This Time Isn't Different
Last year ended with a whimper on Wall Street. The S&P 500 was down 1% for the year, down 4% from its all-time high in May, and no higher than it was 13 months ago at the end of QE3. The Wall Street shysters and their mainstream media mouthpieces declare 2016 to be a rebound year, with stocks again delivering double digit returns. When haven't they touted great future returns. They touted them in 2000 and 2007 too. No one earning their paycheck on Wall Street or on CNBC will point out the most obvious speculative bubble in history. John Hussman has been pointing it out for the last two years as the Fed created bubble has grown ever larger. Those still embracing the bubble will sit down to a banquet of consequences in 2016.
At the peak of every speculative bubble, there are always those who have persistently embraced the story that gave the bubble its impetus in the first place. As a result, the recent past always belongs to them, if only temporarily. Still, the future inevitably belongs to somebody else. By the completion of the market cycle, no less than half (and often all) of the preceding speculative advance is typically wiped out.
Hussman referenced the work of Reinhart & Rogoff when they produced their classic This Time is Different. Every boom and bust have the same qualities. The hubris and arrogance of financial "experts" and government apparatchiks makes them think they are smarter than those before them. They always declare this time to be different due to some new technology or reason why valuations don't matter. The issuance of speculative debt and seeking of yield due to Federal Reserve suppression of interest rates always fuels the boom and acts as the fuse for the inevitable explosive bust.
In 2009, during the depths of the last crisis that followed such speculation, economists Carmen Reinhart and Kenneth Rogoff detailed the perennial claim that feeds these episodes in their book, This Time is Different:
"Our immersion in the details of crises that have arisen over the past eight centuries and in data on them has led us to conclude that the most commonly repeated and most expensive investment advice ever given in the boom just before a financial crisis stems from the perception that 'this time is different.' That advice, that the old rules of valuation no longer apply, is usually followed up with vigor. Financial professionals and, all too often, government leaders explain that we are doing things better than before, we are smarter, and we have learned from past mistakes. Each time, society convinces itself that the current boom, unlike the many booms that preceded catastrophic collapses in the past, is built on sound fundamentals, structural reforms, technological innovation, and good policy."
"The essence of the this-time-is-different syndrome is simple. It is rooted in the firmly held belief that financial crises are something that happen to other people in other countries at other times; crises do not happen, here and now to us... If there is one common theme to the vast range of crises we consider, it is that, excessive debt accumulation, whether it be by the government, banks, corporations, or consumers, often poses greater systemic risks than it seems during a boom."
The third speculative boom in the last fifteen years fueled by Federal Reserve idiocy is about to become a the third bust in the last fifteen years. The unwashed masses who believe what they are told by CNBC are going to be pretty pissed off when they lose half their retirement savings again. None of their highly paid financial advisors are telling them to expect 0% returns over the next twelve years, but that is their fate. The numbers don't lie over the long haul.
My view on "this time" is clear. I remain convinced that the U.S. financial markets, particularly equities and low-grade debt, are in a late-stage top formation of the third speculative bubble in 15 years. On the basis of the valuation measures most strongly correlated with actual subsequent market returns (and that have fully retained that correlation even across recent market cycles), current extremes imply 40-55% market losses over the completion of the current market cycle, with zero nominal and negative real total returns for the S&P 500 on a 10-12 year horizon. These are not worst-case scenarios, but run-of-the-mill expectations.
Hussman recently saw the brilliant take down of Wall Street - The Big Short - and thought it was a highly accurate portrayal of the rampant criminality of the Wall Street banks. They created fraudulent mortgage products, doled them out to suckers, and created complex toxic derivatives, selling them to clients while shorting them at the same time. Hussman's only problem with the movie was that it left the true villain off the hook with nary a mention. Wall Street could not and would not have created the trillions of fraudulent products if the Federal Reserve had not kept interest rates at 1% and had performed their regulatory obligations of overseeing the banks.
The answer is straightforward: as the bubble expanded toward its inevitable collapse, the role of Wall Street was to create a massive supply of new "product" in the form of sketchy mortgage-backed securities, but the demand for that product was the result of the Federal Reserve's insistence on holding interest rates down after the tech bubble crashed, starving investors of safe Treasury returns, and driving them to seek higher yields elsewhere.
See, the Fed reacted to the collapse of the tech bubble and the accompanying recession holding short-term rates to just 1%, provoking yield-seeking by income-starved investors. They found that extra yield in seemingly "safe" mortgage securities. But as the demand outstripped the available supply, Wall Street rushed to create more product, and generate associated fees, by lending to anyone with a pulse (hence "teaser" loans offering zero interest payments for the first 2 years, and ads on TV and radio hawking "No income documentation needed! We'll get you approved fast!"; "No credit? No problem! You have a loan!"; "Own millions of dollars in real estate with no money down!"). The loans were then "financially engineered" to make the resulting mortgage bonds appear safer than the underlying credits were. The housing bubble was essentially a massive, poorly regulated speculative response to Federal Reserve actions.
And now the Fed has done it again. The stock market on most valuation measures is the most overvalued in world history. The rolling tsunami is about to wipe away the life savings of millions for the third time in fifteen years.
The current, obscenely overvalued QE-bubble is simply the next reckless response to Federal Reserve actions, which followed the global financial crisis, which resulted when the housing bubble collapsed, which was driven by excessively activist Federal Reserve policy, which followed the collapse of the tech bubble. As my wife Terri put it "It's like a rolling tsunami."
The pompous professionals inhabiting the gleaming skyscrapers in the NYC financial district are still arrogantly ignoring the imminent bust headed their way. The Fed juiced gains over the last six years will evaporate just as they did in 2007-2009. Cheerleading for and denying the existence of the bubble is a common them among those whose paycheck depends upon them doing so.
One had to suffer fools parroting things like "being early is the same thing as being wrong" until the collapse demonstrated that, actually no, it's really not. The 2007-2009 collapse wiped out the entire total return of the S&P 500, in excess of risk-free Treasury bills, all the way back to June 1995.
Since two crashes weren't enough to teach the lesson, here we are again, at what's likely to be seen in hindsight as the last gasp of the extended top formation of the third speculative bubble in 15 years. The median stock actually peaked in late-2014.
And now for the bad news. At current market valuations, a run of the mill bust will result in a 50% decline. A bust that puts valuations back to 1982 bear market lows would result in a decline exceeding 75%. Whether it is a violent collapse or long slow decline, there is no doubt that returns over the next decade will be non-existent. This is not good news for Boomers or GenX entering or approaching retirement.
For the S&P 500 to lose half of its value over the completion of the current market cycle would merely be a run-of-the-mill outcome given current extremes. A truly worst-case scenario, at least by post-war standards, would be for the S&P 500 to first lose half of its value, and then to lose another 55% from there, for a 78% cumulative loss, which is what would have to occur in order to reach the 0.45 multiple we observed in 1982. We do not expect that sort of outcome. But to rule out a completely pedestrian 40-55% market loss over the completion of the current cycle is to entirely dismiss market history.At present, investors should expect a 12-year total return from the S&P 500 of essentially zero.
The reckless herd has been in control for the last few years, but their recklessness is going to get them slaughtered. Corporate profits are plunging. Labor participation continues to fall. A global recession is in progress. The strong U.S. dollar is crushing exports and profits of international corporations. Real household income remains stagnant, while healthcare, rent, home prices, education, and a myriad of other daily living expenses relentlessly rises. The world is a powder keg, with tensions rising ever higher in the Middle East, Ukraine, Europe, and China. The lessons of history scream for caution at this moment in time, not recklessness. 2016 will be a year of reckoning for the reckless herd.
There's no question that at speculative extremes, recent history always temporarily belongs to the reckless herd that has ignored concerns about valuation and risk at every turn. Fortunately, the future has always belonged to those who take discipline, analysis, and the lessons of history seriously. Decide which investor you want to be.