William McChesney Martin was one of the longest-serving Chairman of the US Federal Reserve, serving from 1951 to 1970. The Fed got a lot less attention then than it does now, but Martin put his stamp on Fed history by famously saying “The Federal Reserve….is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up." In monetary-speak, "taking away the punch bowl" refers to central bank action to reduce the stimulus that it has been feeding the economy.
But today, the Fed, far from removing the cocktails, is continuing to spike the punch. We are in a perpetual financial happy hour, with the Fed and its global central bank cohorts willing to provide the monetary hooch at the first sign of trouble in the markets. This has led to complacency and a widespread “buy the dip” mentality among investors, who have come to assume the Fed will always have their backs. But this attitude has pushed valuations, debt, and importantly, behavior, to levels reminiscent of the previous bubble tops of 2000 and 2008.
Evidence of bubble-like valuations should be the primary concern for long-term investors. Valuations, unfortunately for investors, are in the eye of the beholder, and there is no standard measure for what expensive and cheap really are. An illuminating view of valuation, that avoids earnings forecasting errors, is one that compares the value of corporate equities to Gross Domestic Product. This is available to the public at:
Market Cap to GDP is a long-term valuation indicator that has become popular in recent years, thanks to Warren Buffett. Back in 2001, he remarked in a Fortune Magazine interview that "it is probably the best single measure of where valuations stand at any given moment." It avoids earnings forecasts by simply comparing two values, and though data only go back to 1951, makes glaringly clear that we are back to the valuation peaks that marked the internet bubble top in 2000.
Buffett’s Berkshire Hathaway company has come under increasing criticism for letting its cash pile swell to $128 billion and not pursuing acquisitions. But Buffett’s reticence to throw money at deals reflects his clear opinion of the overvalued state of the markets. He can afford to be patient and wait until values become more palatable, unlike the hyper-bullish Wall Street firms that have a vested interest in whipping up a bullish case regardless of circumstances.
Why should this matter to investors? History has shown that one of the few reliable guides to future returns are the valuations at the time of investment. The Cyclically Adjusted Price Earnings ratio (“CAPE,” also called Shiller P/E) was formulated by Yale professor Robert Shiller, and uses the 10-year average of “real” (i.e. after inflation) earnings as the denominator of the price/earnings ratio. This has the effect of washing out much of the year-to-year cyclicality of earnings and the bookkeeping games played by managements.
The lower chart (“US Forward Looking Returns”) shows the historical relationship between CAPE and the average returns over the next ten years. When the CAPE is high, future returns have tended to be low, and vice versa. With the CAPE hovering at about 31 in early 2020, expectations for returns over this decade should be reined in to more realistic levels. But rather than follow Warren Buffet’s example, the bubble atmosphere we’re in has prompted investors to ignore valuation in the hopes of even higher stock prices to come.
Debt has also increased to levels last seen at previous bubble tops. Household debt, for instance, rose $601 billion in 2019’s final quarter, surpassing $14 trillion for the first time. This also marks a new high water mark, as it is $1.5 trillion higher than the previous peak reached in 2008. Mortgage borrowing accounted for about half this increase, as buyers took advantage of low rates to purchase homes. But student loan debt, credit card debt, and auto debt all increased in the fourth quarter.
Of course, the Fed’s “borrow ‘til you drop” approach to economic management has found ardent supporters on Wall Street and government. Margin debt has surpassed all previous highs, which were themselves set at the peaks of 2000 and 2008. Federal borrowing has blown out, as lower tax revenue and increased spending have inflated the federal budget deficit to almost a trillion dollars, a 25% increase in fiscal 2019.
Debt in and of itself isn’t necessarily a cause for worry, as long as the ability to pay is maintained. Low unemployment and rising wage growth, consistent job creation, and low interest rates are factors which argue for debt being manageable at this moment. But cracks are starting to appear in the debt façade. Almost 5% of auto loans, for example, are 90 days or more delinquent, the highest percentage since 3 Q 2011. Credit card delinquencies have risen to 8.4%, an 18-month high. And among student debt, where more than $100 billion is owed by those age 60 and older, one in nine borrowers were 90 days or more delinquent. And these are the good times--what happens when a true recession takes hold?
Finally, the behavior of investors is a major telltale sign of bubble-like conditions. Backed by the notion that the Fed will always step in to support the markets with liquidity injections, investors have been happy to buy the dips regardless of any fundamental economic deterioration. They have been conditioned to treat shocks, such as the assassination of Iranian general Soleimani this January and the damage to Saudi oil facilities last September, as containable, temporary, and reversible. The expectation of Fed support, and a belief in its effectiveness, is fueling complacency on Wall Street.
Reminiscent of bubble peaks of previous eras is the fact that much of investor money is flowing into a handful of stocks. The five growth stock darlings of today, Facebook, Apple, Amazon, Netflix, and Google, account for a stunning 18% of the weight in the S&P 500, and the technology sector accounts for 23% of the weight.
Perhaps the biggest clue that we are in a bubble is investor complacency (until this writing) towards the coronavirus. Even as evidence was accumulating that the disease was spreading globally, markets (at least the major indexes) were hitting new highs. It seemed odd that the fact of mass shutdowns and quarantines in China, with the obvious impact on global supply chains, was largely ignored by Wall Street.
The coronavirus epidemic has the potential to constitute a structural break for the markets. That is, a big enough shock that fundamentally shifts sentiment. Up until now, markets had been underpinned by the belief that the Fed would suppress volatility and boost asset prices through some form of “quantitative easing” (QE), fueling rallies based on investor’s fear of missing out.
Now, the gap between overvalued asset prices and weaker economics is being laid bare by the global impact of coronavirus. The Fed and its global central bank peers have made it easy to paper over problems with never-ending rounds of QE. Businesses have borrowed to fund stock buybacks and help mask the slowdown in earnings growth. The federal government has been able to toss any pretense of fiscal responsibility out the window, as it has found a ready buyer for Treasury debt in the Fed, which buys government issues with cash created out of thin air, and in turn feeds that cash into the banking system.
We may be at the point, however, where monetary and fiscal policy are reaching the moment of truth, a moment where an economic downturn may be for real. Monetary policy has been extremely accommodative and loose, uniquely so for this late in the business cycle. Federal spending, likewise, has been unusually expansive for this point in the expansion. What tools remain for the Fed and the White House to battle a recession? Now that the impact of the coronavirus is being taken seriously, policymakers cannot operate with the playbook of the last decade, and will face much tougher choices than in recent years. Properly managed, they could lay the groundwork for genuine growth and, hopefully, more constructive politics. A bungled and haphazard approach, though, could lead to recession, financial instability, and even more polarized politics.
Just as happy hour at a bar encourages people to drink more than they should, the Fed’s loose monetary policy has led investors to become overly leveraged and overly complacent. As a result, bubble-like conditions prevail in the markets. The skill with which the Fed lets the bubble deflate will determine how bad a hangover investors will have in the year ahead.