Thanks. That was a long, but good article. I extracted a few excerpts below :
Skipping down the street hand-in-hand with the speculative extreme in valuations is the speculative extreme in leverage. Margin debt – the amount of money that investors have borrowed in order to buy stocks – is now at the highest level in history, not only in absolute terms, but also relative to U.S. GDP
.
I’ll say this again. I believe that future investors will look back on the present moment the same way that we look back on the 1929 and 2000 extremes. People will use us to teach lessons to their children.
The immediate problem is that this whole process of Fed-induced yield-seeking speculation and demand-driven issuance of low-grade securities has now been wholly reproduced, but in magnified form. The only difference is that the objects of speculation involve common stocks, leveraged loans, and corporate debt with “covenant lite” features. Investors and policy makers seem to have little grasp that all of this has happened before, and an even weaker grasp of what is likely to happen next.
The Fed is like a mechanic that loosens the wheel bolts on people’s cars because he thinks it will improve their mileage, then shrugs “we don’t have the tools” to keep their cars from swerving into the ditch.
Here’s a tip. Maybe stop loosening those wheels. Stop putting everyone at risk from experimental fixes that aren’t in the manual and produce consequences that you don’t comprehend. The swerving and crashes are your own doing.
To get a sense of how extreme valuations have become after a decade of deranged monetary activism, the chart below shows the ratio of U.S. total equity market capitalization to GDP. The present ratio is 2.63. The historical norm – not the low, the norm – is 0.78, about 70% below the current level.
The chart below shows the median price/revenue ratio of S&P 500 components. The fact that this is so profoundly beyond the 2000 peak underscores the breadth of this “everything bubble.” Back in 2000, the extreme overvaluation of the market had a “two-tier” quality in which “old economy” stocks were largely abandoned. While there’s no question that the largest capitalization stocks in the S&P 500 are also the most steeply overvalued, it should also be clear that the current bubble has not left “pockets of value” in the broad market.
The problem is that the psychological impulse to own something other than cash, regardless of price, has created a situation where stock market valuations have been bid up to levels that imply negative S&P 500 total returns for well over 12 years.
There’s no way to sustain a bubble without making its consequences worse. The appropriate policy response is to focus on the continued flow of payments through the economy and not the value of paper assets. Much of what investors presently count as “paper wealth” is likely to simply evaporate. Nobody will “get” it in a collapse. It just vanishes.
Again, the stock market would presently have to lose over two-thirds of its value simply to reach historically run-of-the-mill valuation norms
In prior market cycles across history, there was generally a “limit” to speculation. Once sufficiently extreme “overvalued, overbought, overbullish” conditions emerged, one could adopt a bearish outlook even if market internals were still favorable. The only thing truly “different” about the recent market cycle was that the Federal Reserve actively encouraged yield-seeking speculation long after speculative extremes had emerged, by replacing interest bearing Treasury debt with a mountain of zero-interest base money that someone has to hold at every moment in time until it is retired. In response, investors have bid up the prices of other assets to the point where they too are likely to produce zero returns for a very long period of time – even if those zero returns are delivered in an “interesting” way, through a series of collapses and recoveries.
Understand how extreme current valuations have become. In order to simply touch run-of-the-mill historical valuation norms, the S&P 500 would have to lose somewhere in the range of 65-70% over the completion of this cycle
I view the current combination of hypervaluation, price overextension, lopsided bullishness, and unfavorable market internals as a “trap door” situation. Imbalances aren’t resolved sooner just because the imbalances are larger. Instead, crises emerge seemingly out of nowhere, when a vulnerable window or a trap door swings open
This is serious, and there’s no way to sustain it without making its consequences worse. The appropriate policy response to a financial collapse is to focus on the continued flow of payments through the economy and not on bailing out the value of paper assets. You support restructuring of economically important companies, but you don’t use public funds to bail out private investment losses. As the current speculative bubble unwinds, many paper assets are likely to evaporate, because they’re valued at unsustainable multiples of GDP and representative fundamentals. If policymakers like central banks were to buy the assets, the losses would simply be placed on the public books, and they would need to lose two-thirds of their value just to reach run-of-the-mill historical valuation norms.
