If you haven't seen The Big Short, I highly recommend it. I watched it for the first time last week, and it is an excellent portrayal of the events that occurred on Wall Street leading up to the bursting of the housing bubble, and ultimately, the financial crisis. The story is told through the eyes of a handful of savvy hedge fund managers and one Wall Street banker, all of whom sought to profit from the inevitable collapse of the residential mortgage-backed securities market.
The actors in the movie portray real people. Michael Burry, played by Christian Bale, is the brilliant hedge fund manager who forecasted in 2005 that the market for mortgage-backed securities would collapse in the second quarter of 2007. It was at that point that he estimated the interest rates on adjustable-rate mortgages would rise significantly, leading to mass delinquencies and defaults for sub-prime borrowers. Burry spent more than $1 billion buying credit default swaps, which are a form of insurance designed to pay off when the underlying mortgage securities they insure go bust. Several other hedge fund managers and one banker followed his lead in betting against the mortgage-backed securities market. Through further investigation they realized that the unprecedented amount of leverage used to invest in these securities could collapse the entire financial system.
The near-crisis these perceptive money managers all faced was that they were too early in identifying and betting against the ongoing insanity. As a result, they nearly went bust themselves. This is because the Wall Street banks colluded with the rating agencies to support the prices of the mortgage-backed securities, despite the deteriorating market fundamentals. Even as loan delinquencies and defaults increased, the ratings on the bonds did not change, and in some instances the bond prices rose. Ultimately, the fundamentals won out, and their big short was a home run.
While watching this movie, I could not help but think on more than one occasion that "it's déjà vu all over again," to borrow a quote from the late Yogi Berra. The story line is eerily similar today, but the cast of characters is quite different. This disguises the similarities between what is transpiring now and what transpired during the period leading up to the 2008 financial crisis. The obvious parallels are an abundance of liquidity, unsustainable amounts of debt and a clear dislocation between market prices and fundamentals. Other parallels are not as obvious, but just as relevant. Let's hope that the end game is not the same.
The Obvious Parallels
Prior to the financial crisis, interest rates were too low for too long and the liquidity provided by the shadow banking system was abundant. These factors, when combined with extraordinarily easy borrowing conditions for consumers, fostered the malinvestment in housing and mortgage-related securities that led to a bubble.
Today we are in the eighth year of a period during which interest rates have been near zero in the US, while other parts of the developed world are now experimenting with negative interest rates. Liquidity is equally as abundant now as it was then, but today it is being provided by central banks, and it continues to grow. While borrowing conditions remain difficult for consumers, they have been extraordinarily easy for governments, corporations and institutional investors. Malinvestment is an inevitability in this environment, but we can only speculate on where it is occurring today until the losses are realized.
Prior to the financial crisis, it was consumers that took on unsustainable amounts of debt to buy homes that their incomes could not support, while institutional investors leveraged their balance sheets with securities that held this debt and the derivatives thereof.
Today it is corporations and sovereign governments that are taking on unsustainable amounts of debt that their cash flows and tax revenues are unable to support. And it is individual and institutional investors who willingly invest in the securities that both corporations and governments issue, regardless of price or yield.
Prior to the financial crisis, homes were selling at absurd valuations compared to their historical multiples to household income, as the supply of homes could not meet the insatiable demand from investors. Market prices were clearly dislocated from the economic fundamentals.
Today we have a similar dislocation between market prices and fundamentals in both the bond and stock markets. Long-term debt is being issued at paltry yields by sovereign countries that were fiscal disasters just a few years ago. Corporations have also capitalized on extraordinarily low borrowing costs, but rather than investing in their businesses, they are using the proceeds of borrowing to financially engineer their performance results. The ever-growing abundance of liquidity combined with investors' insatiable appetite for yield has inflated the value of all fixed-income securities well beyond what fundamentals would dictate otherwise.
In turn, this hunt for yield has inflated the value of the S&P 500 (NYSEARCA:SPY), which is trading at a multiple to earnings only breached during periods of previous stock market bubbles. Prices have continued to rise despite the continued decline in corporate revenues and earnings.
One final parallel is that those who identified early on that the economic and market fundamentals were going to deteriorate in the current cycle, and who bet against it, have been summarily thwarted on a repeated basis. Even as corporate earnings and revenues began to decline 18 months ago, which practically no one on Wall Street forecasted, the S&P 500 has continued to grind higher, albeit marginally so. Instead of the rating agencies and Wall Street banks colluding to artificially support the prices of mortgage-backed securities, today we have central banks around the world colluding to artificially support the prices of stocks and bonds.
The Inconspicuous Similarities
What is clearly insane is again being gradually accepted as routine and normal by the consensus. During the housing bubble loans could be obtained to buy homes with virtually no documentation. Homes could be purchased with practically no down payment. Individuals with very low incomes were able to buy multiple homes with adjustable-rate mortgages. Everyone assumed they would be able to sell their homes before the adjustable rates rose, and no one believed that homes would decline in value. All of this was clearly insane. It was a national epidemic, but it was widely viewed as the new normal.
Today we have a different kind of insanity. The fact that it is being instigated by central banks, led by the Federal Reserve, makes it a lot less recognizable. Policies like zero-percent interest rates and now negative interest rates are the new normal. There is approximately $13 trillion in negative-yielding sovereign debt around the world. Institutional investors are willing to lend to highly indebted governments for terms as long as 50 years at minuscule yields. As a result of this yield compression, fixed-income investors are buying equities for higher yields, regardless of the ongoing deterioration in corporate fundamentals. There is seemingly no concern for potential loss. Everyone is convinced that every dip in the stock market will be bought, because central banks will continue to support markets. This insanity is again so pervasive that the majority of investors are accepting it as routine and normal.
Additionally, the herd mentality is back in full force. In the years leading up to the financial crisis everyone wanted to own real estate and anything housing-related. As a result, there were a large number of unsophisticated investors buying real estate and homes, as well as mortgage-backed securities, who didn't fully understand or appreciate the risks involved. This led to a very disorderly exodus from the markets that worsened the downturn.
Today everyone wants to own anything that has a competitive yield. The hunt for homes is now a hunt for yield. As a result, I believe that there are many investors who own a lot of different high-yielding securities which they have not traditionally owned in the past. I worry that many don't fully appreciate the risks involved in owning these securities, and when prices begin to fall, there will again be a very disorderly exodus from the markets.
The Final Act
I think the path that we are on right now is so similar to the one we were on nearly a decade ago that no one can see it. Where is the bubble today? It begins with fixed-income securities, but extends well beyond that, because the current valuation of the stock market is being justified by interest rates that have been manipulated downward by central banks.
The final act is approaching, but this does not imply that another financial crisis is an inevitability. In my view, this bubble will burst when interest rates begin to rise, which is how the last bubble burst. What is less discernible is the catalyst for higher interest rates. I can think of three possibilities.
The first is that central banks, led by the Federal Reserve, begin to withdraw liquidity and raise short-term interest rates. This is probably the most unlikely catalyst, because the Federal Reserve is well aware of the bubble it has helped create. This is why it continues to come up with silly excuses for not raising interest rates, despite claiming victory in achieving its mandate. It is simply hoping that the wealth its policies have created trickles down to the real economy in a way that leads to faster rates of economic growth. This simply won't happen.
Another potential catalyst for higher interest rates would be a proposal for a meaningful fiscal stimulus program that lifts expectations for inflation and the rate of economic growth. This would be a step in the right direction for the long term, but it is hard to imagine members of Congress agreeing on such a proposal. I think fiscal stimulus is more likely to come in the form of helicopter money at some point in 2017.
Lastly, the consensus of investors could simply lose faith in the Federal Reserve if the US economy goes into recession, corporate fundamentals continue to deteriorate and government deficits begin to rise. A similar set of circumstances could unfold simultaneously in the Eurozone and Japan.
The inevitable consequence in any of these scenarios, or ones that I haven't discussed, is that a repricing of financial assets will occur. A repricing of assets that have been distorted or manipulated is never orderly, and it typically involves an overshoot in the opposite direction before fair value is reached.
Where is the big short today? I think it is in central banks — but you can't buy a credit default swap on the Federal Reserve. The distortions in market prices are so pervasive due to central bank policies that it is very difficult to pinpoint one area of the financial markets the has the most downside. A logical starting point would be long-term sovereign debt that is carrying a negative yield, but the wake of carnage that will result from a meaningful rise in interest rates will be so broad-based that there will be no place to hide for investors. Cash will be king. Otherwise, continuing to shorten the duration of investments and increase the quality of holdings is the most logical course of action.
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.
Additional disclosure: Lawrence Fuller is the Managing Director of Fuller Asset Management, a Registered Investment Adviser. This post is for informational purposes only. There are risks involved with investing including loss of principal. Lawrence Fuller makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by him or Fuller Asset Management. There is no guarantee that the goals of the strategies discussed by will be met. Information or opinions expressed may change without notice, and should not be considered recommendations to buy or sell any particular security.