Rubber Duckies

Imagine a bathtub full of rubber duckies. Most of them are bright yellow and cheerful eyed with permanent Mona Lisa beaks. But perhaps there are a few other colors, shapes, and sizes mixed in. Maybe, if this particular bathtub is anything like the one I remember my kids playing in, there are a few plastic sharks, whales, and maybe a penguin or a platypus thrown in for good measure. My favorite was always the wind-up scuba diver flippering along endlessly intrigued by who-knows-what under the bubbles. Regardless of the particulars of the floating toys, when you turn on the bath water they all float. Water in, duckies up. Water out, duckies down.

Asset prices and money (credit) behave in much the same way. When there is more money around, assets appreciate (expansion) and when there is less money around, assets depreciate (contraction). Money in, prices up, Money out, prices down.

This is obviously a simplification excluding the longer term human factors in the economic process (namely innovation and population growth). However, it serves our purpose as a way to visualize boom and bust market dynamics. An booming market can defined as the value of the stuff (stocks, bonds, real estate, money markets) people own going up relative to the size of the economy (GDP) and a bust defined as the inverse. This ratio (Household Net Worth to GDP) is shown in the following chart well over half a century.

Household Net Worth to US GDP

Household Net Worth to US GDP

During the period of 1945 to the early 1990's the price of assets (measured in units of economic production) remained range bound. Measured this way, asset valuations gradually rose into the early 1960's, fell as inflation became pronounced and eventually peaked in 1980, and then rose again ending entire fifty-year period close to where they began.

However, since the early 1990's the credit and market cycles have been particularly pronounced with asset valuations rising substantially overall with sharp corrections during the recessions following the tech stock boom of the late 1990's and the housing bubble culminating in the Great Recession of 2008- 2009. Over the past 25 years, aggregate asset valuations rose over 40% according to this measure.

Going back to our rubber ducky analogy, the household net worth line in the chart above is similar to the rise and fall of the floating toys (e.g. prices of stocks, bonds, real estate) in the bath. Why do they go up and down? Because of the amount of water (money/credit) in the tub.

A boom is created by a combination of available money (money, debt, credit are fairly interchangeable) and a reason (a narrative or story) to buy. There are almost as many ways to measure amounts of money and credit in our modern economic system as there are economists. Certain types of credit and debt instruments have become much more liquid and increasingly used to buy assets at the macro (Inter-bank) level. We'll use treasury securities, government agency securities (Fannie Mae mortgage securities for example), and Federal Reserve credit. The prevailing narrative depends on the period.

In 1990, there were about $2.5T of Treasury Securities, $1.5T of Agency Securities and $340B of Federal Reserve Credit. These three sources added up to $4.25T, or 71% of GDP. A decade later, at the end of 2000, the total stood at $8.34T or 81% of GDP (Treasury $3.36T, Agency $4.35T, Fed $635B). The narrative of that era was American Technological Dominance. This was the era when the Cold War was one, when America displayed overwhelming military force in Iraq (Operation Desert Storm), when the personal computer became ubiquitous, and the Internet was born. Confidence and optimism abounded. Booming markets fueled by credit growth certainly didn't hurt.

And then the technology bubble burst, resulting in widespread bankruptcies among Internet, telecom, and technology companies. The result ultimately was large stock market losses (particularly the richly-valued technology stocks), and a US Fed determined to rapidly drop interest rates (at the time the prominent Central Bank tool) and "reflate" the markets.

The chart below shows the course of Federal Reserve interest rates over the same time horizon as the net worth chart from before. This shows the Fed's efforts to react to recessions (the grey bars on the chart) by lowing borrowing rates aggressively. A critical aspect of our analysis is that there is no free lunch in economics and no way to "print to prosperity". Deliberate intervention in markets carries a cost even if that cost is not immediately recognized. 

Effective Federal Funds Rate

Effective Federal Funds Rate

In 2002 economist Paul Krugman, Nobel prize winning professor of economics at MIT and Princeton wrote about the difference between typical economic fluctuations and credit boom-bust dynamics. He even specifically called for the Fed to create a housing bubble to replace the Nasdaq bubble! The following is a direct quote from his "Dubya's Double Dip" article written in August 2002 in the New York Times, "The basic point is that the recession of 2001 wasn't a typical postwar slump, brought on when an inflation-fighting Fed raises interest rates and easily ended by a snapback in housing and consumer spending when the Fed brings rates back down again. This was a prewar-style recession, a morning after brought on by irrational exuberance. To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble. Judging by Mr. Greenspan's remarkably cheerful recent testimony, he still thinks he can pull that off." 

The housing bubble was indeed created. As all good replacement bubbles must, it exceeded the previous bubble in scope. Toward the end of the mortgage finance and housing price bubble in 2007, Treasury securities exceeded $6.0T, Agency securities had surged to $7.4T and the Fed's balance sheet chipped nearly another trillion dollars at $950B. The total then stood at $14.4T or 99% of GDP.

The narrative shifted to the American Dream of Home Ownership (also plausibly named "Real Estate Always Goes Up"). With mortgages easy to obtain and rates declining, the lure of gains and fear of missing out combined with widely availability of real estate financing to drive prices upwards. Eventually rising interest rates and declining affordability slowed the boom. A recognizable characteristic of credit booms is that when the growth ends, a bust follows.

We know what happened next. In 2007, the housing bubble popped and credit growth turned sharply negative as one lender after another approached bankruptcy. The Federal Reserve repeated its burst bubble prescription, recently learned in the early 2000's, and turned again to forcing interest rates lower and encouraging credit growth. This time though, lower interest rates and optimistic talk weren't encouraging enough. The FASB accounting standards board changed rules to no longer require banks to value their credit portfolios at market prices and the Fed created a new tool. Called Quantitative Easing (QE), Central Banks led by the US Fed began creating money to purchase bonds and other credit instruments. These efforts stopped the bust in its tracks,and got credit growing again by early 2009. As shown below, heavy Central Bank money creation and asset purchases have been a persistent feature of global financial markets ever since.

Global Quantitative Easing (QE)

Global Quantitative Easing (QE)

What has unfolded in monetary and credit terms since early 2009 is astonishing. As of the end of 2016, Treasury securities had reached $16.0T. Surviving the mortgage bubble bust (Fannie Mae and Freddy Mac insolvency and receivership), and returning to growth, Agency securities stood at 8.52T. The Fed’s balance sheet ended 2016 at $4.43T. Again, the replacement credit boom has exceeded the preceding credit bust. The total of these sources of credit now stands at nearly $29T or 156% of GDP.

Household Net Worth to US GDP

Household Net Worth to US GDP

Today's narrative is Interest Rates Will Stay Low (as will inflation and economic growth). This story points to continued scarcity of yield (earnings, cash-flow, profits, and dividends) and the unfortunately common refrain in today's financial media that There Is No Alternative to investing in common stocks even as richly valued as they admittedly are.

It is futile to try to predict exactly when and how the market's prevailing winds will shift, but history shows us that nothing lasts forever. With recent coordinated efforts by Central Bankers to inch rates up and rein in asset purchases (QE), the initial steps may now be taking place.

(Additional investment specific commentary follows for client subscribers)

References:

http://www.nytimes.com/2002/08/02/opinion/dubya-s-double-dip.html?scp=4&sq=krugman%20mcculley%20bubble&st=cse

http://creditbubblebulletin.blogspot.com/2017/06/weekly-commentary-washington-finance.html?m=1

https://fred.stlouisfed.org/graph/?g=cvIg

http://www.bloomberg.com

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