I recently had a meeting with a prominent Silicon Valley investor who confidently stated to me the following: "Unlike the late 1990s or the mid 2000s, when you would periodically hear investor concerns over the technology (dotcom) or housing sector bubble - I don't seem to hear anyone that concerned about our markets right now. Doesn't that concern you?"
The insinuation was that all was well with the risk markets and that investor complacency was a good thing. Truth be told, if only anecdotally speaking, I became even more convinced that my global investment thesis for the remainder of the decade will prove to be correct. As always, I told my investor friend, they never ring the bell at the top - they didn't in 2000 or 2007, and they certainly won't now.
A more definitive answer to his inquiry would be that as we near the end of the post-2008 'asset inflation' cycle, investors need to look no further that the US Federal Reserve actions, or inactions, themselves. Specifically, the Dow Jones Industrial Average has now nearly tripled off its March 2009 market low, yet Fed policy has remained constant with its perpetual zero interest rate policy (ZIRP) now nearly six years running. Never before in the history of the Federal Reserve has monetary policy remained so accommodative for so long while the economy and job creation improved and asset prices flourished.
Why has the Fed, along with the other advanced economies' central banks remained on hold while asset prices from stocks to real estate to artworks to baseball cards have skyrocketed? Is the Fed in a box with no 'painless' way out? If actions speak louder than words, then the Fed's inactions are clearly deafening.
From the Tulip Bulb Bubble of 1637 to the Housing Bubble of 2008, speculative bubbles typically 'bust' when the following conditions occur:
- Too much supply trading at record high prices
- Too little economic growth to sustain #1
Although today's asset bubble is as obvious to see as any asset bubble in history, it is equally as obvious as how many investors are failing to acknowledge it. Human nature certainly plays a role here as most people, including myself, are inclined to live optimistically and think positively. Also, numerous studies have concluded that investors 'collective memory' is about 2 ½ years. If true, the Crisis of 2008 is old news and the Technology Bubble of 2000 is ancient history.
With that said, what is the next asset bubble to bust right now? It is a difficult question to answer when the risk-free rate itself, the US Treasury market, is pinned at 0%. Virtually every asset on the planet has a financing component to its own valuation, and when the financing rate is minimal everything becomes skewed to excess.
I believe the answer lies in the explosion in the supply of new government debt created across the developed world in just the last six years alone. Debt creation in the US, Eurozone, and Japan has nearly doubled from $20.8T in 2007 to $39.5T today. At the same time, GDP growth has declined steadily over that same time period (see chart below). Meanwhile, in classic bubble form, government debt prices are at or near all-time highs. In unprecedented form, central banks have been printing money out of thin air to monetize this new massive supply. No doubt that central bankers' motivation includes ensuring a perpetual low cost of funds in order to maintain a respectable sovereign debt credit rating if not their own country's solvency. It is estimated by some that nearly 60% of all new government debt supply has been purchased by their respective central banks - with the Fed, ECB, and Bank of Japan balance sheets up over 300% since 2007. In the US, the Federal Reserve Bank balance sheet has grown over 600%, from ~$750B in 2007 to $4.5T today.
For instance, no one in their right mind would ever lend 10-year money to the Government of Japan for a measly 35 basis points given their dangerous Greece-like debt to GDP ratio (~240%). Central banks have truly become the 'unsustainable' lender of last resort; artificially suppressing sovereign yields while propping up debt prices. Unsustainable because in the end, all bubbles in history end the same way. The free markets eventually prevail.
For the last several years, many market prognosticators have repeatedly called for a market correction in the risk markets. Several notables have even called for a major market 'crash'. These doomsayers have been repeatedly wrong.
So why am I calling for a major risk market correction beginning as early as the fall of 2015? I will answer my own question with both an 'Investor Premise' and a telltale 'How Does A Government Bond Bubble End' signpost happening right now, hiding in plain sight for prudent investors paying attention.
To ignore the cyclical nature of the U.S. economy and market history is to ignore the reality of financial markets. Since 1973, like clockwork, the US has experienced risk market corrections every 5-7 years. These corrections have not all been exactly the same in terms of market sector, breadth or duration, but they have all had very high positive price correlations to the downside across nearly all risk asset classes. In other words, a balanced and diversified asset portfolio was not immune from these market corrections. Studies have concluded that most traditional investors are asset diversified as opposed to risk diversified. As a result, neither large caps, small caps, international stocks, venture capital, private equity nor real estate (2008) have provided little if any portfolio protection during market selloff periods.
From a portfolio liquidity perspective, investors should also consider the following dilemma: When the next major correction occurs, how will our policymakers be able to respond to provide a 'timely' remedy to repairing the economy as well as our personal portfolios? What tools are still left in their toolkit? These are very important questions to consider, as their 35-year Keynesian fiscal and monetary playbook is clearly nearing exhaustion. Fiscally, the days of endless borrow & spend are over, and monetarily, interest rates are pegged at zero. As a result, for the unprepared investor, the next risk market correction may lead to significant illiquidity that may prevail for a longer period of time than previously experienced.
I believe cracks appearing in the global sovereign debt market will likely be the catalyst of the next major market correction. How does a government (sovereign) debt bubble end? What are the signposts that investors should be looking out for? Ludwig von Mises, the founding father of Austrian economics and the anti-Keynesian movement, spoke of the end of credit expansionary policies (see below).
Broadly speaking, Austrian economists warned that perpetually pulling forward demand from the future into the present day would eventually create problems with the currency. It should be noted, that right now, we are witnessing a major deterioration of both the Euro(€) and the Japanese Yen(¥) relative to the world's reserve currency the US Dollar. In fact, both currencies have fallen by nearly 20% in just the last 6 months alone. Weakness in these major currencies is forcing international capital flows into the US Dollar, which is finding its way into both US Treasuries and US equity markets - at least for now. Global monetary and fiscal policies are losing their effectiveness to grow the global economy. In particular, both European and Japanese policymakers are now 'pushing on a string' and investor confidence is beginning to erode. Nominal interest rates in Greece are once again beginning to drift precariously higher. A reemergence of the 2011 sovereign debt crisis may be close at hand; however sovereign debt levels for the regions are significantly higher that they were just a few years ago.
For the very near term, the US financial markets are the only 'game in the town' for the global investor. The US economy remains the best-looking house in an ugly neighborhood. US stocks and risk assets should move higher in the early months ahead. Aside from the supporting technical and fundamental research that furthers upholds a continuation of the bull market; investors should take heed to one of my favorite longtime market trader quotations:
"Mr. Market will make a fool out of the most people the most amount of time it can."
With that said, many retail investors have yet to fully wade back into the US stock market still reeling from the pain of 2008-9. It is reasonable to expect Mr. Market's best move right now to 'fool the masses' would be an early move higher, thus luring more investors back into the risk markets. A US stock market melt-up is still possible. See Kirk Bostrom's August 2014 Seeking Alpha article: sppfund.com/expect-a-final-melt-up-in-us.../
As 2015 progresses however, US companies currently benefiting foreign capital inflows, low interest rates and low energy price tailwinds will begin to face major earnings headwinds with a strong US dollar and global instabilities around the world. An emerging confluence of economic, financial, non-financial, geo-political and political risks are building and will likely appear in US financial markets by Q3 of 2015. Also, now seven full years since the onset of the Crisis of 2008, both cyclical and seasonal patterns make the fall of 2015 highly susceptible to the onset of the next major correction here in the United States.
Investors should begin to reduce portfolio exposure to risk based investment holdings including US equities no later than the second half of 2015. With risk assets highly correlated to market corrections, all investor risk asset holdings should be considered including venture capital, private equity and real estate holdings.
I would also advise investors to consider moving out of non-US holdings in 2015, including international stock and bond investments. The US dollar and US risk markets should greatly outperform international and emerging markets, particularly in local currencies. Aggressive US investors should consider shorting both the Euro (EUR) and the Yen (JPY). I believe we will see weakness relative to the USD to <.80€ and <200¥ before 2020.
Fixed income investors should begin to shorten all bond portfolio maturities. Although I don't expect the Fed to raise interest rates in 2015, they may 'hint' at the notion once again in their early 2015 meetings. In the end, global market volatility and a strong US dollar will likely keep Fed policy on perma-hold for 2015. As longer-term US interest rates may benefit in the near term from global instabilities, I expect that longer rates will begin to rise towards the end of 2015. As in every preceding risk market correction, cash holdings will be at a premium. Liquidity to fund other attractive investment opportunities, liquidity to fund lifestyle, and/or liquidity to fund philanthropy all typically become the highest priority for most investors through market correction periods. Our current 'return on capital investor mentality should eventually convert to 'return of capital' investor mentality in late 2015.
Investors should also be weary of the municipal bond market. Poor credit quality ensures poor liquidity if not potential insolvency in the short years ahead. Tread lightly here.
Lastly, commodities and hard assets will underperform as long as the US dollar remains strong. That said, I expect in the short years ahead that the US dollar will also begin losing its luster. As the US dollar weakens relative to other world currencies, in particular the 'commodity' currencies of Canada and Australia/New Zealand, investors should look for a major capital transfer out of global financial assets and into the global commodity and hard asset sectors.
The world will not come to an end, but prudent investors should be taking precautions against the end of the current asset inflationary cycle. Economic cycles and market corrections in the free markets will eventually lead to a new prosperous cycle and even greater opportunity ahead - although perhaps not until after the end of the decade.
Kirk D. Bostrom
Strategic Preservation Partners LP
Disclaimer: The views expressed are the views of Kirk Bostrom through the period ending December 29, 2014, and are subject to change at any time based on market and other conditions. This material is for informational purposes only, and is not an offer or solicitation for the purchase or sale of any security and should not be construed as such. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. The opinions expressed herein represent the current, good faith views of the author at the time of publication and are provided for limited purposes, are not definitive investment advice, and should not be relied on as such. The information presented in this article has been developed internally and/or obtained from sources believed to be reliable; however, the author does not guarantee the accuracy, adequacy or completeness of such information.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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