We aren't going to have another financial crash. In fact, nothing at all is
going to happen. Forecasting the United States economy is about as exciting as
predicting next quarter's gross domestic product in 1957 Poland. You want to
know what's going to happen, comrade? Read the Five Year Plan. With 40% of US
personal income coming from transfer payments, it's almost nostalgic to call it
capitalism.
The so-called American economic recovery won't die, because it's undead. It was
a zombie to begin with. Equity investors during the past six weeks came to the
collective conclusion that the US is not in the early phase of an economic
recovery, but in the endless middle of a structural slump, in the term of Nobel
Prize winner Edmund Phelps.
President Barack Obama's response to the 2008 economic crisis that swept him
into power has changed the character of the
American economy. Call it Zombinomics.
Back in the antediluvian age when investors took risk (and sometimes panicked),
the price of option hedges on major stock market indices traced something like
an electrocardiogram of market risk. When the banking system went bankrupt in
2008, the VIX index of equity option volatility spiked to 80%. That means
investors placed a roughly two-thirds probability that the price of the S&P
500 index of US stocks would change by 80% over the next year. That's the
financial equivalent of cardiac arrest.
Cost of option hedges on S&P 500:
During the slow, sickening stock slide of the past six weeks, the market's
pulse barely fluttered. As the above chart shows, the implied volatility of
S&P 500 options traded at the bottom of its range, at the same levels it
registered before the crisis.
There's no need to hedge risk, because there's no risk to hedge. Banks are the
least risky proposition out there, at least the big ones that can't be allowed
to fail. They're not risky, because they're not really alive. The safest person
on the world is a coma patient in an iron lung. A grand piano might fall on the
healthiest fellow in the world if he runs about loose, but the regulators have
the banking system in a respirator.
United States banks are shedding exposure to private borrowers at an
astonishing rate. Not since numbers were collected have we seen anything
remotely like this, as the chart below makes clear: the blue line shows the
total loans and leases of US banks, and the red line shows the change in the
outstanding level from the peak during the two years preceding each point.
Banks reduce total loans and leases to private borrowers
Source: Federal Reserve, author's calculations [1]
Apart from the nearly trillion-dollar reduction in bank lending to private
borrowers, the banks have also reduced their holdings of bonds reflecting
private risk (mainly mortgage-backed securities) by about $200 billion. It's
the Slaughter of the Guilty. US households that put 10% down on a house during
2000-2006 as home prices rose 10% a year earned 100% a year on their equity.
Goldman Sachs' return on equity never broke above the low 30% range. Compared
to homeowners, investment banks are on the back of the line at the punch bowl.
The banks borrow at nothing from the Federal Reserve and lend the money back to
the Treasury (by purchasing its securities) at nothing plus. It's a miserable
living, as the low prices for bank stocks emphasize, but it's a safe living -
sort of like living inside an iron lung. And the world banking system has a
trillion dollars of excess capital. Some of that will be eaten up by continued
mortgage defaults in the US and the de facto bankruptcy of Greece and perhaps
other weak links in the European Union, but not enough to repeat the events of
2008.
Corporations in the US, meanwhile, are sitting on a trillion dollar cash hoard.
They don't want to borrow money. They want to lend money. Instead of borrowing
to the brim and gearing up their capital structure to goose up shareholder
value, as they did during the decade leading to the Great Crash of 2008, they
have turned survivalist. Inventories are a thing that corporations are not
buying: the inventory to sales ratio is the lowest in 20 years.
Inventory to sales ratio: Total business (ISRATIO) Source: US Department of Commerce (Census Bureau).
Nobody has taken any risks, so there is no risk to liquidate. There isn't much
money to make, either. Welcome to the monetary equivalent of the Night of the
Living Dead.
Over two years ago, on March 13, 2009, I wrote (at the "Inner Workings" blog on
this site, blog.atimes.net):
It's not about getting a recovery going.
That's not going to happen, not if Martians land in flying saucers with a
billion tons of gold to invest in bank capital. It's about preventing something
worse than we have now, namely screaming, bug-eyed, blood-in-the-streets,
rape-the-crops-and-burn-the-women panic. Zombie not bad. Zombie good. Zombie
better than alternative, which is you dead. Really dead. No breath, never get
live again. Zombie is as good as it gets. You zombie, you still alive, sort of.
You not zombie, you dead. Opposite of zombie not happy, lively, active.
Opposite of zombie is you push daisies up. The best we can get out of this is a
zombie banking system, one that still pays its debts because it earns enough
interest from the toxic assets left over from the last boom.
We
observe a slow grind downwards, rather than a crash. What follows might be a
bit technical, but it's worth including simply for the utter weirdness of the
results.
S&P 500 during the past four years: Market volatility (rolling standard
deviation of returns) vs market percentage change
On the horizontal axis, we are looking at the realized (empirical) volatility
of the S&P 500 index, calculated as the rolling standard deviation of
returns over 50 days. On the vertical axis, we see the percentage price change
of the S&P 500 over the preceding 50 days.
As we should expect, markets are more volatile on the way down: if we
scatter-plot the 50-day standard deviation of daily returns to the S&P
(empirical volatility) against 50-day returns (percentage change, we find that
the trend line slopes downward: lower returns are associated with higher
volatility. As we move to the left along the horizontal axis (lower returns),
we tend to move up on the vertical axis (more volatility).
The most recent data point is way off the trend line (it is shown in the large
diamond on the lower left). In other words, we have had a big price change with
very low volatility.
How is the market pricing equities?
The great Reagan expansion of 1984-2008 gave us a very different sort of equity
market than we have seen before or since, namely a market in which investors
looked to future price appreciation rather than present income. During the
great stock market boom of 1979-1999, reinvested dividends made up only 20% of
total return rather than the pre-boom average of 63%.
Investors had such confidence that earnings would rise, or that the
price-earnings ratio would rise, that they ignored current income. Was that a
bubble? Not at the outset; an entrepreneurial economy destroys the safety of
existing cash flows, and creates value in new enterprises. As the US economy
shifted from a Fortune 500 preserve to a creative-destruction economy during
the 1980s, this sort of outcome should have been expected.
One way to visualize the relationship is to compare the yield on corporate
bonds to the dividend yield on stocks. In the chart below, we observe the
Moody's long-term Baa-rated corporate bond yield as a multiple of the dividend
yield. Typically, bonds yield about twice the dividend yield (as they should,
for dividends may be expected to grow over time, while bond yields are fixed).
During the Reagan boom, though, the Moody's bond yield briefly rose to six
times the dividend yield. That was a bubble. We are now back to the pre-Reagan
boom multiples, as the American economy shifts from a dynamic, entrepreneurial
entity, to a sclerotic, half-socialized affair.
Moody's Baa-rated corporate bond yield as a multiple of the S&P 500 dividend
yield
And this leads us to the reason that volatility failed to bark. It appears
technical, but it points to a fundamental conclusion. Investors are
hard-pressed to earn income in a market where the 10-year Treasury yields less
than 3% and the dividend yield on the S&P 500 is around 1.85%. So investors
sell call options on stocks they own ("covered calls") to pocket extra income.
This strategy has become so popular with income-hungry investors that a whole
class of exchange-traded funds has adopted the approach. As soon as the cost of
options goes up, there is an entire class of investors ready to sell options to
earn current income, and this suppresses the price of options (expressed in
implied volatility).
This shows that investors don't really think they are giving up a lot of future
upside by selling call options; they would rather have the current income in
their pocket. The emphasis on current income rather than price appreciation
stems from two factors. One is that more investors are retiring and require
current income; another is that after the "lost decade" of the 2000s, investors
may have less confidence in long-term price appreciation.
This technical phenomenon in the options market would not occur, to be sure,
unless the underlying economy justified it. As we saw, the actual volatility of
US stock prices is remarkably low for a declining market. The US economy is
stuck in the mud; it can't go forward, but neither should we expected it to
move very fast in reverse.
Are stocks too expensive? Here's a very rough gauge:
A newly-issued 30-year corporate bond rated Baa (lowest rung of investment
grade) sold at par (a dollar price of $100) would pay a coupon of 5.78% a year,
and return the principal upon maturity. $100 investment in the S&P 500
stock index would pay a dividend yield of 1.92% as of June 10.
Assuming that half the expected return on the S&P comes from dividends and
half from price appreciation, at what earnings growth rate would stocks and
bonds return the same? The answer is just under 4% a year. With 2% real
earnings growth over 30 years (a substandard outcome) and 2% inflation, stocks
should do about as well as bonds. And that's assuming no defaults in a bond
portfolio. (The example assumes that you spend rather than reinvest the current
income).
What the market appears to be telling us is that growth expectations are
depressed, consistent with the so-called "new normal" of lower performance.
It's not the end of the world. It's just the end of investors who expected that
asset price appreciation would allow them to get away without saving for
retirement.
Note
1. I have adjusted the data to take into account a shift of approximately $400
billion of loans from off-balance sheet entities ("structured invested
vehicles") on to bank balance sheets during 2009.
Spengler is channeled by David P Goldman. Comment on this article in
Spengler's Expat Bar
forum.
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