, buying the dip.  while the fed and market continues to mop up all those sloshing-around dollars, the market will climb even higher, beyond a 20,000 dow.  is it distorted?  yes.  but as long as those dollars are siphoned off into the greatest wealth transfer ever, the fed will be sure that the dollars are mopped up as it eases its way out of this mess over the next decade.    

Bankergod
Bankergod

Two Key Articles:

http://ourfiniteworld.com/2014/03/04/reasons-for-our-energy-predicament-an-overview/

http://ourfiniteworld.com/2014/01/02/why-a-finite-world-is-a-problem/

>>> Median wages are down roughly 10% in recent years – consistent with Gail’s theory that wages do not keep up with oil price increases leading to lower consumption levels and deflation – which are being countered by QE ZIRP and other stimulus

>>>Big Oil including Chevron and Exxon have cut capex citing the inability to turn a profit on new projects even with oil at $100+  --- (again consistent with Gail’s position)  so the beginning of leaving oil in the ground because it is not profitable to find and extract has begun 

>>> Of course oil prices are already too high and are destroying growth (pull off QE and ZIRP and growth completely collapses) so the higher prices required to motivate Big Oil to go after new sources cannot happen because that would exacerbate an already intractable problem

>>> Oil prices cannot go lower or capex will be slashed even further and Big Oil has an insolvency problem --- and the only current sources of oil growth – tar sands and shale --- will collapse --- and the price of oil would quickly accelerate far beyond the $147 that it high a couple of months before the Lehman collapse 

>>> Stimulus has masked the problems and has offset the impacts – for now…  but at some point we will start to push on a string

Bankergod
Bankergod

Yadda yadda yadda... we know (and the central banks know) where this is going to end --- in tears.


So why are they doing these things- what are the fighting?


HIGH PRICED OIL DESTROYS GROWTH

According to the OECD Economics Department and the International Monetary Fund Research Department, a sustained $10 per barrel increase in oil prices from $25 to $35 would result in the OECD as a whole losing 0.4% of GDP in the first and second years of higher prices.http://www.iea.org/textbase/npsum/high_oil04sum.pdf

(imagine what $100+ oil does to growth - hint: growth ends with oil at that price -- QE and ZIRP can compensate -- for awhile)

THE PERFECT STORM (see p. 59 onwards)

The economy is a surplus energy equation, not a monetary one, and growth in output (and in the global population) since the Industrial Revolution has resulted from the harnessing of ever-greater quantities of energy.

But the critical relationship between energy production and the energy cost of extraction is now deteriorating so rapidly that the economy as we have known it for more than two centuries is beginning to unravel. http://ftalphaville.ft.com/files/2013/01/Perfect-Storm-LR.pdf

tz1
tz1

Put more simply, Imagine if you could borrow a million, billion, or trillion, and would only have  to pay interest - zero - in perpetuity.  You could do anything no matter how stupid.

fosforos
fosforos

Why do you keep calling the Central Bankers "Keynesians?" Keynes (who was just about the only economist to understand financial markets well enough actually to make a lot of money by trading in them) would have been just as horrified as you are at their irresponsible policies of fueling financiaL speculation and enforcing financial repression. 

jrmcdowell
jrmcdowell

Perhaps "valuations are normal" considering the interest rate environment. Dividing by zero can lead to a lofty number. In mathematics, it's infinity. In the stock market - which is also constrained by longer term bond rates - it can still be a high figure. Why can't the number (PE) be 20, 25, or 30?

But dividing by zero also has real world as well as stock market ramifications. It's highly inflationary. There are roughly 45M renter households in the US. These folks, along with a generation of young people entering the economy, are going to pay much higher prices for any wealth building assets they wish to acquire. 

ZIRP is destroying (or at least greatly hindering) the chances of economic mobility for the asset-less ranks of our society. Throw in higher food and fuel costs and it's the perfect inflation-driven storm for this group. All courtesy of the Fed. 

My comments should not be construed as any recommendation to buy or sell stocks as each person can make their own decisions in that regard. And public comments notwithstanding, it is quite possible that the Fed is concerned about blowing a bubble. They're shutting down QE in October because likely they don't want to add any more rocket fuel to the market. They could also be concerned that too many joe six-packs will catch on to the fact that the output chute of the printing press was not being directed at them. 

sduraybito
sduraybito

 David, Can you comment on how suspension of FASB 157 plays into the credit markets and whether the Fed considers its balance sheet exempt from any markek-to-market rules?Thanks, Peter

SPARTAN1967
SPARTAN1967

DON'T GET MAD AT THE FED.

DON"T GET MAD AT INCOMPETENT CONGRESSMEN.

FINANCIALLY, how can small, medium, and large get even?

Blacks in the 1960s fought for civil rights.

They boycotted, and they struck, and they backed supporters?  What can the financially "TAKEN" do today?

SPARTAN1967
SPARTAN1967

DAVID STOCKMAN please issue a list of HEDGE FUNDS which specialize in cashing in on market crashes:  who are the sharks waiting to eat up the small fry historically.  

Which were the hedge funds which crushed the crippled banks as the NYSE stopped "shorting bank stocks"?

Who are the WALL STREET houses which are kiting over-valued stock portfolios and who are the houses who who will kill the FED exactly the way that the Bank of England cheats were clobbered?

We all know that CENTRAL BANKERS CHEAT.  We know that ZIRP is confiscation of savers  wealth.  Please list the payers on the field to counter the FED CHEATS? 

BrianMcM
BrianMcM

@droubal This is the paradox: as long as Central Banks are able to convince the investing world that they will backstop any crisis or run on confidence, the market cannot decline much for any reason at all, even world war.  To my knowledge of financial history, this is unprecedented in all history.  Not even the Tulip Mania had the implicit guarantee of the Dutch government as a backstop.  This bubble can be blown very large by the reckless and irresponsible behavior of world Central Banks.  They may think they are doing good, but like the lid on a pressure cooker, all they do is guarantee a devastating global explosion rather than steam getting let off a little at a time.  The longer this goes on, the worse the final outcome.  CBers are trapped by their good intentions.  That is the entire point of Dave Stockman's regular rants.

DavidYoung2
DavidYoung2

@Lostinaword Wow, Pilgrim, you have been drinking the KoolAid.  A country that will eventually default in some fashion on some $130 Trillion in Unfunded Liabilities IS DOING QUITE BADLY.  Stay in the stock market.  Remember the S&P 500 peaked at 1550 in Year 2000 and even at 2000 today is only 29% higher on an index basis.  Add dividends and you have garnered a whopping 5.1% per annum, non-compounded, over 14.3 years.  WORTH THE RISK, PILGRIM??? America is in deep Doo-Doo, A FACT you will see before the first snowflake falls.  Sage of Wexford.

BrianMcM
BrianMcM

@dylanbernstein Primrose has this right....this game only continues so long as the ROW goes along with it.  There are plenty of signs the ROW is preparing to abandon the USD.  The meeting of BRIC CBers, forming their own currency alliance, is a strong indicator.  So is the accumulation of Gold by EMs.  So are the deals China is making for non-USD trading between countries (Brazil and Russia).  The USD is quickly moving towards non-Reserve status and once that transformation is complete, the theory that dollars must return to the US in a crisis will be bunk.  Then will come the true collapse.

primrosedave
primrosedave

@dylanbernstein 

What happens when "the rest of the world" stops viewing the USD as a safe place to put money? They start trading with each other in their local currencies and trade their USD for harder, more local assets. What happens when USD equity and bond holders need some income beyond the paltry low interest regime?  they bid up the price of junk assets until the yield bears no relationship to the risk involved... guaranteeing a junk bond crash (like right now).

Bankergod
Bankergod

@fosforos 

Many say the central bankers are stupid (they are not) or that they are trying to make the wealthy wealthier (if you are already a billionaire would you risk your billions with such insane policies - just to get a few more billion?)

They are not stupid nor are they stupid greedy.  

Then ask yourself - why are they committing economic suicide?

See my answer above

DavidYoung2
DavidYoung2

@jrmcdowell Interest rates are grossly suppressed so applying a Risk Free Interest Rate to discount future corporate earnings is also a distorted exercise.  If simplistically we apply just the current inflation rate of 9% in the real world as a risk free and necessary rate, your Present Value model does not allow a valuation to infinity, but a PE that is at the top of the historic norm in the 23 to 27 times Prior Year Earnings, the metric that has any certainty of accuracy.  Make sure you raise your arms above your head as the Yellen Roller Coaster screams over the Top.

droubal
droubal

@BrianMcM @droubal 

Brian, I agree, this is an experiment that will end badly. I see monetarist economists as people with advanced degrees in model building and mathematics, but they have no common sense.  Or if they do, it has been replaced by hubris.  

Their MO will be the same after the next crash, re-inflate assets with QE.  It will probably work again, at some point, but someday there will be consequences, in the form of really high inflation.

jrmcdowell
jrmcdowell

@DavidYoung2 @jrmcdowell "Interest rates are grossly suppressed". Gee, ya think? The question is what is going to "un"-suppress the rates? Good luck with the CPI calculating that 9% inflation rate.

DavidYoung2
DavidYoung2

@jrmcdowell @DavidYoung2 A sovereign debt default or a chain of defaults stemming from a corporate or bank failure, probably in Southern Europe, will start the chain of events that will revalue bond prices downward and yields upward AS DEFAULT RISK COMES BACK INTO VALUATIONS.  

When you evaluate assets for purchase, such as stocks, you had better use real-world parameters in your valuation model or you will reach the wrong conclusion to buy or sell. I have been an investor for 45 years and will be able to retire in the next 3 to 4 years without relying on Government hand-outs.  Proof in the pudding, Ya Think?