The Winter Of Our Discontent

by: Eric Parnell, CFA

The relentless winter weather this year has certainly spawned discontent for many across America. Fortunately, the threat of more snow and ice will soon give way with the onset of spring and the arrival of warmer days. Many participants in capital markets have also found themselves mired in an extended spell of discontentment that has spanned for more than a decade. But unlike the steady changing of the seasons, the problems that continue to plague investment markets may persist in a seemingly endless winter that never turns to spring. And with this discontent comes risks that should continue to be evaluated carefully when managing investment portfolios today.

The critical flaw with capital markets is deeply ingrained. It has little to do with the stock market and its ability to go up. If anything, the rising stock market is just one of the many symptoms of the underlying problem. Instead, it is a dilemma that has infected all asset classes to varying degrees. And until it is eradicated or at least effectively addressed to some degree, an increasing number of participants are likely to leave the markets with no intention of returning in the future.

"Can you honestly love a dishonest thing?"

-John Steinbeck, The Winter of Our Discontent

So what exactly is the problem? It is the deteriorating sense of integrity, ethics and justice underlying capital markets. Not that the investment arena has ever provided us with anything close to absolute purity, as bad actors and unscrupulous behavior are guaranteed to exist in all areas of life with financial markets in particular having more than its fair share of checkered moments in its past. But the events both surrounding and in the aftermath of the financial crisis have been particularly worrying in this regard.

So how exactly have capital markets become particularly dishonest today? Because a toxic environment has been created through a combination of public policy actions and private market responses to these actions. For what has increasingly developed in the last few years for capital markets is a troubling acceptance of a sense of entitlement, a warped sense of fundamental reality and the injudicious practice of assuming greater risk by letting others bear the cost. In short, we have descended into an environment where responsible behavior and risk prudence is penalized while aggressive actions and risk overreach is not only encouraged but also rewarded. Unfortunately, such is not the sustainable foundation for the long-term health of capital markets.

The seeds of today's problem can be traced all of the way back to the stock market crash of 1987 and the introduction of the 'Greenspan put' when the Fed rode to the rescue by injecting massive sums of liquidity into the financial system. With this action came the explicit expectation that the Fed would put a floor under markets at any signs of financial panic. Not coincidently, stock market price-to-earnings multiples quickly increased to levels that were higher than their historical average and have sustained these elevated multiples in the years since buoyed by the increasing belief that the Fed will come to the rescue no matter what. And we have seen several instances since, where this theory was put to the test including the collapse of Long-Term Capital Management in 1998, the bursting of the technology bubble starting in 2000 and the financial crisis since 2007. In each instance, market participants were allowed to reap the rewards of their actions in the build up. But in contrast, if the risks associated with their actions resulted in a market destabilizing event, the pain from these losses were alleviated either through policy accommodation if not the outright ability to simply remove these losses and pass them along to the taxpayer or the Federal Reserve. In short, a "heads I win, tails you lose" game has been increasingly fostered in the years since. And unfortunately, we are arriving at a juncture a quarter of a century later where the fiscal and monetary resources have become sufficiently depleted because of these repeated rescues and that the costs accumulated over all of this time may finally be coming due.

"To be alive at all is to have scars"

-John Steinbeck, The Winter of Our Discontent

The events surrounding the financial crisis several years ago have greatly compounded the problem. The global economy was nearly brought to ruin back in 2008 because of reckless behavior by financial institutions that included excessive leverage, imprudent subprime lending activity and creating complex financial products whose pricing did not reflect their underlying risk. Such activities were not discouraged by public policy, as relaxed regulations and ample access to liquidity actually helped fuel the problem. The fact that these imbalances eventually led to the near implosion of the financial system is a problem in and of itself. But it has been the response to this situation in the years since that has been even more problematic. Of course, the global financial system could not be allowed to fail, and the aggressive policy response by fiscal and monetary policy makers including the launch of QE1 was an appropriate response during the depths of the crisis. But once the situation had been stabilized by the summer of 2010, it was crucial for policy makers to stand back, force those that had pushed the global economy to the brink of collapse to deal with the consequences of their actions and allow the cleansing process to begin. Unfortunately, a decidedly different approach was taken that has not only deferred the suffering any scars, but has since served to create an entirely new and arguably bigger problem down the road.

As we all learned in Econ 101, there is no free lunch. And this holds just as true for monetary policy as anything else. Since the summer of 2010, the Fed has engaged in QE2, Operation Twist and QE3 in nearly quintupling their balance sheet since the financial crisis to $4.2 trillion to date. But these programs have never come without a cost, as it has been a case all along where those responsible participants in investment markets have been forced to sacrifice to the benefit of the profligate. With interest rates slashed to zero percent for more than five years now, savers and those that are living on fixed incomes such as retirees have borne the cost of these programs. No longer can retirees secure a reasonable rate of interest on their FDIC insured savings in order to sustain themselves. Instead, they are now being forced to gamble the savings that they spent their entire lives accumulating and have a limited ability to recoup in investment markets with securities such as stocks (NYSEARCA:SPY), high yield bonds (NYSEARCA:HYG), senior loans (NYSEARCA:BKLN), real estate investment trusts (NYSEARCA:VNQ), master limited partnerships (NYSEARCA:AMLP), high yield munis (NYSEARCA:HYD) and emerging market bonds (NYSEARCA:EMB) where the principal value is not only unsteady but has been subject to declines in value of as much as -50% or more in recent years. While these typically more risk averse investors have fared reasonably well in these asset classes in the last few years, there is no guarantee that such a favorable outcome will continue into the future.

Of course, retirees and savers are not the only ones that have borne the cost of rescuing the financial system. It has also been the American taxpayer, as the U.S. government launched into what was the largest fiscal stimulus program in history in the immediate aftermath of the crisis. Unfortunately, what we have been left with since the outbreak of the financial crisis is a federal debt that essentially doubled to nearly $17 trillion and an economy that is still struggling to achieve any sustainable pace of positive growth.

"I shall revenge myself in the cruelest way you can imagine. I shall forget it."

-John Steinbeck, The Winter of Our Discontent

All of these aggressive policy responses and the costs associated with them would have been worth it only if we saw the economy repair and revitalize itself for the next growth phase. Unfortunately, what we have been left with is yet another mess that threatens to end just as badly if not worse than previous episodes. For the reckless institutions that nearly destroyed the global financial system and were rescued by the extraordinary actions of monetary and fiscal policy makers have exploited their good fortune by returning to many of the same ill advised behaviors that got us into the financial crisis in the first place. Missing from today's economy is the widespread sound lending activity that forms the foundation of sustainable growth. Instead, a good deal of this liquidity support has leaked its way into financial markets to artificially inflate asset prices with stocks leading the way in this regard. As for lending, we have seen return of speculative activity such as covenant-lite loans in an effort to satisfy the seemingly insatiable demand from yield thirsty investors, many of which have been forced into even considering these higher risk securities for their portfolios in the first place because of the Fed's endless zero interest rate policy. I have had a number of conversations with bankers in recent months and many have stated with varying degrees of lament that they are once again engaged in many of the same types of lending activities today that they were carrying out in 2007.

In short, financial institutions today are committing among the worst offenses imaginable to the general public. They are expressing their gratitude for being saved from oblivion by completely forgetting how they helped cause the financial crisis mess in the first place. And now we are once again looking down the barrel of another potential market meltdown in the coming years as a result.

"It is so much darker when a light goes out than it would have been if it had never shone"

-John Steinbeck, The Winter of Our Discontent

None of this had to happen. The global financial system was largely stabilized by the summer of 2010. The many segments of capital markets that had completely seized up during the depths of the crisis had returned to normal activity. And the threat of major financial institutions being sucked down into the vortex had been alleviated with confidence and calm being generally restored to markets. This was the time to allow the economy to cleanse itself of the excesses that had accumulated to spark the financial crisis in the first place. This was the time to allow some pain to be felt by the financial institutions that had caused the mess just as Fed Chairman Ben Bernanke had essentially promised during his 60 Minutes interview from March 2009. Growth would likely continue at a below trend pace during this cleansing period, but such an outcome should be reasonably expected given the magnitude of trauma the economy narrowly escaped at the height of the crisis. And by permitting financial institutions to work through their problems and allowing the economy to properly heal at that point, policy makers would have maintained more than sufficient policy resources to further guide the markets through the healing process while allowing the free market system to carry out its rational function.

Instead, the stimulus kept coming and coming. And what were once extraordinary measures to rescue an imploding global financial system became policy actions that are now not only commonplace but also demanded like an intoxicating drug by global financial markets and its participants. The result? What was once a circumstance a few years ago from which the Federal Reserve in particular could have sensibly extracted itself has now become a situation where the Fed is increasingly trapped in a complex net with heavy consequences associated with any action in makes in either direction. For the longer the Fed continues to apply further stimulus and add to its already alarmingly bloated balance sheet, the risk of one or more destabilizing asset bubbles continues to escalate. But as evidenced by the market response last summer and the instability witnessed in emerging markets over the past year, the Fed is now forced to be most delicate in not only stopping stimulus but even reducing the pace of adding further stimulus in order to prevent the risk of a massively sharp market correction.

The potential for another major market trauma has been created as a result. For it will feel so much darker to investors if the S&P 500 corrects by -40% or more from its current record highs to the 1000 to 1200 range, which of course is where it was trading as recently as two years ago, than it would have been if markets had been left alone back in the summer of 2010 and allowed to trade on their own at prices that were still historically elevated but far closer to historical fair value at that time.

"A day, a livelong day, is not one thing but many. It changes not only in growing light toward zenith and decline again, but in texture and mood, in tone and meaning, warped by a thousand factors of season, of heat or cold, of still or multi winds, torqued by odors, tastes, and the fabrics of ice or grass, of bud or leaf or black-drawn naked limbs. And as a day changes so do its subjects, bugs and birds, cats, dogs, butterflies and people."

-John Steinbeck, The Winter of Our Discontent

We will eventually arrive at the day where the stock market reaches its final zenith and the decline begins again. Bad news will no longer be good news but will instead finally return to what it has been all along - bad news. Unfortunately, since bad news has been good news for so long, investors should reasonably expect an extended period of the converse at some point in the future where good news is suddenly also bad news. The universe has an uncanny way of netting such things out over time. Along the way, capital markets will continue to evolve in texture and mood and will be warped by a thousand factors. And exactly what brings stocks to their final peak and subsequent decline remains to be seen. But while a rapid acceleration of economic growth to stem any such correction would be an ideal outcome, such appears increasingly unlikely given that the 2014 economic recovery that helped justify the robust 2013 advance in stocks is once again failing to materialize. Instead, tomorrow's market decline is likely to be marked by specific events that may be difficult to fully recognize today. Such are the daily changes in the markets and the global economy and geopolitical backdrop that influence it, and it highlights the importance of proceeding with caution in a market built on such a soft foundation.

One can only hope that with any such correction that a sense of order and justice is finally restored to capital markets. They will certainly never be perfect and unscrupulous actors will always remain, but a return to fundamental decision making and properly functioning free market system where sound decision making is rewarded, poor decision making is penalized with losses and failure is allowed to take place would be a most welcome outcome in helping to restore confidence among the broader investing public. In the meantime, we remain mired in a winter of discontent for many investors that threatens to drag on much longer than it should. Let's hope the onset of a new spring of integrity, ethics and confidence in financial markets is not to far around the corner.

Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long the stock market via the SPLV and XLU as well as selected individual names. I also hold a meaningful allocation to cash.