A rationale for the Fisherian high plateau in global equities (vía Ricardo Tejero)

I have been predicting a bust in equities for so long that, over the course of time, I have engendered a reputational problem. I never said the timing of a system reset was easy (no bells are rung at tops). But, even after protecting myself with a long list of caveats, it is clear that the market reset I keep on anticipating, is long overdue. That’s a fact that I will reluctanctly admit to (like it or not).

Thankfully, by now it is not only me. We are a solid bunch in the back and front benches of the “conspirationist horde” that believe all market pricing is now fake. That “we” includes us Austrian economists, Macros, and Hedge Fund managers, together with a bunch of the establishment banks that are ostensibly moving to the dark side of the force.

The issue is that it hurts our egos (and our pockets) to see that equity market pricing is conspicuously proving us wrong. Nothing exceptional. We are all wrong more frequently than we would care to admit, and I am no living exception.  The odd thing is that, this time around, we got the reasoning, and the economic modelling right. A lot better for sure than the varied DGSE models run by the Fed banks. We anticipated the global macro outcome quite neatly, and we got bond and currency markets mostly right. How come equity markets are not providing us with our well deserved success fee?

Looking back, it’s been nearly a decade since a couple of us, timidly at first, began to explain the inconsistencies in the Central Bank driven, global pricing model for financial assets. It has been a long slog for an initially pitiful group of free thinkers. We were mostly on our own, until we got to this point when the big names in investment, and even Deutsche Bank, JP Morgan, Citi, Goldman, or Bank of America are expressing their concern for the ridiculuous mispricing of assets. A ridiculous price level that only only subsists because of the orgy of Central Bank, printing, nirping and outright manipulation. Not new. We said we were blowing a new bubble years ago, but nobody listened. Now the big players are joining in.

Icahn, Gundlach, Bass, Druckenmiller, Gross, Grantham, Soros, Edwards, and many others are now clear, and outspoken, about the massive risks to the system that go unobserved for the majority of investors. It is easier for them than for the banks, they have weaker links to the establishment. Anyway, be it by relevant investors and analysts, Banks, or us bloggers and small size investment offices, I think the message has been clearly formulated. By now even dumb market players should be hinting that all is not well with actual market pricing. Yet the conundrum is that markets continue to price risk south (conversely risk assets are bid up).

From a purely intellectual standpoint, I feel my views have been vindicated by events. Most of the Keynesians are jumping ship, and converting to Say’s law in droves. The world economy is in a dreadful state after years of printing and lending. Nevertheless, I think it’s hopeless to treat myself and readers with more of the same reasoning. We deserve better.

We all know by now, that the great moderation and the subsequent grand monetary experiment did not succeed. Great! But what’s the use of winning the reasoning contest, if you cannot use your prescience to generate financial returns? I remember Bill Gross stating some time ago, that it is not about getting the GDP prognosis right, but about anticipating the shape of the yield curve. Despite being notoriously right in our real economy prognosis, explicitly suggesting how inefficient and wasteful this money printing and nirping episode would turn out to be, something is amiss or underestimated in our reasoning.

Bubble pricing subsists and we have to be able to explain than phenomenon. I can’t buy the “stupidity of the crowd” argument any longer. At least to a full extent. Manipulation won’t cut it either. Manipulated daily as they are, prices would not be at this level if investors were selling massively. Not even the Fed valuation model (same quality as their DSGE models: rubbish!) can justify this price plateau by now (it offered a reason to buy risk assets in the initial and midstages of the bull market born March 2009). Maybe Irving Fisher would find a rationale for this new permanently high plateau. I can’t.

Market prices incorporate the knowledge in the market, even though that does not mean the market is efficient in its pricing. By now most players know, or are at least uneasy, about the pervasive melt down risks in China, the not so well hidden inevitable defaults in European periphery, the Abenomic disaster, the fact that productivity is dead in the water (to use Greenspan elocuence), the top line stagnation in corporate P&L’s, or the valuation excesses. People are also well aware of the Brexit, Trump, Le Pen or AfD disruptive potential. Violence is likely, and with Hillary it could even be war with China or Russia. Against this backdrop, it is obvious that equities are priced for perfection -and none of the major risks have been discounted by prices.

Schiller PE for the S&P 500. Courtesy multipl.com

I very much doubt the “wisdom of the crowd” mantra, but, nonetheless, I think the arguments of the dark side of the force are public, and compelling enough, by now. Mobs may not be smart at all, but I have to disagree with Einstein for once. They can not be infinitely and indefinitely stupid.

Aditionally, anecdotal evidence keeps pouring in daily, suggesting that our postulates are not being denied anymore by conventional thinkers. Nobody denies any longer that Keynesian recipes are exhausted (they never worked). Notwithstanding those notorious facts, oblivious market players continue to inflate the mother of all bubbles. To cut to the chase, I am missing something. I will label it “Behavioural abandonment by investors”.

In the beginning (March 2009) stocks surged on a valuation drive (stocks were cheap on traditional criteria), greased and enhanced by QE1. We then went on to a second phase after 2012, where Corporates were growing their profits nicely. This move was supported by QE2 and QE3, providing ample liquidity and low discount rates for prospective corporate cash flows. Add the ECB and BOJ stimulus in, incorporate NIRP spreading around geographically, and Corporate bond buying by the ECB. It was all going to turn out to be ephimeral, but there was a short term reason for jumping in. And we Austrians would be “out” if that monetarism had fixed the real economy and prices continued their bullish trajectory. We said not, and we were right. We were brave at the time.

price to sales

Price to sales S&P 500 multipl.com

notsomerrygoround

The Yellen Call explained. Upside is really limited (save 4 QE4)

But now we have found out that monetarism did not work, that profits are down, and top lines are not growing, and will not grow for some time. Cost inflation is for the first time a relevant input. Europe and China are basket cases, and Japan is really past common sense. The sensitivity of GDP growth to credit growth decreases by the hour. Still, amazingly, valuation is stretched like we were expecting an economic boom for our world.

On top of it all, Yellen has voiced she will tighten if the market goes up configuring what has been described as the Yellen Call. I talked about that call a couple of months ago, and it is being confirmed by her speeches and FOMC member fed-speak. Unless we get a reflationary surge, the upside is really limited. What the hell keeps prices up now?

Right now I think only behavioural economics can explain what’s going on. Sometimes you have to opt for something that you know will kill you in the long run. It is a daunting spectacle to watch the annual migration crossing of the crocodile infested Mara river, by Zebras, Wildebeest, and Kudus. A must see. They know a few are going to die, but, regardless, they all plunge into the river and hope they will be the lucky ones. It makes sense. The herd knows best: either they cross the river or they die of thirst. So they close their eyes and, scared enough, wilfully play Russian roulette. In fact they are opting for the lesser evil. If they cross the river, they might survive, if they don’t they are dead anyway.

Yield starved investors that need the income (for performance related, or individual reasons) act in a similar way. Unfortunately, the Mara river reasoning is only applicable to investors partially. Few, if any, will be killed by the odd crocodile (ie Valeant?), in this Central Bank protected environment. But, at some point, a river flood will wipe them all out. Most, and not only a few, will drown simultaneously. I think most investors understand this has more than a fair chance of happening, but can’t afford to do otherwise. In the back of their minds, the TINA reasoning (there is no other alternative) resonates loudly. They merrily cross the river, and decide to worry about the flood when it comes (if it comes).
The only way to understand such extravagant risk taking, both by individuals and professionals, is resorting to an extended behavioural pattern of abandonment.
 We are all very tired after nearly a decade of extending and pretending. We don’t know what to do with our money, or our client money, other than chase de benchmarks that measure performance in any given investment category. We are all fed up with NIRP, extend and pretend, and fake pricing.

So, at some point, we all let go. Managers of pension funds try to survive in the short run, even if that implies being wiped out in the long run. They need to compound 7% annually! Professional fund managers chase their indexes, or face early financial death brought forward by their career risk. Individual investors need some capital gains to alleviate their nirped returns on bonds. They have to pay for food, lodging and basic amenities.

Most cannot chose. Many of them even end up buying ETFs. That is tantamount to giving CBs a power of attorney to manage their money. So the elasticity of market prices to bad or good news, is as low as it has ever been. That brings volatility and volume down. Investors have given up on worrying or thinking. You can’t blame them. To wit, every single time things turn for the worse, ETF’s stand pat, and individual investors buy the dip. Add some manipulative support from the Fed, and it all reinforces the Pavlovian experience. We macros and independent thinkers are always caught wrong footed. Investors salivate at every dip.

All Yellen an acolytes have to do, is suppress volatility, and ensure that professional and individual investors are complacent and relaxed. Investors on their part, are willing to endure the extravagant risks, and only want some soothing words to do so. Yellen can provide plenty of those. With a dose of arrogance, Mario is smart enough do so as well. Add in some POMO manipulating of the closes and technical turning points, and all will be fine. Until it isn’t! But who cares, after all life itself is a business that always ends up filing for bankruptcy -and nonetheless we all remain loaded up with as much equity as we can hold.

I am aware that the argument falls far from the conventional economics reasoning tree, and unequivocally belong to the behavioural economics camp. But that is where I think you have to find the ultimate reason for this perpetual bubble blowing. I think we are well past the missionary game behavioural pattern, when investors duly followed the Central Bank piper in order to make some easy money. At the time, people still though monetarism would fix the world economy. Going long was a bet on normalization of the world economy. Right or wrong, the call made some sense.

The missionary game was good for a time, but most of those investors would be out by now, if they were offered an alternative that provided some indispensable income to them. NIRP and ZIRP are now a lot more significant from a behavioural point of view than as an input for cash flow discounting valuation. Talking valuation Hussman style is nonsense nowadays (sorry for that John). Nobody cares about valuation, because they can’t afford to. And they don’t like to be reminded of their risks either. They know them, have no alternative, and want to go with the flow for as long as this Russian roulette goes. There is always a time to go bankrupt, but it is normally best to postpone it.

To make things worse, long bonds offer even higher risk than equities. When you overpay for a bond, on top of the credit risk you have a reflationary risk (getting paid pabck in a debased currency). At least equity pricing, however exhuberant, protects you from reflation, a bolivarian solution that is being adopted by more and more brainless economists.

This instinct for daily financial survival, is brutally powerful. Central Banks offer investors short term solace, in exchange for investors mating with them. But they are financial “praying mantis” females in disguise. You know their copulating protocol. The female kills when she is done. Investors should be well advised that they will be wiped out, when CBs are finished. I hope they enjoy the orgasm. Contradicting Saint Augustine, I plan to remain chaste … beginning yesterday!

I do my best to read and think a lot every day. I have concluded that we need an external catalyst to set up the system reset process (read financial debacle). The weight of evidence will not tilt the balance, because you cannot hope that the mob will understand some kind of black swan risk, when their short term survival depends on that event not happening. You can cry Wolf for as long as you like, nobody is going to listen. They cannot afford to do so. The situation will remain very fragile throughout though.

Three different kinds of events could be the catalyst for financial disaster.

  • A prominent systemic bank or sovereign default. Unlikely to be allowed by the establishment, but a game changer if it happens. Debt sustainability would be questioned.
  • A global recession (it does not have to be a depression, at least initially). Inevitable, at some point. It would visualize the unsustainability of welfare states and sovereign debt. When?
  • A worldwide relevant social disruption. You never know. It could be anything that relevantly breaks the global social contract. Maybe Brexit?

Lacking that kind of events, I think we will keep on muddling through -the economy flirting with stall speed every now and then. Credit growth and printing will help sustain the model forward, but we will need ever higher doses of the monetary medicine (credit growth and money printing) to keep things running. Think helicopter money, debt forgiving by central bank holders (Japan), credit expansion (China) or whatever. Absent a catalyst, I think they will get away with it for longer. In the end though, sooner or later, something will give, and it will be remorseless financial genocide by CBs.

Financial genocide can take two forms, and only one of them will crash equity markets. It will be implemented using one of the two alternatives (probably both to an extent).

  • Debasing the currency (diluting the purchasing power of nominal values of currency). Nominal values of assets do not fall, but real values are cut to half.
  • Or haircutting debt payments and dividing by two the nominal prices of equity or real estate.

We can only guess the proportion that debasement and defaults will play in the financial destruction that will ensue. But wealth accumulated during decades will disappear. In fact it is already gone if we really marked assets to the adjusted possibilities of debt payment, or if we worked with an adequate estimate of future free cash flow for equities. We live under the illusion of wealth that is already not there. Fake pricing is what helps keep this story alive, but inflation or asset price deflation will materialize the genocide.

Investors will gladly trade in self-immolation the day after, in exchange for a decent tomorrow. Admittedly, without “tomorrow”, there cannot be a day after. It is a rational conduct after all. Particularly if you assign a relevant potentiality to the reflationary option.

Nevertheless I will not compromise. I will hoard cash, and take career risk as the preferred option. It is largely the best option available -but only if if you can fund it, and your ego is strong enough to withstand ignominy. Any minute, you can always deploy your cash to protect yourself from the reflationary option. Capital mobility is essential when you face uncertain times -and cash or short term safe bonds offer just that.

We live interesting times. Time will have the final say. Sometime, somewhere over the rainbow.


All that you touch
All that you see 
All that you taste 
All you feel. 
All that you love 
All that you hate 
All you distrust 
All you save. 
All that you give 
All that you deal 
All that you buy, 
beg, borrow or steal. 
All you create 
All you destroy 
All that you do 
All that you say. 
All that you eat 
And everyone you meet 
All that you slight 
And everyone you fight. 
All that is now 
All that is gone 
All that’s to come 
and everything under the sun is in tune 
but the sun is eclipsed by the moon. 

“There is no dark side of the moon really. Matter of fact it’s all dark.”

Eclipse. Roger Waters

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