There's something deeply anomalous about a stock market crash at the peak of
United States corporate profitability. Nothing like this ever has happened
before. Nonetheless, judging from overnight moves in Asian markets, last week's
plunge in world stock markets will be repeated in Europe and America on Monday
morning - although recent intraday moves have been so extreme that one is loath
to guess.
Standard and Poor's downgrade of American sovereign debt from the highest,
triple-A rating may be the silliest pretext for a stock
market crash in world history. America is the only big industrial country in
the world that will have more taxpayers rather than fewer when a newly-issued
30-year bond matures.
Working-age population by region, assuming constant fertility Source: United Nations
In Asian trading, the US 10-year note lost about a point and a half, a modest
response to S&P's action. But the 3% to 4% declines in regional stock
markets and a parallel fall in US stock futures, is harder to explain. Stock
markets never have undergone this sort of crash when corporate earnings
outpaced the alternatives by such an extreme margin. The earnings yield on
stocks is a full 5 percentage points higher than the yield on 10-year US
Treasuries, something we have not seen for a generation.
The so-called Equity Risk Premium (ERP) - the earnings yield on stocks minus
the 10-Year Treasury yield - stands at a generational high. The corporate bond
market assigns a low risk to corporate earnings. In a world short of earnings
to fund history's largest retirement wave, why is the market selling an S&P
earnings yield of 8% to buy 10-year Treasuries at 2.5%?
Systemic strains exist, first among them the likely restructuring of Italy's
enormous government debt, but there is no reason for this to become a global
liquidity event. Central banks stand ready to provide unlimited liquidity.
There are good reasons to sell European banks. The American economy is weaker
than the consensus forecast, and the US consumer may have dug in for the
duration. But the link between US GDP and corporate earnings is the weakest in
history, and 46% of S&P sales are outside the US.
If equity earnings are strong - and careful analysis reinforces the impression
that they are - then we have observed a liquidity event like 1987 rather than a
systemic crisis like 2008. The banking system, whatever its difficulties, is
not the source of the liquidity problem, for banks have been reducing their
holdings of risk assets for two years. Governments are not the source of the
liquidity problem, for government stimulus in the West has been irrelevant to
the economy since 2008.
There is, however, a bubble in the world economy. Anecdotal evidence points to
hedge funds as the bubble that has popped. With equity hedge funds down 10.72%
year-to-date on the Hedge Fund Research Index as of August 3, investors are
demanding their money back. The debt-ceiling cliffhanger in Washington may have
provoked the redemption calls, and the S&P downgrade might provoke more.
But the reason for the downgrades is that hedge funds have crippled out. Hedge
funds can't earn the 15%-20% returns they promise investors in a world of 3%
bond yields and 2% gross domestic product (GDP) growth. Investors desperate for
higher returns, including pension funds, returned to the hedges during 2010 and
2011, and are now suffering spasms of buyers' remorse.
That prompted an across-the-board liquidation of all assets, including
commodities and emerging market equities most favored by the hedges. The nearly
$2.6 trillion of hedge fund assets constitute the system's only real bubble:
too much money chasing too few returns, with a lot of fingers on the recall
button. As of May, equity hedge funds with $1.25 trillion in assets had
strongly net bullish positions.
They are stampeding to get out. Their overwhelmingly bullish bias left them
vulnerable to a wave of redemptions, what has happened to the real-money
investors who require the income that only the equity market can provide?
No-one can fund a retirement on Treasuries yielding 2.4%, or a corporate bond
index yielding less than 3.5%.
There are other investors, to be sure, who need income to fund current and
prospective retirements cannot act as quickly as the hedge funds. Pension funds
and insurers require months of committee meetings to change their allocations.
They shifted massively to bonds after 2008, moreover, and their book yields
cannot be replaced in the present market. Tactical asset allocation is out of
the question; they can filter funds into the equity market slowly.
If them that has 'em can't hold 'em, them that wants 'em can't buy 'em. That
leaves individual investors to ponder the cheaper valuations on the equity
market. The trouble is that the vast majority of American households are deeply
in the hole: according to the Federal Reserve's most recent survey of personal
wealth, American households' real estate is worth about a third less than it
was in 2006, that is, $16.1 trillion compared to $22.7 trillion.
The problem is that most Americans approaching retirement age in 2007 had most
of their net worth in non-financial assets.
Apart from real estate, the next-largest component of middle class wealth was
in the form of equity in small businesses. Small business has had no share in
the recovery. A rough gauge of small business income is non-farm proprietors'
income as reported in the GDP tables. As the table below indicates, corporate
profits have soared to a record, but proprietors' income remains below the
pre-recession peak.
Judging from the surveys published by the National Federation of Independent
Business and other organizations, small business remains in a slump. That is
not surprising, for reasons spelled out in a recent study by New York Federal
Reserve economists. Most small business growth during the past decade followed
the housing bubble.
Stock crashes in the past have followed bouts of what former US Federal Reserve
Chairman Alan Greenspan called "irrational exuberance," or external
circumstances that made equity unattractive. The chart below sums up a
generation of valuation and equity returns.
Equity risk premium vs S&P 500 price change
The last three big drops in the S&P are circled on the chart. All of them
occurred when the Equity Risk Premium was negative - that is, when Treasuries
offered more yield than stocks. When a safe asset yields more than stocks,
investors have to clap their hands and say "I believe in earnings" in order to
hold stocks. But we have never had stock market crash when stocks earned nearly
three times the Treasury bond yield on a current basis.
The US government won't go bankrupt. China won't sell its Treasuries (who would
buy them?). The world's Asian epicenter of economic growth won't roll over and
die. Italy's $1.4 trillion debt might be restructured, Europe's banks might go
under the auction hammer, and today's Europeans might postpone their retirement
for 10 or 15 years - but that won't change the grand scheme of the world
economy. If Italy were the problem, we wouldn't see the sharp rise in the euro
that occurred in early Asian trading.
The bubble that has popped here is not American government debt, but the
overstretched and overpromised hedge fund industry. It's impossible to tell how
long the liquidation will continue. But the stock market today does not run off
fumes as in the dot-com days of the 1990s, nor off the phony profits of
ultra-levered financial companies as in the 2000s. Corporate America is flush
with cash, financially sound, and making better money than ever before.
For that reason, I consider this a liquidity event like 1987 rather than a true
crisis like 2008 (with a $6 trillion shock to household balance sheets and the
evaporation of bank equity). It's not the end of the world. It's just the end
of the hedge fund industry.
Spengler is channeled by David P Goldman. Comment on this article in Spengler'sExpat bar forum.
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