Thursday, December 4, 2014

Why the glass is half full

The world seems divided, these days, between those who are optimistic because lots of things have improved by more than expected, and those who are pessimistic because asset prices have increased by more than they should have. (I've been in the former camp for the past six years, in case there was any doubt.)

Here's how bad things were projected to be six years ago, as I noted in this post at the time:

Either the markets are right and the end of the modern world as we know it is right around the corner, or corporate bonds and stocks are absurdly, grossly and egregiously undervalued. I say that because the pricing today of corporate bonds and stocks assumes that we are entering a period that will be significantly worse than what occurred during the Great Depression of the 1930s.
At the risk of simplifying a complex subject, the Depression was largely the result of a massive contraction of the banking sector and money supply, a massive contraction of world trade set in motion by the Smoot-Hawley Tariff Act of 1930, a massive increase in government intervention in the economy, and a massive increase in taxes meant to offset a similarly massive increase in government spending. 1929-1933 was by far the worst period. The economy shrank by 26.5% in those four years, and prices on average fell by 25%. This was a nightmare for anyone with debt, since economic activity collapsed and dollars became much more expensive to acquire. By 1936, the peak year for cumulative defaults, about 14% of all corporate bonds were in default, according to the National Bureau of Economic Research, making it the worst corporate bond disaster in U.S. history.
According to Lehman data, the current level of spreads on investment grade bonds implies that about 9% will be in default within five years, and fully 70% of speculative-grade bonds will be in default. That further implies that 24% of all corporate bonds currently outstanding will be in default within 5 years. If only 14% of firms defaulted on their debt during the depths of the depression, what sort of economic conditions would it take for almost one-fourth to go out of business?
Tim Bond, an economist at Barclay’s Capital in London, has calculated that the current level of spreads on corporate bonds (which is by far the highest ever recorded—600 bps on investment grade, and 1700 on high-yield bonds) implies 3-4 years of a 15% annual contraction in GDP. That would be about twice the average 7% annualized rate of contraction during the worst period of the Great Depression, 1929-1933.
According to my model of equity valuation, which I have discussed here, and which is a variant on the Fed Model and Art Laffer’s model, the stock market is assuming that corporate economic profits (as calculated in the National Income and Product Accounts) decline by at least two-thirds over the next few years. In relation to GDP, that would put them 25% lower than the worst period (1974) since they were first measured (1959).
Any way you look at it, the pricing on corporate bonds and stocks today implies that the next several years will be the most disastrous in the history of the U.S.
In order to fully appreciate why that prediction is unlikely to prove correct, consider that not one of the key ingredients that precipitated the depression exists today. Although we do have a banking crisis, the Fed has taken incredibly aggressive steps to prevent a monetary contraction or deflation from occurring. Indeed, as I have noted repeatedly, there is more money and bank lending in the world today than ever before. World trade has expanded greatly since the depression, and an outbreak of widespread protectionism in the near future seems like a very remote threat. We have had some meaningful increases in government spending, but so far we have not seen any attempt to raise taxes.

What did it take for the past six years to be the buying opportunity of a lifetime? Simply this: the future turned out to be much better than expected, even though this has proven to be the weakest recovery in history.

Those who see the glass as half empty point to the Fed's massive Quantitative Easing program, and assert that the Fed has inflated asset prices by printing massive amounts of money. I think that view is groundless. The Fed hasn't been printing money. They've only been exchanging bank reserves (T-bill substitutes) for notes and bonds, in response to the world's almost insatiable demand for safe, risk-free assets.

Equities are up not because the Fed has been printing money, but because corporate profits have been setting all-time records for the past several years.

The economy is growing not because of government spending stimulus or monetary stimulus. It is growing in spite of all the stimulus. Government spending saps the economy's strength because government spends money much less efficiently and effectively than the private sector spends its own money. Monetary stimulus is powerless to create growth, because growth only results from more work, more investment, and more risk taking; growth can't be conjured out of thin air, it must be generated the hard way, by making the economy and its finite resources more productive. An economy can't spend or print its way to prosperity; prosperity has to be earned. Easy money doesn't help growth, it hurts growth because it creates uncertainty about the future strength of the dollar and the future rate of inflation, and all that, in turn, makes people less likely to take risks and invest in the future.

In a subsequent post I plan to review a series of charts documenting the remarkable extent to which the economic fundamentals have improved in just the past two years.


Benjamin Cole said...

Agreed, save for the stance on QE. If anything, the Fed was too timid in its use of QE and may have suspended the program prematurely. The Fed did not exchange reserves for bonds, rather it printed money and bought bonds. The sellers of those bonds have either spent the money, invested the money or put it into banks. All those actions helped the economy.

Plus, we get an added benefit of having paid down the national debt. There is little dispute the Fed monetized national debt with beneficial impact.

If QE has no beneficial impact, I do not understand why such economists as Milton Friedman, John Taylor Frederic Mishkin and Ben Bernanke are advocates of QE.

Even Allan Meltzer advocated that the Bank of Japan pursue QE.

randy said...

In the theme of glass is half full, this Schwab commentary on sentiment fits well.

These Yale surveys are longer-term in nature and highlight the persistence of skepticism during the bull market underway since March 2009. So, although I and other sentiment-watchers may fret about data like that seen in NDR’s Crowd Sentiment Poll (and/or among its component indexes), there is little to worry about from a longer-term sentiment perspective. This has been the "most hated bull market in history" as noted by BIG, and reinforces the "wall of worry" the stock market is likely to continue to climb.

Anonymous said...

Double the artificially low 10 year cap rate and you halve the theoretical market capitalization.

QE increased the money supply so it did help the economy - one time only. There was no multiplier and probably isn't when you are artificially creating demand. That maybe why money velocity continues to decline.

If the FED holds their bonds to maturity they will end up with cash from the treasury as an asset instead of bonds. What will they do with the cash? If they give it back to the Treasury they are still stuck with the created reserves on the liability side of their balance sheet. That would be one big negative net worth. So, the balance sheet of the FED will remain big because there is no way they are going to push the bonds back to the banks.

Anonymous said...


Would you elaborate on the mechanics of this transaction?

"They've only been exchanging bank reserves (T-bill substitutes) for notes and bonds."

So literally the FED is using the excess reserves of the member banks to purchase notes and bonds?

I've never really understood exactly "how" the FED is doing that.


Anonymous said...

think, allow me to offer the mechanics. I think it works this way. The Treasury creates and sells bonds at auction to directs (domestic buyers), indirects (foreign), and the banks (primary dealers). These are the people and institutions that want to hold safe assets. With QE, the banks sold bonds to the FED out of their inventory. When the banks replenish their inventory by buying more bonds at auction, they are transferring the cash previously called reserves to the Treasury.

Hummm. When I say it this way it sounds like the FED was just transferring newly created money to the FED via the banks. The number of bonds in the hands of those who wanted safe assets stayed the same.

Other countries have had their FED buy bonds directly from their Treasury with newly created money.

Scott Grannis said...

Here's what the Fed has done:

To begin with, the Fed cannot "print money" directly. If the Fed buys something, it can only buy it from a bank, and it can only pay for it by crediting the bank's Fed account with "reserves." Reserves pay interest, so it's the equivalent of the Fed borrowing money from banks. From the banks' point of view, they are lending to the Fed and in exchange receive something that is functionally equivalent to a T-bill: short-term in nature, floating interest rate, and default- and risk-free.

Since late 2008, the Fed has pumped up the supply of bank reserves by about $2.6 trillion through its purchases of Treasuries and MBS. About 94% of those additional reserves currently are held by banks in the form of "excess reserves."

Where did the banks get the bonds to sell to the Fed? Banks have essentially used strong inflows of savings deposits (symptomatic of a very risk-averse public) to purchase bonds, then sold those bonds to the Fed in exchange for reserves which they were content to hold.

Banks have in a sense been "investing" their deposit inflows in bank reserves. The public's demand for the safety of savings deposits (which carry a government guarantee but yield almost nothing) has been very strong, and banks' demand for reserves (which have an implicit government guarantee and pay almost nothing) has also been very strong, and both reflect lots of risk aversion.

It all starts with a public that wants to save money in a risk-free, cash equivalent form, and with a Treasury that needs to sell lots of bonds to fund a huge deficit. The public poured trillions into bank savings deposits. The banks didn't want to lend most of that money to anyone but the government, so they used the money to buy notes and bonds which they then sold to the Fed in exchange for reserves.

In the final analysis, the huge increase in bank savings deposits ended up funding most of the federal government's deficit. The Fed's role in all this was to essentially convert trillions of notes and bonds into T-bills, in order to satisfy a huge demand for T-bill equivalents.