Steen Jakobsen, chief economists and CIO of Saxo Bank has some interesting observations on the illusion of low interest rates and the vital flaw in Pimco's bullishness at a market peak.
Please consider From Here to Eternity in the Age of Low Interest Rates.
Eternity is here. Eternity in low interest rates for longer. Eternity in excess return from stock markets, eternity in no growth, eternity in low productivity, eternity in chasing yields. The chasing yield game now joined by central banks like the Swiss National Bank and recently also big investors like Pimco, who at the top of the market no longer sees the stock market in a bubble!
The main common denominator is low interest rates – so where the market and Pimco mathematically correctly uses the low interest rates for longer as an input which produces a superior return, a few of us who were around in 1987,1992, 1998, 2000, and 2007/08 know that market tends to mean-revert. This concept that if we have a superior return over a longer period, it will need to be met by a negative performance to average “out” is dead now.
Stock Market Bubble
We have a generation of traders and investors who see any dip as a buying opportunity and policy makers who argues everything being equal, it’s better to have a stock market bubble than disorderly markets and depression.
The illusion is almost perfect now – probably the best argued and most confidently performed illusion in my career.
Zero Bound Rates
We learn in economics that the marginal cost of capital is the true allocator of capital. Whoever can and will pay the highest marginal price of money gets it – in today’s world.
However, EVERYONE and I mean everyone inside the 20 percent of the economy which is the listed companies and banks get whatever credit they want and need indiscriminately of their marginal cost and risk. The land of zero bound rates.
To make the example even more clear, this afternoon I could go to my bank manager with a proposal to put 100 or even 1,000s of hot dog stands on the main street in Fredensborg(where I live) – my expected return will be infinite as long as the interest rate is zero!!!!!
To make the mistake, in my opinion, of thinking that ANY analysis can really be done when we are at zero percent is the vital flaw of Pimco, SNB, policy makers and the stock market, so I am not saying the Dow at 100,000 is not possible, neither will I second guess Pimco’s new found bullishness, I am merely applying history, maths, engineering and economics laws to the issue.
Having spent this week with major policy makers in Switzerland at an offsite I am not comforted. They all agree with… me!
They accept that their monetary policy exclusively goes to the 20 percent of the economy which is the listed companies. While they are concerned about how markets' valuation, they are more concerned about the lack of growth and their inability to reach their inflation targets.
My bigger point here is that this is not "different times", the system's low volatility will be replaced by higher volatility, the zero bound leads to bubbles by definition unless you of course believe in eternity and most importantly, mean-reversion and compounding remains the two most powerful tools in finance.
• Germany is slowing down – will reach zero growth by Q1-2015. It will remain the “biggest surprise” in Europe
• Growth overall will disappoint again…..
• Euro growth will be sub: 1% - the US sub 2% (yes, despite nonfarm payrolls which I deem to be a useless indicator for US economy)
• The Fragile Five will start to weaken soon….ZAR and BRL remains my favorite shorts, and outside F5 I am short AUD. The long side right now is EUR, JPY
• Long German bunds, Danish government bond, and 10-Year US ….. I see new lows in yield by Q1-2015
• Equity: Like Nikkei, Israel, Russia, Korea relatively: Short DAX, SPX against it
• Corporate bonds in clear bubble. Long-term default rate now below yield.
• Stock market: Don’t see a top yet, but remain with my higher conviction that the timing of a 30 percent sell off happens in H2 of 2014. Risk reward is skewed: 10 percent upside vs. 30 percent downside.
What's the Downside?
The mean-reversionists like Steen, John Hussman, myself, and a shrinking handful of others have been ridiculed to death recently.
Nonetheless, I stay convinced, and in general agreement with Steen on the major points above except the potential downside. Whatever upside is left, mean reversion says the downside will grow with it.
History suggests bear markets will destroy many bears, some by turning bullish at the top, others by turning bullish way too soon after a correction.
And given the oft-stated downside has been something like 30% for at least two years, I suggest the downside may be a lot deeper or last a lot longer than most bears think.
Mike "Mish" Shedlock