Beanie Baby And Other Bubbles: What The Fed Can And Cannot Do

| About: SPDR S&P (SPY)

Summary

Valuations that disconnect from fundamentals are called bubbles.

The narrower participation of the current equity and bond bubble may affect how they end.

The Fed's powers are less than what it wants the world to believe.

The Fed does have the power to burst bubbles.

A bubble occurs when the valuation of an asset disconnects from fundamental metrics. The Beanie Baby bubble (mid-1990s) is an extreme example of this. There was no fundamental justification for anyone to pay hundreds or even thousands of dollars for a $5 plush toy. It was a case of groupthink, greed, and devious marketing by the toy's creator, Ty Inc. (Ty Warner Inc. at the time).

The 2007 housing bubble, is another example. It came about thanks to the same groupthink and greed, nourished by the government's encouragement of home ownership, and dispatched by financial industry over-reach and larceny.

Other famous bubbles, such as the South Sea bubble and the ridiculous (relatively speaking, since all bubbles are ridiculous) tulip bubble, had slightly different technical causes. But they, along with every other bubble that Humans have ever been involved in, have the same Human behavior/emotion of crowd mentality and individual greed as common factors.

Source: bostoncharts.com

Some bubbles, like the Beanie Baby bubble and the last housing bubble, have wide mainstream participation, while bubbles like the present bond and equity bubbles have a more limited and technically sophisticated participation. It is a narrower slice of the population that can participate in these latest bubbles, mainly because the QE funds that are being used to inflate them are only available to the top of the pyramid. The groupthink and greed, however, remain constant.

This narrower participation may mean that the bursting of the bubble could happen without the characteristic public mania phase that normally occurs just prior to the 'pop'; the public just can't afford to attend this Fed-fest.

While this game of financial musical chairs is a consequence of central bank monetary largess, one has to understand that it was unintended and unanticipated by the Fed et. al. Even though the Fed wants the world to think that they can do amazing things such as rescue the real economy, create jobs, and increase inflation, the truth is that the Fed can do none of those things.

What the Fed Can Do:

  • It can control the lending rate between banks.
  • It can buy and sell Treasury bonds along with other securities, thereby affecting money supply (but not velocity).
  • It can provide the financial industry with funds. In 2008, the Fed gave the industry $16 trillion, which is equal to the entire GDP of the U.S.

What the Fed Can't Do:

  • It cannot force anyone to borrow more money.
  • It cannot determine which are value-creating investments, and which are financial speculation.
  • It cannot deliver money to the base of the economic pyramid where it would increase the velocity of money and create value; all it can do is provide liquidity to banks. (www.financialsense.com)

The crucial aspects of the real economy that matter are beyond the Fed's sphere of influence, so it is no great mystery that there has been no recovery on the ground, and no spike in inflation.

The Fed never predicted or intended to do this:

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And one assumes (incredibly) that they didn't see this coming:

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The bond and equity bubbles continue to move in-synch and ignore EVERYTHING that isn't interest rate related. NOTHING matters:

Not the dumpster diving for yield that is boosting bonds:

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Notice that the 10-year minus the 2-year Treasury rate tends to diverge from the Corporate bond minus the 10-year Treasury as the economy heads towards recession. Even though the requisite negative differential between the 10 and 2-year Treasuries has not yet materialized, the divergence has begun and is pointing to an inversion in the near future. All it would take is for the Fed to warn of an impending rate hike.

Not the low industrial utilization:

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This makes five out of the last six quarters with lower capacity utilization. How does this justify the increased value for stocks?

Not low wage growth:

Wages and Salaries as a Share of GDP (St. Louis FED)

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The real economy grows from the bottom up, and this chart shows the near-constant austerity that has been imposed on the economic base. You cannot grow an economy through austerity so why are equities growing in value?

Not high P/E:

S&P 500 Price to Earnings Ratio (multpl.com)

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P/E has only been higher during the tech bubble and during the housing bubble. A reversion to the mean (15) would require either a 60% increase in earnings (see earnings chart below), a 40% drop in the price of equities, or a combination of both.

Not lower earnings (although this quarter seems to be less bad):

S&P 500 Change in Earnings (multpl.com)

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Earnings have been dropping for more than a year, yet the market continues adding value to stocks.

Not lower sales:

S&P 500 Change in Sales (multpl.com)

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If what is needed is a 60% increase in earnings in order to bring P/E back to the average, then we fail to see how that can be accomplished with decreasing sales.

Not high price to sales ratio:

S&P 500 Price to Sales Ratio (multpl.com)

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Investors are paying more for every dollar of sales than at any time in the last fifteen years. Are the present sales really more valuable than the sales at the top of the housing market bubble?

In addition to all the fundamentals that the market is ignoring, there are also a number of geopolitical concerns that are being ignored:

  • European and UK instability.
  • A military coup attempt leading to a tyrannical, fascist crackdown in a NATO partner.
  • The possible election, as president, of an individual that the rest of the world views as a dangerous narcissistic-clown. The world does not view that possibility as good for trade or business in general.

This leaves no doubt in our minds that equities are in a bubble. Others on Seeking Alpha have noted the complete disconnect from the fundamentals that should inform the valuation of equities, and they provide similar reasoning.

The difficulty, of course, is timing the bursting of the bubble. Since even ludicrous bubbles like the Beanie Baby bubble can take years to burst, as investors we have to be prepared to watch the bubble grow beyond all reason. We are shorting equities via SPXS, but are insured through puts on our position since there is no telling how long this bubble will last.

In conclusion, even though equities may be costlier in the future, it is a certainty that they are overvalued today. A 60% growth in earnings, a 40% drop in equities, or a combination of both is required to bring valuations back to Earth. Since the bubble-pricing of equities and bonds are the unintended consequence of the Fed's (and other central banks') policies, the slightest misstep by the Fed would make all the bubbles disappear along with 40% of equity values.

Disclosure: I am/we are long SPXS.

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.