The View from the Top
The past few weeks have been very good for those invested in the financial markets. Major stock market
indices are at all-time highs and the excitement surrounding technology plays such as Bitcoin and
Twitter brings to mind nothing so much as the irrational exuberance of the late 1990s.
With that history in mind, I can’t help but feel that we are at or very near a market top and that a
serious correction that will destroy much of the financial wealth held in people’s homes and retirement
plans is inevitable and perhaps very close at hand.
Looking at the past, we can see that since the beginning of the 1990s no asset-price bubble has stayed
‘popped’ for very long. Instead, monetary authorities have reacted to financial crises by lowering
interest rates and printing money in order to either re-inflate the bubbles that have burst or blow
entirely new asset-price bubbles. Memories of the devastating unemployment and human misery of the
Great Depression of the 1930s have made central banks determined to prevent financial crises from
turning into full-blown recessions by whatever means necessary.
Thus, in the wake of the bursting of the tech-stock bubble in 2000, the Bank of Canada cut interest rates
from 5.75% to 2%. This reduction in interest rates led, in turn, to a housing bubble that has continued to
grow ever-larger, helped along by the near-collapse of the U.S. financial system (brought on by falling
American home prices) in the fall of 2008 which caused the Bank of Canada to lower rates even further
to less than 1% and to leave them at 1% since early 2011.
American central bankers seeking to re-inflate home prices but having no room left to cut rates have
had to pursue unconventional policies, the most famous of which is the US Federal Reserve System’s
quantitative easing (or “Q.E.”) policy, whereby the central bank prints $85 billion dollars every month
with which to buy U.S. Treasury bonds and other financial assets. The purpose of the program is to bid
up bond prices and thereby suppress long-term interest rates in order to make mortgages more
affordable for prospective homebuyers and loans more affordable for businesses seeking to expand
output and employment.
However, rather than fuel a boom in real investment, much of the newly printed money has fuelled a
boom in the stock market instead. The true nature of this boom was revealed in May when the mere
hint of a reduction in Q.E. (a.k.a. ‘Tapering’) resulted in a fall in bond prices and a rise in bond interest
rates that in turn led to a sharp selloff in global stock markets and a marked slowdown in the U.S.
housing market. Faced with this response, the US Federal Reserve backed down and announced in
September that it would continue buying $85 billion of bonds each month with newly-printed money.
Thus reassured, stock markets around the world proceeded to rally to the record levels we see today.
Looking at this situation, analysts at Bridgewater Asset Management, in an article entitled “Has QE
Reached the Limit” from the November 5th “Bridgewater Daily Observations” worry that such
unconventional monetary easing is reaching the end of its effectiveness.
Financial crises turn into serious recessions when people become desperate to turn their assets into
cash and thereby cause prices to plummet. In this situation, printing money is an effective way of
satisfying the demand for cash and easing investor panic. Safe in the knowledge that they can access
the cash they need, investors feel no need to sell their assets. As assets are not being sold, prices remain
steady and confidence is maintained.
However, if, as is the case presently, asset prices are already high and there is a lot of idle cash
available, money printing will be less likely to spur the increases in business investment and homebuying required to increase spending and reduce the level of unemployment. Instead, knowing that real
asset prices are high by historical standards, pumped up as they are by low interest rates and
quantitative easing, individuals and firms seem content to keep their money in cash.
While waiting for lower real asset prices, though, people do seem willing to use some of their cash to
speculate in the stock and bond markets so long as they feel they can close their positions quickly and
take profits if conditions turn sour. In fact, so long as others around them are engaging in this sort of
trading activity they may even feel some pressure to take part so as not to miss out on gains and fall
behind their peers.
It is this sort of investor behavior that explains the sell-off in risky assets from May to August and the
robust returns that have characterized the past few weeks. So long as investors feel that central banks
are committed to keeping interest rates near zero and pumping additional money into the system the
financial markets are buoyant, while the moment central bankers threaten to remove such support the
markets tank.
This suggests that the US Federal Reserve and other global central banks are increasingly facing a no-win
situation. Despite having lowered interest rates to near zero and having pursued unconventional policies
such as Q.E. for over 5 years, consumer and investor confidence, spending and employment remain
depressed even as financial asset prices are at record highs. If central banks choose to keep rates near
zero and continue printing money in order to try to stimulate growth in spending and employment, they
will continue to inflate increasingly large asset-price bubbles that, when they burst, will make previous
financial crises look tiny by comparison. On the other hand, if they acknowledge that money printing is
not having much impact on the real economy and choose to raise rates and reduce the rate of money
printing in order to deflate the asset bubbles that have already formed in the bond and stock markets
the resulting correction will shrink investor portfolios by hundreds of billions or even trillions of dollars,
leading almost certainly to a serious financial crisis complete with bankruptcies, bank failures and rising
unemployment.
Essentially, the choice faced by the world’s central banks is between a serious correction and recession
now or an even more serious correction and recession a few months or years down the road. My bet is
that given this choice, central banks will opt for the latter and recklessly continue to provide monetary
stimulus to the financial markets simply in order to avoid a spectacular meltdown on their own watch.
However, with each passing day the chances grow that central banks will begin to lose control of the
bond market as investors, aware that prices already at 300-year highs are unlikely to rise any higher,
start selling their bonds to lock in profits, thereby depressing prices and pushing up interest rates in a
disorderly fashion that is bound to make the resulting recession especially damaging.
For individual investors, the danger is clear. While it may be possible to continue to make money in the
financial markets while the current zero interest rate/quantitative easing regime continues, it is a
certainty that financial asset prices will fall significantly when monetary conditions change and interest
rates begin to rise. To use a colorful metaphor, don’t concentrate so closely on picking up the nickels in
front of you that you fail to notice the steamroller coming at you from behind.