I was really blown away by Professor Arturo Bris's article, "8 Reasons Why A New Global Financial Crisis Could Be On The Way." In it, he says that he thinks "we should always wonder what the cause of the next crisis will be," and that "There are eight possible scenarios that could cause the next crisis, none more important or likely than the others."
Those eight scenarios are a stock market (SPY, DIA, QQQ) bubble bursting, a Chinese banking crisis, an energy crisis, a new real estate bubble, corporate failures, a geopolitical crisis, a poverty crisis, and hyperinflation. In other words, it is equally possible that any of the sorts of crises that have ever happened in the history of finance could happen, er, soon.
And, yet, he also claims that "There is no single episode of financial panic in the last 50 years that could not have been prevented. This time, let us look ahead, not react after the crisis."
So, what should we do to avoid this impending crisis? "Politicians and corporate executives should now look to diversify, to seek varied geographical presence, to be flexible, resilient and to manage risk." Not specific enough for you? "They should cultivate and reward talent and improve their credibility in society….Invest internationally and make acquisitions….[G]lobal leaders should be making employment, sustainability and social cohesion the top priorities of their nations."
I am trying to imagine what a 'politician seeking varied geographical presence' might mean. Keeping a jet warmed up on the tarmac?
This sort of blurry-eyed analysis is too common among mainstream market observers, because they are smart enough to know that they have a high probability of being very, very wrong were they to say anything specific. Mohamed El-Erian engaged in the same thing: "Macro-prudential progress, while notable, has fallen short of what national authorities initially envisaged, and international coordination has fallen short of what is needed to make it all work globally. Investors would be well advised to take this into consideration in making their Fed-driven trades, especially if they involve positions that will be difficult to sell or unwind in more volatile markets." That was his answer to the question: "What If the Fed Has Created A Bubble?"
The Fed, he says, has driven the stock and bond markets to "bubblish" proportions but that the real economy has failed to "converge" with those sorts of valuations--which is almost the definition of a bubble to begin with, isn't it? "The danger," he says, "is that the economic recovery will ultimately fail to validate artificially high asset prices…". If the prices are "artificially high" then they are by definition not "validated" by the real economy, so one is tempted to ask whether we should be mindful of the real economy at all. Nevertheless, he is worried that this could lead to "significant financial instability and adverse 'spillback' for the economy."
It is certainly hard to disagree with that. Artificial highs and real lows could result in spillback. But, the only question is, When? "Ultimately." Okay, never mind when; Where? Your "Fed-driven trades." So, any of you who predicted back when all the "unconventional" policies began six years ago that they would specifically cause a stock market boom--and I do not think there were many of you--please be cautious now. Never mind that you are already well ahead of the rest of us.
I sincerely doubt that there are many genuine Fed-driven trades in the stock market. The notion that QE was driving the stock market up did not gain any traction until we needed an explanation for why stocks were rising. When QE began, how many people were saying, "You know what? This could cause a very nasty stock market bubble?" If prices were going to skyrocket, the argument was that it would be in precious metals (GLD, SLV) and consumer prices. When gold and silver and other commodities were exploding upwards into 2011, QE was blamed, and then prices crashed, and we never hear of that argument any more.
This is all economic quackery. Nobody knows why stock markets have done better in the "bad times" of the present decade than they did during the "good times" of the last decade. Correlation is not causation. Stocks have rebounded since 2009 in nearly the same way they rebounded after the earnings shock of 1921.
In fact, nothing is causation. Causation is a myth we tell ourselves to force the world to "make sense." Of the truly interesting questions about life and the universe, we have absolutely no answers; instead, we are forced to come up with discrete categories like physics, biology, economics, and politics and then treat them as autonomous, simply because giving them a certain space to work within allows us to execute some useful tasks. But, we still do not know the origin of life or of existence, to take the most basic problems facing science. Even the word "know" is itself highly problematic.
In economics and market analysis, we need to begin again.
Unfortunately, it will probably take a Depression-style catastrophe or something more significant to induce a reset of that magnitude. Economists have had tremendous power and authority over the last century, and yet, there is not much to show for it.
It is possible that is about to change, however.
So, are we on the verge of a global financial crisis? Assuming that the previous one ever finished, sure. But, that by itself is pretty useless knowledge. If the late 1990s and early 2010s were periods of global financial crises, you made out pretty well in the US stock market if you had the guts to stick it out. Commodities and other markets were, of course, punished.
By using multiple "thin slices" of market behavior over the last fifty, one hundred, one hundred fifty years, I think I can make some predictions about the immediate future that will help us negotiate the next few years.
Using earnings volatility data over the last 140 years, I found that a bull market such as we have today tends to run seven or eight years after an earnings crash such as we experienced going into 2009. The relationship between earnings and prices is far more complicated than Robert Shiller's simplistic explanation of market behavior allows.
That type of earnings crash has no precedent since the Depression, but the dynamics of the relationship between earnings and stock prices has remained constant even despite the radical changes in the behavior of prices and earnings since that time.
We also know that the concurrent earnings yield (current earnings divided by current prices) are highly correlated with real commodity prices in a way highly reminiscent of what Keynes called "Gibson's Paradox," which was the correlation between producer prices and consol yields up until the gold standard began to erode with the establishment of the Fed a century ago. It was believed to have been lost, Larry Summers (briefly?) believed he had rediscovered it in the early 1980s, but I am pretty sure that I have re-discovered either the real thing or a very close approximation to it.
In any case, if stock market prices are to continue behaving in an extremely bullish manner, and real commodity prices are positively correlated with the earnings yield, we can expect further downward pressure on commodity prices as stocks continue to defy gravity and "common sense," or what I like to call "naïve rationalism," the idea that reality should behave according to one's logical assumptions. Shiller's behavioral finance is a perfect example of this: if prices do not behave in a way that appears to be rational to you, the only rational explanation must be that the world is irrational. As modest and level-headed as Shiller appears to be in his writings and interviews, I cannot help but mark this sort of logic as a textbook example of intellectual hubris.
Why are global commodity prices positively correlated with the American earnings yield? I haven't any clue. Readers often suggest that this is because commodity prices (RJA, DBC) are inversely correlated with stock prices, but that is not quite true. Before the Depression, and especially before the establishment of the Fed, the earnings yield was determined by shifts in earnings, not stock prices. It is only since World War II where the earnings yield has been dominated by stock prices (of course, the polarity briefly flipped during the crisis five years ago when the P/E ratio shot up because of the biggest collapse in earnings since the early 1920s).
As for why it is specifically the American earnings yield that seems to be in play, it is possible that it is not. The American yield may only be the largest and most influential segment of a global earnings yield, for which we have no long-term data, unfortunately.
In any case, historical precedent suggests that stocks will continue to rise and commodities will continue to fall over the next couple of years. During bull markets, stocks also tend to be inversely correlated with yields (UST, IEF, TYD), and that became true again after 2011. Since the end of Bretton Woods in the 1970s, stock returns also tend to be significantly higher when the yield curve spread is determined by movements on the long end of the curve. If there is any justification for "blaming" the Fed for the bull market in stocks, it might be there, but again, correlation is not causation. It is possible that the Fed is reacting to conditions that have created the bull market, not vice versa.
Bull markets also do not tend to come to an end until the yield curve has flattened out considerably, and even then, a flattening of the yield curve tends to be followed by an oil (OIL, USO) shock, which, as Stephen Leeb pointed out a long time ago now, has been a reliable predictor of stock market crashes over the last 40+ years.
The yield curve spread, of course, remains very wide, and oil prices are stable and appear to be declining.
Poor stock market returns also tend to follow spikes in the oil/gold ratio. The reason appears to be that specific commodities react differently to the Gibson Effect mentioned above. Oil seems to react before gold to imminent changes in the direction of the earnings yield. Again, since the earnings yield is primarily determined by stock prices in the post-gold-standard market, this makes the oil/gold ratio a useful predictor of stock market performance.
We can break the relationship down, however, as well. Oil shocks are taken for granted, although the cause of oil shocks, like everything remains a mystery, and it is not clear why they should specifically impact stock markets. Of course, it sounds plausible that there is a direct, causal relationship, and in economics and market commentary, that is good enough.
But, let's take the less familiar relationship of gold to stocks. Gold appears to lag oil, but it may also be an indicator in its own right. At the beginning of secular bull markets, the oil/gold ratio collapses often because gold spikes at the conclusion of a bear market in stocks. That is what happened in 1980. Even though oil prices were extremely high, the spike in gold (and silver, by the way) appears to have been the end of the line for the commodity bull of the 1970s and the beginning of the twenty-year boom in stocks.
This happened again in 2011. Oil initially collapsed going into 2009, but two years later, oil had largely recovered, precious metals went parabolic, and people cried out that this was the signal that inflation was getting ready to rip through the economy. Of course, it didn't. Then, the anti-gold crowd argued that this was a demonstration that the gold market was out of its mind and so forth and was just another irrational bubble. We would really be so much better off if we would jettison words such as "bubble," "irrational," and "cause" from our thoughts on markets. Unfortunately, these are the bread and butter of market commentary. But, this is not bread and butter we can eat; instead, the result is the mishmash we get from the delusions of rationality that we find in Bris, El Erian, Shiller, et al: lots of "knowledge" about how economies work but with no ability whatsoever to spell things out. Only a layer of rationalism built upon a deep foundation of plausible-sounding assumptions.
A month or so ago, I think, I wrote an article about the history of relative commodity prices since 1900. What I found was that the relationship between supply and price was far more complex than what we all "know" to be the case. It is next to impossible to demonstrate a discernible relationship between supply, demand, and price in any given commodity. But, on a relative basis, amongst primary commodities, there is a strong, long-term inverse correlation between price and supply across commodities. In what comes to the same thing, there is a distinct tendency amongst primary commodities for the total value of a given commodity's global production to approximate the total value of each other commodity. Adam Smith was only half right when he asked why diamonds are more expensive than water. The "right question" appears to be rather, Why is it that diamonds and water are equally valuable or tend to be so?
Interestingly, the way this balance between precious metals and basic commodities (i.e., diamonds and water) is maintained is that for every expansion in production in the latter, the former rise in price. In other words, especially over the last 35 years, the prices of gold and silver have tended to track with the production levels of cheap commodities like bauxite, fertilizers, and iron. When we see gold and silver prices caving in, that tends to mean that production levels in basic commodities is stagnant or declining.
Commodity prices generally tend to be highly correlated with one another, so prices and production can be loosely thought of as running together. Of course, it is emerging markets (NYSEARCA:VWO) that are most dependent on commodity production, so when we see precious metals prices collapsing, we can be relatively sure that emerging markets are feeling the pain most substantially.
And, if we layer these thin slices for a moment, it suggests that the boom in American stocks that we are experiencing since the crisis, especially since 2011, is being felt as a crisis in emerging markets as prices and production soften for commodities.
When Bris asks if there will be a global financial crisis, well, there already is one, and it has not run its course. Emerging market growth has been stagnant for at least three years now, but bull and bear episodes tend to alternate every seven years. What is missing is not a crisis; open the newspapers, and anybody can see that there is something amiss in emerging markets, and that it is playing out in low-intensity conflicts. We have not had a panic, however, which is perhaps what Bris means by "crisis." A panic in emerging markets tends to coincide with a sharp appreciation of the dollar (NYSEARCA:UUP) against virtually all comers. There have only been brief retreats to the dollar since the crisis began, although it should be said that the dollar has been picking up steam in recent weeks while commodity prices have been losing it in nearly equal measure.
I am not very keen on attempting to time market moves down to the minute, hour, day, week, or even month, but it appears to me that the panic phase of the crisis might be very close indeed, but what I take from this is that investors should definitely not be diversifying geographically; rather, if they intend to protect themselves from a global financial crisis, they should be concentrating their holdings in American bonds and equities. As in the early-mid 1980s, late 1990s, and 2011, American securities performed well as the dollar strengthened and commodities collapsed, although there was certainly heightened volatility. In 1998 and 2011, for example, stocks dropped 20% in weeks, but as it turned out, those were largely forgettable episodes when we look back on them. We gloss over the late 1990s as being irrepressibly optimistic now.
The beginning of the panic (I would like a word that is not so purple, but nothing springs to mind at the moment) I expect will be marked by, to repeat in no particular order, a surge in the dollar, a collapse in commodity prices (especially precious metals), a collapse in emerging stock markets, and a fall in Treasury yields.
The ten-year yield has been testing the 2.40 level for a couple of weeks, the dollar has been rising, and commodities are looking increasingly anemic. I do not have any reliable short-term indicators for such a panic, and if it occurs, it could begin in another six months rather than six weeks, but my point is less to time such a panic as to point out the conditions that suggest one may be approaching.
Either way, I expect that over the next two years, we will continue to see downward pressure on emerging markets, commodity prices, and American bond yields, and upward pressure on American equities and the dollar. The notion that it is time to bail on American equities just yet, as Shiller (or at least the P/E10 metric he has popularized), El Erian, and Bris seem to be hinting at, does not seem necessary quite yet.
This is not to say that America will not get her comeuppance, too. As I already indicated, that will probably happen, or rather begin to happen, in 2016-2017, and the only comparable precedent, the 1920s, does not bode well for what will follow for the US or the rest of the world.
In any case, I would not take the analysis of the sort published by Bris and El Erian to heart, unless you are better able than I am to translate it into concrete terms. As for me, I am still asking myself, Where? When? Why? And, I don't know, but I think I can guess.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.