The goal of this article is to analyze the current broader market environment, with a focus on using credit cycle theory to determine whether the current economic expansion is inherently sustainable, or vulnerable and due for a reversal. We'll also look at recent developments that may point to an impending catalyst.
Forewarning- the bulk of this article presents a detailed discussion of credit cycle theory and macroeconomics, but the discussion is ultimately followed by actionable trading/investment insights.
A Little History
In order to properly size up the current market environment, we must first understand how we got here. We can divide the current bull market and economic expansion into three phases, beginning with the initial recovery in stock prices off the 2009 lows:
Phase 3: 2015 - 2016 Falling Earnings and Volatile, Range-Bound Stock Prices
Follow the Liquidity
So what explains the levitation in stocks at record highs? The answer: liquidity. As legendary investor Stanley Druckenmiller once said:
Earnings don't move the overall market; it's the Federal Reserve Board… focus on the central banks and focus on the movement of liquidity… most people in the market are looking for earnings and conventional measures. It's liquidity that moves markets.
The three lines on the chart above a clear divergence between rising stock prices and falling earnings, driven by increased liquidity provided by rising Federal Reserve (Fed) asset levels.
At least on the surface, it appears that the 50% increase in stock prices since 2012 has more to do with the 60% increase in financial market liquidity via the Fed, rather than the non-existent corporate earnings growth over the same period. But, how does this work?
Rising asset levels held by the Fed correspond with increased financial market liquidity because the Fed uses newly created money to purchase these assets from private market holders - typically banks. This new money can then be used by banks to issue new loans, or to purchase other financial assets- directly or indirectly. Since the Fed typically purchases U.S. Treasuries (and MBS more recently), these asset purchases cause interest rates to fall. Lower interest rates incentivize investors to reach out onto the risk curve in order to generate sufficient investment returns. The reduction in interest rates, combined with increased liquidity in the financial system, fuels a rise in asset prices based on the increased demand for (from new liquidity) and lower supply of (due to asset purchases) financial assets.
To understand why this scheme will not generate sustainable economic growth and instead has set up the economy for another inevitable recession, we must understand the interaction between the monetary system and economic growth.
Savings and Investment (Not Spending) Fuels Economic Growth
The economy is simply a system by which we create the means of transforming matter from one form (raw materials) into some other desired configuration (consumer goods). Since human labor is limited in its capacity to transform matter, economic growth is dependent upon our capacity for creating tools (i.e. capital goods) to enhance this transformation.
Investment is the process by which we create capital and investment fundamentally requires savings as a prerequisite to provide the resources required for capital creation. This is because capital creation requires the consumption of resources today, and will not generate any production to replace those resources until some later point in the future. Thus, there must first exist excess resources to "fund" the investment process in the meantime. If these resources do not exist, there is no physical, material wherewithal to see the investment through to completion.
On a physical level, you save money by producing an excess of resources relative to what you take in from the economy. The cash you accumulate represents your claim on these excess resources. When you use that cash to invest in a corporate stock or bond, for example, you temporarily transfer these claims on resources to a corporation, who will hopefully use them to create capital that will yield production at some point in the future. If the value of that future production exceeds the value of the resources required to produce the capital, this yields a positive investment return that enables greater future consumption.
This is a critical point, because if economic growth requires investment and investment requires savings, this implies that the fundamental requirement for economic growth is savings.
The Keynesian Spending Fallacy
Of course, the view that savings fuels economic growth opposes the conventional Keynesian economic narrative that spending drives the economy. The Keynesian belief that spending forms the basis of economic growth derives from the surface relation that one man's spending is another man's income, and thus higher spending = higher incomes = economic growth.
The problem with this superficial analysis is that it ignores the necessary process that enables increased spending in the first place- production. And as we discussed, increased production requires capital investment, which requires savings.
Without the initial production, spending simply transfers previously produced goods from one part of the economy to the other. Thus, spending is the result of previous economic growth - but does nothing to generate future economic growth. In fact, all else equal, the more we consume today, the less resources we have available to provide for tomorrow's production.
Measuring the Economy
The Keynesian spending fallacy is rooted in the idea of using GDP to measure economic health. Since GDP is calculated by simply summing up total spending across the economy, (i.e. consumption + investment + government spending) anything that boosts GDP is, de facto, considered good for the economy.
The problem with this approach is that GDP only provides a snapshot in time of current economic transactions, and the measurement makes no differentiation between spending on consumption vs. investment. Furthermore, it does not consider whether the spending is fueled by debt or savings. Because of these shortcomings, GDP cannot tell you anything about the long-term sustainability of economic growth - it only tells you about current activity.
For example, imagine you and your neighbor both earn $50,000 per year. Your neighbor spends $60,000 each year, taking on debt to buy fancy cars, eat out five times a week, and take luxurious vacations. Meanwhile, you only spend $40,000 per year, and invest $10,000 in long-term savings bonds. On the surface, your neighbor's economy appears better and his GDP is higher. But of course, your neighbor's extra spending today will come at the expense of lower spending tomorrow, when he must repay (or default) on his debts. Conversely, your lower consumption today will pay off with greater consumption and thus a higher GDP tomorrow.
Interest Rates Allocate Scarce Savings
Savings, like all economic goods, are inherently scarce. The interest rate is the price by which savings are allocated and like any form of price control, artificially low interest rates will encourage overconsumption, misallocation and shortages. This sets the stage for the credit cycle, where an investment boom based on overconsumption and overinvestment is inevitably followed by a bust, when scarce savings must be replenished.
On the surface, artificially low interest rates may seem like a positive, because more lending = more investment = more economic growth. But again, similar to the flaw in the Keynesian spending fallacy, this line of thinking fails to consider the necessary step required for investment in the first place- savings.
The flip side of every lending transaction is an implicit requirement for savings that must support the investment process. Accumulating savings requires time and effort - artificially lowering interest rates does nothing to increase the supply of saved, excess resources. Without an increase in savings, artificially low interest rates simply encourage excess consumption of the pre-existing economic resources, setting the economy up for a shortage of savings and a recession down the road.
You Cannot Fight a Recession
In the Keynesian view, since all spending is equal and all spending generates growth - then government spending and artificially low interest rates can provide a boost to the economy when the private sector pulls back on spending during a recession. The problem is, there's a reason the private sector pulls back on spending following a period of excess consumption - scarce resources must be rebuilt and bad debts incurred during the boom period must be liquidated. The argument that the government should step in to fill the spending void, ignores the more fundamental question of why the void exists, and whether we should even try to fill it in the first place.
Keynesian Policies as a Political Tool
The problem is, the process of underconsumption and accumulating savings is slow and painful in the short term. Politicians are not in the business of selling discipline and patience, they are in the business of promising a free lunch. The Keynesian policies to support debt-fueled consumption to temporarily boost economic growth overlap perfectly with the short-term incentives of the political system at the determinant of long-term economic growth.
Indeed, the founding father of this school of thought readily admitted his lack of concern for the long-term ramifications of economic policy, evidenced by his infamous quote:
In the long run, we're all dead.
Unfortunately, we are now approaching the long-term results of yesterday's short-term profligacy, tracing back to the stimulus measures that fueled the Housing Boom in the aftermath of the Tech Bubble. Leading Keynesian economist Paul Krugman provided the following blue print that the Bush Administration followed to "fight" the recession caused by the Tech Bubble:
To fight this recession the Fed needs…soaring household spending to offset moribund business investment. [So] Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble.
- Paul Krugman in a 2002 New York Times editorial.
Well, we all know how that turned out.
Since the economy didn't actually have the resources to support a massive increase in home creation following the capital destruction of the Tech Bubble, the temporary boom of home construction was fueled by unsustainable debt creation (made possible by low interest rates and credit creation from the Fed). Once the bubble burst, we ended up with increased debt levels and fewer home owners.
Data Refutes Keynesian Policies
Of course, we followed even more extreme policies to "fight" the 2008 Recession. After 7 years of massive economic stimulus that's seen government debt double to $20 trillion, and the balance sheet of the Fed ballooning by more than $3.5 trillion, what do we have to show for these radical measures?
Declining real income levels through both boom/bust periods:
At the same time, domestic production of consumption goods is 9% lower than pre-crisis levels. Sure, we might have created part time, low paying jobs, but today there are only 71 million bread winner jobs (at least 50k/yr full time jobs) - fewer than when Bill Clinton left office. We still have 45 million Americans on food stamps (Source). What more evidence do we need that, despite the most aggressive Keynesian policies ever tries, the economy has gone backwards for 15 years?
Letting the Recession Run its Course
History also provides a guide to periods where recessions were simply allowed to run their course. The 19th century is filled with examples of short, sharp recessions that ultimately recovered within 6-18 months and without any government intervention.
Perhaps the most clear-cut example is the sharp but short-lived depression of 1920-1921, compared to the prolonged malaise of the 1930s Great Depression, where the government took the most aggressive measures up to that point in time to fight the recession. An in-depth analysis is beyond the scope of this article, but Jim Grant does an excellent job detailing the 1920-1921 period in his book, The Forgotten Depression of 1921, which is summarized in multiple places, including here and here.
The Inflation Question
By definition, investment based on savings should be deflationary because the total money supply is unchanged from start to finish. The source of the investment returns is the result of generating a greater quantity/value of goods compared to the value of the resources spent creating the capital, but no new money need be created. Thus, the inevitable result is a greater value of goods against an unchanged supply of money - resulting in natural deflation.
The United States experienced deflationary growth throughout much of the 19th century, and in particular during the "Gilded Ages" following the Civil War from 1865-1900. There was no central bank and the money supply was relatively stable (i.e. gold/silver), and thus investment was based on market-based interest rates financed by savings. During the 19th century, individual savings rates ranged from 20-30% (compared to around 5% today), which fueled the incredible investment and economic growth during that period.
Conversely, investment based on artificially low interest rates and credit creation should be inflationary, because the actual resources to support the increased investment demand do not actually exist. Each credit cycle has unique inflationary dynamics, where some sectors in the economy become overinvested in, which drains capital away from other areas of the economy that become underinvested in. In the early 2000s, excess credit went into housing, at the expense of other sectors like commodities extraction, causing a surplus of houses and a shortage of commodities. This is one reason why commodities like crude oil sky-rocketed in price leading up to the 2008 Financial Crisis. These rising commodity prices eventually forced the Fed to raise rates and pop the bubble. The easy availability of credit enabled millions of Americans to take place in the temporary wealth created during the boom, as they bought houses on credit and took out home equity loans to finance consumption.
Today's credit expansion is different. The money is mostly flowing into the financial sector - evidenced in absurdly high prices for sovereign bonds trading at negative yields, and soaring stock prices in the face of stagnant earnings growth. Most corporations are not using debt for actual capital creation, they are repurchasing their own shares to financially engineer earning-per-share growth via share reduction, since net incomes are largely stagnant. We haven't seen a broad-based bubble because the majority of financial assets are held by the top 10% of the population, which has only fueled wealth inequality and the rise of political tensions (a la Donald Trump and Bernie Sanders).
We also haven't seen a major increase in commodities prices because commodities production is one of the few sectors that have actually engaged in capital expenditures - likely a response to the soaring prices in the preceding bubble. This overinvestment in commodities has created an epic glut in products like crude oil, natural gas, copper, etc. Ironically, in the current credit cycle we've seen the exact capital flows compared to the Housing Bubble- where excess credit has gone into commodities production at the expense of other sectors like construction and home building, causing a shortage of homes and a glut of crude oil.
The lack of capital available for home building is evidence in the shortage of construction labor and materials, which has caused a severe inventory shortage in housing. The combination of inadequate housing supply and increased speculative credit bidding up financial assets like real estate has created an epidemic of rising costs for homes and apartment rents, despite declining real incomes.
Where Are We Today?
Given this theoretical framework, we can fast forward to analyze the current credit cycle. Following the 2008 Financial Crisis, the government once again stepped in to provide "stimulus spending," lowered interest rates to zero and engaged in record credit creation via the Fed.
The initial boost from the crisis measures began to lose momentum in 2012, causing the Fed to launch QE-3, the most aggressive monetary stimulus program in U.S. history. $80 billion/month in Fed asset purchases from late 2012 through 2013 provided the liquidity that boosted stock and bond prices to record highs. This process began to taper off at the end of 2013, and ended in October 2014. Perhaps not coincidentally, October 2014 marked the peak in corporate earnings and ended the low volatility uptrend in U.S. equities from 2012-2013. Beginning in late 2014, when the asset purchases stopped, the steady uptrend in U.S. stocks was replaced with a stagnant trading range filled with downside volatility shocks (more on this later).
Going back to the original series of charts, we can zoom out to the entire bull market cycle and see that the initial boost from low interest rates and credit expansion is beginning to lose steam.
GDP growth for the trailing 12-month period has recently fallen to just above 1%, as consumers and businesses have begun to retrench in recent months.
Another way to track economic activity is to measure transportation volumes, since every good that is produced and sold must first find its way to customers via some kind of transportation route. A negative reading in transportation activity has reliably coincided with every economic recession in the last 30 years and the index recently went into negative territory in August of 2016.
What's more, we're seeing an even sharper decline in global trade, which has recently approached the lowest levels since 2008.
The Recent Trading Range
Clearly, valuations are stretched compared to underlying fundamentals, which leaves the market highly vulnerable to the kinds of sharp repricing shocks that we've seen over the last two years. This increasingly drawn out and compressed trading range appears to be setting the market up for decisive break, especially based on the more recent shorter-term consolidation.
The current earnings season could provide the catalyst to inspire a move out of the current trading range. In recent months, analyst estimates have flipped from expectations of earnings growth to expectations of earnings contraction. If analysts are correct, this will mark the 6th consecutive decline in quarterly earnings for the S&P 500.
Despite this deterioration in growth prospects, equities remain elevated. In fact, investors have recently rotated from the defensive sectors, like utilities and consumer staples, to the more cyclical parts of the economy, including industrials, emerging markets and technology. Part of this rotation has likely been due to the recent strength in crude oil, which may be providing a false signal of economic growth that's really just been fueled by OPEC jawboning. Indeed, Honeywell (NYSE:HON) - a leading, global industrial bellwether - recently disappointed the market with an unexpected downgrade in its earnings guidance. This warning from Honeywell was followed by Dover (NYSE:DOV) and PPG (NYSE:PPG), suggesting a potential broader trend of macro weakness that we should be expecting at this stage in the current credit cycle.
The Bottom Line
Going forward, investors in the current market would be well-advised to consider the following questions: Have we built a sustainable foundation for economic growth, or have we simply inflated another unsustainable debt-financed bubble that will inevitably burst? Do the fundamentals support the current price of financial assets? What's the potential downside risk and how will I prepare for it?
You can bet that the world's top investment minds have considered these questions, so don't just take my word for it - consider what they are doing with their money.
Let's start with Warren Buffett, who uses a simple, but reliable indicator to determine the broad valuation level of financial assets relative to the size of the economy. This so-called "Buffett Indicator" is flashing a warning signal for stocks. - currently sitting at levels last seen leading up to the bursting of the Dot-Com and Real Estate Bubbles. When this ratio gets too expensive, Buffett has historically shifted his portfolio holdings towards cash - preparing for the inevitable bargains that appear during market downturns. Buffett appears to be following his indicator, evidenced by Berkshire Hathaway's (NYSE:BRK.A) (NYSE:BRK.B) cash holdings soaring to $72 billion in recent months - the highest cash levels since the founding of Berkshire more than 40 years ago.
Then there's Ray Dalio of Bridgewater - the largest Hedge Fund in the world, which profited during the 2008 Financial Crisis by accurately foreseeing the unsustainability of the housing bubble. At a recent CNBC conference, Dalio stuck a particularly cautious note that "we may be approaching the end of the debt cycle."
There are many others, including:
George Soros and Carl Icahn have each built up large short positions in U.S. stocks; Bond King Jeffery Gundlach recently advised investors to "sell everything"; Stanley Druckenmiller advised investors to "get out of the stock market, and own gold"; Paul Singer: "It's a dangerous time in the global economy."
Of course, some investors might point out that we've been hearing these warnings for some time now, and they would be right. Ultimately, bubbles can last longer than many think reasonable of even possible. But one thing is and has always been true - when financial bubbles get inflated, it's only a matter of time before they burst. Historically, these cycles tend to last anywhere from 4-7 years. We're currently in year 7 and approaching year 8 of the current cycle. How much more juice is left in the tank?
Disclosure: I/we 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.