The Silent Boom

by: Eric Parnell, CFA

Exactly ten years ago this week, I wrote an article on Seeking Alpha entitled A History Of Market Violence.

It is worthwhile to revisit a decade later the parallels between The Great Depression and the financial crisis described in this article.

Despite the decidedly different outcomes between the 1930s and the 2010s, many of the underlying problems continuing to fester under the surface remain the same.

This reality has important implications for the stock market outlook heading into the next decade.

The decade that was. Exactly ten years ago this week, I wrote an article on Seeking Alpha entitled A History Of Market Violence. This article published on March 5, 2009 effectively at the financial crisis bottom for the U.S. stock market considered the parallels that existed at the time between the financial crisis and The Great Depression. How have we fared over the past decade in resolving these various historical comparisons? And how do these outcomes today inform us about what to expect going forward?

A decidedly different outcome. One clear difference between the past decade and the 1930s has been the outcome for the U.S. stock market. Consider the following chart below tracking the cumulative monthly price return of the U.S. stock market in the 15 years following the 1929 stock market peak versus this same return in the more than 11 years to date since the 2007 stock market peak. If policy makers have accomplished nothing else, they have undoubtedly achieved the goal of completely turning the stock market around.

Mission accomplished. But at what cost?

Revisiting the parallels. In March 2009, I wrote that many parallels could be drawn between the events surrounding The Great Depression and the financial crisis at the time. More specifically, I focused on seven key similarities. Beyond the resoundingly positive stock market response, how have we fared over the past decade in resolving these seven areas of concern? Let’s revisit each in order.

1. Excessive debt and leverage. Back in 2009, I wrote that excessive debt and leverage “is the root fundamental cause behind the Great Depression and today’s episode that ultimately led to a banking crisis and a breakdown in the financial system.” In the 1930s, lending activity contracted for years into the depression, essentially compounding the economic challenges at the time. In contrast over the past decade, the U.S. and the world has feasted on a veritable smorgasbord of debt and leverage.

This includes a corporate debt to total capitalization ratio in excess of 40% today that is greater by half than the already high 25% reading prior to the financial crisis.

It also includes a margin debt level that is more than 50% greater today than the peak levels reached prior to the financial crisis in 2007.

And it also includes a U.S. debt to GDP ratio that has spiked from an already high 65% prior to the crisis to over 100% today.

Debt and leverage may have soothed the pains from the financial crisis. But has the extraordinary policy response of encouraging so much additional debt and leverage unwittingly sown the seeds for an inevitably much greater crisis in our future? Only time will tell.

2. Monetary policy prior to the downturn. Policy makers raised rates in the years leading up to the 1929 and 2007 peaks. What was true then remains true today. The key takeaway a decade later today is that the Fed has been raising interest rates since late 2015 including a much more assertive push higher throughout 2017 and 2018 with effects that are still feeding their way through the veins of the global financial system. Will the final outcome from this latest rate hiking cycle that lies beyond what is today by some measures the longest stock bull market in history be different this time? Fingers crossed.

3. Monetary policy during the downturn. Back in March 2009, I wrote the following: “The Fed tightened monetary policy far too soon during the Great Depression, leading to compounding deflationary effects. The risk today appears to be the opposite. The Fed has openly stated its commitment to maintain easy monetary policy for an extended period in order to combat prevailing deflationary pressures. As a result, it is likely that policy may stay too loose for too long, leading to the potential for compounding inflationary effects down the road and the development of new speculative bubbles.”

Umm, yeah. The Fed maintained its commitment to easy monetary policy alright. Not only did they explode their balance sheet in epic proportions, they encouraged other major global central banks to do the same. Way, way, way too loose for far, far, far too long. But after all this time and effort, it still failed to defeat the defeat the deflationary pressures that still linger under the global economic surface today. And even though this policy has more than proven itself to do more harm than good, central banks appear headed back to the same monetary stimulus well as the economic outlook deteriorates in 2019. Great plan, right!?! As for the development of new speculative bubbles, I don’t even know where to get started with this one. Let’s just emphatically check this box, which undoubtedly will end well the way that all wildly excessive speculative bubbles do, right? Moving on . . .

4. Fixed currencies. Back in March 2009 I wrote the following:

“The global commitment to the gold standard in the early 1930s and the need to maintain fixed exchange rates ultimately forced many countries to assume tightening monetary policies even if local conditions warranted a decidedly different policy response. This helped compound weakening economic activity worldwide. While the gold standard does not exist today, many of the world’s largest economies in Europe share the euro currency, with many countries essentially maintaining a fixed exchange rate and taking on the same monetary policy despite vastly different individual economic circumstances. The potential economic instability of several countries in the Euro Zone not to mention the spillover effects of a mounting financial crisis in Eastern Europe may lead to more pronounced economic weakness from the region with subsequent feedback effects filtering through to the entire global economy.”

This issue was on the radar screen ten years ago. We knew it was coming based on past precedent. But here we are a decade later and it has all played out as described. The policy bandages will continue to be clumsily applied as we watch the painfully slow yet seemingly inevitable demise of the European Union and its common currency experiment. And it is when challenges start to extend beyond the reach of global policy makers when the excrement really starts flying into the fan for global financial markets.

5. Taxes. This is where the story starts to get particularly interesting today. Back during The Great Depression, the Hoover administration raised taxes including a major increase on top wage earners in an attempt to balance the budget. This tax increase in 1932 led to a decline in disposable income and a further contraction in consumer spending and economic activity. With the 2020 Presidential election quickly approaching, we have a chorus of candidates declaring the intent to raise taxes significantly on top wage earners. But not to balance the budget mind you. Instead, Modern Monetary Theory ((MMT)) is also on the agenda, which oversimply implies that government debt levels do not matter when considering massive new Federal spending programs. Both sides of the political aisle have turned profligate and are trending in the direction of much more debt, not less. See point #1 above for how well that all plays out.

6. Protectionism. In March 2009 I wrote the following:

“During the Great Depression, many countries engaged in protectionist trade policies such as tariffs and quotas in an attempt to promote domestic economic activity. This included the United States and the notorious Smoot-Hawley Tariff Act of 1930 and the Buy American Act of 1933. Such protectionist measures had decidedly negative consequences on global economic growth including massive contraction in global trade and foreign demand. Despite these past lessons, the protectionist instinct is building today in many countries across the globe. This once again includes the United States, which engaged in rhetoric opposing NAFTA during the Presidential election campaign, has been increasingly reluctant to approve new free trade deals and included “Buy American” provisions in the recently approved $787 billion stimulus package.”

We knew from past experience that protectionist policies only served to compound the economic problems. Yet here we are a decade later today engaged in protectionist trade policies such as tariffs in an attempt to promote domestic economic activity. Moreover, NAFTA has been rewritten and new free trade deals such as the TPP discarded. The protectionist instinct is not only alive and well in 2019 across the world, it is expanding. While the instinct may certainly be understandable, it tends to lead to undesirable outcomes for the global economy and its financial markets before it’s all said and done.

7. Global credit. In March 2009, I wrote that

“if the flow of capital from China to the United States were to abate or reverse, our ability to adequately finance our own recovery efforts may come under significant strain.” This risk continues to loom today. Not only have disruptions in capital flows from China often resided at the heart of several of the post crisis market traumas (see the so called ‘taper tantrum’ back in 2013 as one of many examples – this had little to do with Bernanke and almost everything to do with what was happening in China at the time), but we are now actively engaged in a trade war with the same country that could inflict similar future pain if it so chooses. While we can rely on the protections of mutually assured destruction to keep our markets safe for now, one never knows how this will play out in the future, particularly if the China economy comes under undue strain in the future.

Lessons never learned. Yes, the U.S. stock market has rallied like gangbusters over the past decade since the calming of the financial crisis. But even this has resulted in unfortunate negative spillover effects. For while policy makers continue to focus on the wrong metric in U.S. stock prices and bend over backward to defend them at all costs (see the epic flip job just carried out by our latest Fed Chair and stock market savior), they continue to feed the beast of wealth inequality that according to the Congressional Budget Office among others is increasingly compounding on itself (see chart below) and that has fostered an increasing social unrest that has included ushering a growing number of candidates once considered as being from the far-left and far-right fringe into positions of power and influence across the world. Recall the last time political trends like this were playing out across the globe? Unfortunately, this trend did not end so well a decade later by the late 1930s and early 1940s. We’ll see how things play out this time around.

Implications for the market outlook heading into the next decade. Unfortunately, the outlook is not so good. This does not mean that policy makers can’t continue to artificially inflate the U.S. stock market to new all-time heights before it’s all said and done. But such an outcome only serves to obscure the underlying problems that not only remain unresolved a decade on but continue to fester and grow. And when the next recession finally hits and the stock buybacks from grossly overleveraged companies that spent years at the low interest rate trough taking on debt to engage in financial engineering that has propped up the markets for years finally go away, look out below on the S&P 500 Index, as things could get difficult for a long while before the cleansing process plays itself out.

This does not mean that certain segments of the U.S. stock market still cannot perform well into the next bear market. U.S. large cap value stocks and their record underperformance relative to U.S. large cap growth stocks in particular stand out as an attractive upside opportunity even in a more difficult broader market environment (it is worth noting that large cap value stocks performed great for an extended period when the tech bubble was bursting from 2000 to 2003, and the same may very well happen again once the next bear strikes in the future).

But as I have always said including in my March 2009 article more than a decade ago now, a variety of other asset classes outside of U.S. stocks can prove resilient and add considerable value even when the U.S. stock market is going down. This includes long-term U.S. Treasuries, precious metals including gold, selected safe haven currencies, and alternative strategies among others. In short, even if the U.S. stock market is going down, this does not mean that capital markets are not offering other outstanding return opportunities.

The Silent Boom. In many respects, we have experienced the polar opposite to The Great Depression of the 1930s. Over the past decade, we have had The Silent Boom that has included one of the longest economic expansions and stock bull markets in history. Yet a relatively small percentage of the population reaped the spoils of this economic growth, and a growing swath of the global electorate is feeling left out, frustrated, and agitating for even more dramatic changes in leadership to address the many problems that have been left to persist and fester over the past decade. Ironically, both The Great Depression and The Silent Boom despite their vast differences are leading to many of the same unfortunate outcomes, none of which are sustainable constructive for risk asset prices such as stocks in the long-term.

Stay long as long as the post crisis stock market party lasts. But be prepared for when the lights finally go out.

Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners and Global Macro Research makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners and Global Macro Research will be met.

Disclosure: I am/we are long TLT, PHYS. 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: I am long selected individual U.S. large cap value stocks as part of a broad asset allocation strategy.