Long before the subprime crisis of 2008, economist Hyman Pinsky theorized that financial bubbles are caused by a combination of four factors:
– The advent of a transformational new technology
– Easy credit
– Amnesia about the last bubble
– The abandonment of traditional, conservative methods of stock valuation
When I was a young international equities analyst, back in the mid-1980s, Japan was enjoying the mother of all bubbles. I learned early on that markets do get carried away sometimes, and that they can remain irrational longer than analysts can keep their jobs. How can I forget the great energy analyst at my first company who was fired for not recommending Enron?
Four decades ago, the Japanese had good reasons for optimism. Their economy was booming. The country was a technological powerhouse. Among other impressive achievements, Japan accounted for a full 50% of the global semiconductor production. Every electronic gadget seemed to be made in Japan. Interest rates were the lowest in the industrialized world. Massive trade and current account surpluses supported a strengthening yen. Cash-flush Japanese snapped up global icons, from Van Gogh’s Sunflowers to Rockefeller Center.
Near the end of the decade, optimism morphed into euphoria. Unable to justify earnings multiples approaching–sometimes reaching–triple digits, traditional value investors were left owning relatively undervalued blue chips which never participated in the bull run. Value became a dirty word.
Japanese investors had not experienced a financial bubble before. A post-war generation of investors made money hand over fist, often just by looking at charts. The more a stock went up, the more attractive it became. There was a total abandonment of traditional stock valuation.
When the bubble finally burst in 1989, the Nikkei lost half of its value and a deflationary spiral set in. Real estate crashed. The Nikkei eventually lost more than 80% of its value and would not retest its 1989 high for 35 years!
Fast Forward to 2008 When Everything Changed
Fed Chairman Ben Bernanke was a student of the Japanese economy. When, in 2008, the subprime crisis hit US markets, he was determined to avoid the Japanese experience of decades of stagnation. His predecessor, Alan Greenspan, had shown him the way. Black Monday of 1987, the collapse of Long-Term Capital in 1998, or the bursting of the dot.com bubble were all dealt with by injecting liquidity into the economy.
The Federal Reserve under Bernanke took the “Greenspan put” to a whole new level. The severity of the subprime crisis required a drastic response. Quantitative Easing was born. The Federal Reserve’s balance sheet exploded and financial markets stabilized.
As soon as the effects of the first Quantitative Easing program (QE) started to fade, a second one was launched. Then, just before COVID brought the world to a standstill, a third QE was implemented. Then, in response to the shutdown, an enormous fourth program of debt purchase inflated the Fed’s balance sheet to unheard of levels. The rest of the world followed suit, although to a lesser degree.
A recent note from the Banque de France observed, “Since 2007, central banks’ balance sheets have expanded very strongly. That of the Eurosystem (i.e., the consolidated balance sheet of the European Central Bank and the national central banks) has increased more than fourfold, and those of the Bank of Japan (BoJ) and the US Federal Reserve (Fed) by a factor of about six and eight respectively over the period between 2007 and 2020.”*
The US economy is the most dynamic in the world and, like Japan in the 1980s, the US has become the global leader in many technologies. However, the substantial valuation gap between US equities and their European and Japanese counterparts can largely be explained by how much the Fed has used its balance sheet as a new and formidable toolkit.
Quantitative Easing has been successful in creating a wealth effect, probably even more than policymakers imagined. There seems to be a direct correlation between the size of central banks’ balance sheets and stock market performance. The more aggressive the monetary policy, the better the stock market performance. I believe this goes a long way to explain the S&P and Nasdaq’s consistent and unprecedented outperformance vs. European markets since 2008. Japan, which has been more aggressive than Europe, is finally seeing a resurgence of its stock market as well.
It’s The Long End, Stupid!
Today, even though the Federal Reserve has started to reduce its balance sheet, it is still over $7 trillion-that is twelve zeros-compared to “only” $880 billion before the financial crisis of 2008.
Pundits on financial shows don’t seem to get it. They spend most of their time trying to predict the next interest rate cut. But they are missing the point. Financial authorities have been managing the long end of the curve while aggressively raising the short end.
Had they not done so, rates on 10-year Treasuries and mortgages would be much higher today. Furthermore, a flattish or even slightly inverted yield curve also nurtures the hope that inflation will come down in the future. Working hand in hand with the Federal Reserve Bank-her former shop-Secretary Yellen is financing our out-of-control debt with short-term Treasuries. As Key Square Group CEO Scott Bessent puts it, she borrows from her credit card to pay back her mortgage loans.
The Cost of Monetary Engineering
How can the unprecedented monetary policies implemented since 2008 not have long-term ramifications? We may have been able to avoid major recessions, both in the wake of the financial crisis and during the pandemic but, as a result of these machinations, we have now created an economy in which central banks have largely replaced market forces. This has all kinds of consequences. Some obvious, some we still don’t understand.
For example, pushing interest rates to zero led officials to embrace the bizarre Modern Monetary Theory, which claims that deficits don’t matter when the cost of servicing the debt is so low. Unfortunately, it also ignites not-so-transitory inflation forces, which lead to higher interest rates.
Today, with public debt out of control, and interest rates rising, debt service eats up more than a quarter of all federal tax revenues!**. According to the Federal Budget Office, the deficit for 2024 is projected to be $1.9 trillion, with a full $892 billion going to pay for interest on the debt. These numbers are staggering compared to 2024 fiscal tax revenues of $3.29 trillion! When will markets take notice? Italy starts to look like an example of fiscal rectitude in comparison.
Amnesia
The current bull market has been driven by monetary expansion and very stimulative fiscal policies. AI is the new transformational technology. What about investors’ amnesia and unreasonable valuations?
The seminal financial crisis of this generation came in 2008. The market meltdown was scary, but very short. The sell-off at the outbreak of COVID was even shorter. Both times, prompt fiscal and monetary stimuli resulted in an instant bounce in stock prices.
One can hardly speak of amnesia. Investors do remember these bubbles bursting. But, did we learn the right lesson from it? The Fed’s rapid reactions have successfully avoided major recessions. My generation knows it can count on the Federal Reserve Bank’s self-imposed third mandate of protecting asset prices. Market corrections have thus become mere buying opportunities.
Transformational New Technology And Abandonment Of Conservative Stock Valuations
Today’s beneficiaries of excess liquidity are the AI stocks, Nvidia and ARM prominent among them. Similar to what has happened in previous bubbles, Artificial Intelligence is truly transformative. The problem is how to identify the true long-term winners.
As with previous game-changing technologies (railways, telephone, electricity, automobile, internet, etc.), analysts struggle to value AI’s potential. Fund manager and author Alasdair Nairn points out in Engines That Move Markets, losers are easier to identify than winners. In the mid-90’s, who could have known, for example, that Amazon was a better bet than AOL? After all, Amazon dropped to $0.54 in 2001 and its lack of earnings made most fundamental investors run away from it. In contrast, it was already easy to see that brick-and-mortar retailers would lose out if they did not adapt to the new reality.
Today, valuations of large technology companies are reaching levels reminiscent of the internet bubble or Japan’s stock market craze at the end of the 1980s. In a previous generation, after the crash of 1929, the economist Max Winkler observed that the stock market had discounted not only the future but the hereafter as well.
Before the brutal correction of the young 21st century, FOMO (Fear Of Missing Out) drove valuations of the new internet companies, including Pets.com, to ridiculous valuations. The internet changed the world, but much money was lost chasing the early players. Likewise, Artificial Intelligence will undoubtedly improve productivity. But history tells us very few companies end up being great investments. Companies making the equipment needed for the AI revolution, many located overseas, seem to be a safer bet at this point.
Investors all too easily get carried away. Our natural tendency to behave like lemmings is reinforced by the success of index ETFs. The more expensive technology shares become, the greater their weight in the index becomes, and the more index ETFs have to buy them. Index ETFs have pushed momentum investing to its ultimate logic.
With momentum working so well, fundamental investors have become an oddity in the US, just as they did in Japan four decades ago. In a recent Bloomberg interview, a strategist at BoA Merrill Lynch lamented that fundamental investors have become an extinct species. David Einhorn, founder of Greenlight Capital, observed on the same radio channel that fundamental investing no longer works. Traditional methods of stock valuation have apparently become obsolete. How does one value Nvidia’s future earnings? Can we assume their technological advantage will last forever? Today’s valuation seems to do just that.
Conclusion: Time to Look Outside the “Go-Go” US
I don’t believe we are in the ninth inning of the frenzy yet, but we surely are closing in on the end game. Not that a financial crash is inevitable. Hopefully, an orderly correction can be engineered, but more attractive investments may be found outside the “go-go” US. After 16 years of uninterrupted underperformance, European and especially Japanese shares are looking very attractive.
Japanese stocks are experiencing a resurrection, with the Nikkei index finally surpassing its all-time high of 1989. Europe is leading the developed world in cutting interest rates and, with many undervalued stocks, may be the best contrarian bet.
The dollar has also been remarkably strong considering the US ballooning national debt. It is doubtful this would have been possible without the dollar being the world’s reserve currency. But that too may be coming to an end. The euro is a credible reserve currency, and the BRICS countries are moving away from the dollar. Most ominously, the Saudis have called the end of the petrodollar.
When most investors have given up, international diversification seems an attractive contrarian strategy.
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