Originally published September 27, 2017
So much for "ghoulies, ghosties and long-leggedy beasties" having a monopoly on "things that go bump in the night."
No longer is this classification reserved for things that taunt, tantalize and toy with our terrors as that traditional Scottish poem first invaded our minds. Earlier this summer, some avid astronomers, tasked as they are with mapping out the infinitely capacious celestials, literally stumbled upon a distinctly different sort of bump in the night. A mysterious 'cold spot' sighted telescopically might actually be a bruise of sorts, "the remnant of a collision between our universe and another 'bubble' universe during an earlier inflationary phase."
Such a discovery would strip the 'uni' right out of universe landing us smack dab in a 'multiverse' in which all conceivable outcomes are playing out at once in a layered rather than singular reality. In the event this panoply of parallel possibilities has left your brain in a painful pretzel, ponder not another moment. The jury is in and the verdict is parallel universes in quantum mechanics and the cosmos alike are unanimously unproven.
As for other bubbles of a different stripe, but also spotted during other earlier (asset) inflationary phases, a growing chorus of vaunted visionaries has begun to chant that we are at the precipice of colliding with any number of parallels in investing time.
Yours truly recently wrote of the Panic of 1907, a crisis of confidence brought on by an exogenous event - in this case, the 1906 San Francisco earthquake - that caused a six-week run on most New York banks. As was the case in the years that led up to the 2007 crash, 1907 was preceded by a magnificent era, the Gilded Age, and dominated by one J.P. Morgan. Compress time and loosely liken Alan Greenspan, a banker's ally among allies, to the bigger than real life personality behind the cultural shift to speculation.
How would 2007 have played out had Alan Greenspan remained at the Federal Reserve, the very institution that emerged from the Panic of 1907? We'll never know though he never did allow an institution to fail on his watch, for better or moral hazard worse. As was the case with Morgan, history will forever remember Ben Bernanke being at the helm and allowing insolvent institutions to fail on his watch just before, that is, rescuing AIG.
Separately, a few brave souls have dared to compare the feverish times that led up to the crash of 1987 to today. Forget for a moment that it is nearly too neat, having something of similar magnitude unfold exactly 30 years on. The Dow had soared by 40 percent at its August 1987 peak; it's up a pittance of 13 percent thus far this year. And interest rates were appreciably higher than they are today, which is easy enough to imagine.
That said, there are similarities. Stocks are racking up one record after another, seemingly blind to the news flow. Goldman Sachs' strategists recently noted that the benchmark S&P 500 has nearly broken the record for the longest period of time without suffering a five percent correction; only four other times rival the current stretch. Multiples, meanwhile, are higher today than any other years save 1929 and 2000.
But then, these statistics all but beg to be bested. The truly petrifying parallel is that of investors' mindset, or better said, lack thereof. If it seems odd that only eight percent of large-company stock funds have outperformed the S&P 500 over the past five years, it's because it is plain spooky.
This is no great defense of active investing, mind you, simply an observation that it's impossible that every manager has up and lost all of their acumen. It is the 'auto-drive' mentality that smacks of the closely held convictions investors had in their Nifty Fifty (TFANG anyone?) being bulletproof. Or worse, today is a hybrid era - investors sleep well at night ensconced in their low-cost index funds' 'safety,' which is nothing more than the combination of a handful of savior stocks wrapped in today's answer to portfolio insurance - that is, of course, passive investing.
Because so few believe it to be the case, passive investing will not end well. The investing approach not only magnifies the largest market-cap stocks' influence on blind portfolios, it effectively negates the need to perform fundamental analysis. Though the premise is sound on its face, the outcome of passivity has grown to be a complete unknown given it's never been in the ring at its current, record weigh-in level. We know one of two critical parameters - the size of the entrance. The size of the exit, however, is a complete TBD, as in to be determined.
It shouldn't shock you that an increasing number of institutional investors have grown alarmed at the passive investing trend. To mitigate their enigmatic exposure, many have poured into managed futures funds, otherwise known as "commodity trading advisor" hedge funds, or CTAs.
CTAs are automated vehicles that follow market momentum, which is great when everything is awesome as is the case today. The fact that CTAs bet against already-falling markets? That worked well in 2008, when they were less than a third of their $300-billion current asset size, a figure that doesn't include cheaper copycat 'simple momentum' funds. Those who've adopted CTA strategies now include a much wider swath of investors in stark contrast to CTAs' traditional users, pensions and other sophisticated investors.
Consider these words from a recent Financial Times interview with David Harding, head of Winton Capital and one of the largest players in the CTA:
When an institution allocates to a momentum strategy in the hope of cushioning itself from stock market downdrafts, it really is commissioning someone to sell stocks on its behalf in a falling market; no different to the failed portfolio insurance that was implicated in the 1987 crash.
For a closer proximity potential parallel, look back no farther than 2007. The accelerant back then came down to one word: leverage. In the spirit of more is more, in the interim decade central banks have piled on $20 trillion or so in fresh debt while corporations have gorged themselves on record borrowing.
As for households, U.S.-based consumers have re-levered back to prior highs, albeit with appreciably less mortgage debt. In other countries, such as Australia and Canada, nosebleed debt-to-income levels have made for many petrified policymakers as they contemplate the economic implications of household deleveraging. Surely it won't be as nasty as what was witnessed in the U.S. and U.K? Surely not.
And then there's China, the 'it' girl, the standout among leverage gone wild in a post financial crisis world. Given they play by a different set of rules, how China's policymakers address their homegrown debt bubble is anyone's guess. If you figure that one out, please let me know.
In all, global debt sits at $220 trillion and counting, about $70 trillion higher than it was ten years ago. How leverage, and more importantly deleveraging, play into the next market reset is as good a mystery as any given the different form it's taken on in this cycle and the unaddressed situation, shall we say, of that black box we refer to as 'derivatives.'
For all of the parallels that can be drawn, though, it is that of 1937 that should give investors most pause. None other than Ray Dalio, who has masterfully managed his hedge fund Bridgewater's assets to $160 billion, raised the alarm in a recent CNBC interview.
Dalio's case is unnerving in its simplicity. The years leading up to both 1929 and 2008 were marked by a huge debt build, which policymakers answered identically - by lowering interest rates to zero. In both instances, these extreme exertions succeeded in reflating the stock market. Fair enough.
But it's the cultural comparisons that resonate most. Nationalism was rampant and spreading against a backdrop of rising inequality worldwide. And antitrust was gaining in acceptance as a counter to the deepening sense of societal injustice.
Dalio makes his case stronger yet by drawing the Fed into the fray. You may not recall, nor should you, but 1937 was all about the Fed overtightening the economy right back into a contraction, which in turn put the 'Great' into the Great Depression.
Will something similar play out today? With all due deference to most of the those who cover the Fed in the media, Janet Yellen's speech to the National Association for Business Economics Tuesday was anything but dovish.
In case you missed the consensus conclusion, it started and ended with one Yellen quote:
My colleagues and I may have misjudged the strength of the labor market, the degree to which longer-run inflation expectations are consistent with our inflation objective, or even the fundamental forces driving inflation.
The takeaway, for most, was that the Fed was set to ease, not tighten.
But then why make such a splash at the last Fed meeting, all but broadcasting a December rate hike was in the offing just to contradict that a few days later? Go back for a moment and focus on one word in that last quote: "Misjudged." When was the last time you heard a central banker admit fallibility? And therein lies the key. Yellen's words are on their face highly unusual as they involve something that is completely out of character for her, a mea culpa.
Yellen's de facto about face was followed by a proposition that, "it would be imprudent to keep monetary policy on hold until inflation is back to two percent." As for her years of hand-wringing over wages not responding to the low level of unemployment, she countered herself by saying, "inflation may rise more sharply in response to robust labor market conditions than anticipated." Her conclusion, akin to an admission of guilt: "It would be imprudent to keep monetary policy on hold until inflation is back to two percent."
In the event you're not convinced she means business, she added this kicker: "Persistently easy monetary policy might eventually lead to increased leverage." The added emphasis on eventually is for obvious ironic purposes.
In a few weeks, the Federal Reserve Board will be whittled down to three members. What better time for that other voting member, New York Fed President William Dudley, to exert even more influence than is customary. In the event you missed the news flash, the NY Fed has rolled out a brand spanking new inflation metric called the Underlying Inflation Gauge.
Google it if you're so intellectually inclined, but you really need only know that this much more holistic take on price pressures clocked in at 2.74 percent over last year in August, up from 2.64 percent the prior month. In FedSpeak, that's called, "Hitting our two percent inflation target, and then some."
Add up Yellen's words and Dudley's new take on inflation, bearing in mind we're talking respectively about the Chair and the Vice Chair of the Federal Open Market Committee, and you can safely deduce that the third consecutive December rate hike will be followed by more of the same. This is an entire series of hikes on the launch pad. The Fed will conclude its cycle, at least that's what they've taken great pains in the past few weeks to communicate.
The flip side of this tough talk could well come from across the pond. Mario Draghi was nervous enough about the prospects for a European Central Bank taper that he cancelled his planned remarks on that subject at this past August's Jackson Hole central bank confab. The German elections have no doubt elevated his anxieties and he could choose to disappoint the hawks once again at the upcoming October ECB meeting.
Does any of this add up to a full reprieve for stretched markets? Well, no, not in the end. But a tightening Fed and an easing rest of the world does suggest variable rate instruments will capitalize on this disconnect in the interim. As the Wall Street Journal detailed, U.S. leveraged loans might not have much more room to run. Volumes this year are on track to outpace the 2007 record of $534 billion; total loan fund assets hit a new all-time high in August.
Europe, however, still has room to run, all things central banking considered. 2017 volumes there are running at less than a quarter of their 2007 record pace. If you are on the nimble side, you might want to have a peek at the Invesco European Senior Loan Fund (IESLGXE:LX, $106.49). If you are downright determined to gain direct exposure, and currency risk is something with which you have a decent comfort level, shoot up a flair. There is a plentitude of precise ways to play the space.
As for our eventual date with destiny, it would help if you could indulge me an etymological detour, and wax Greek for a moment. The word parallel breaks down into two neat parts - para, as in 'alongside,' and allelois for 'one another.' What if, in fact, we innocents are existing in the investing world's answer to a parallel multiverse? What if history is aligning on multiple historic counts and we're living them all at once? A deep thought to be sure and a cautionary tale if there ever was one, or more.