The stock market is to the 1% what food stamps are to the poor – Tyler Durden, Zero Hedge blog
At the end of World War II, as the world’s last remaining and therefore pre-eminent economic power, the United States was in the envious position of being able to generate nearly $1 of GDP growth for every incremental dollar of debt taken on. By 1980, the marginal utility of debt in the US had dropped to about 30¢ of growth per dollar of new debt. This decline was partly due to the oil price shocks of 1979, which took so much purchasing power out of the economy that consumers and businesses had far fewer dollars available for consumption and investment after paying for oil and meeting interest and principal obligations on existing debt. The recession of 1979-1980 also brought about a huge increase in defaults, which is the main downside of debt, and this provided a self-reinforcing austerity on an economy already dealing with a sharp cut in spending power. (Image: ClaraDon)
Still, back then new debt produced some GDP growth. Fast forward thirty years. Somewhere around 2008 to 2010, the marginal utility of debt for the US dropped to zero. There was so much debt on the books at all levels of society (including government), eating up so much income in the form of principal and interest payments, that when the shock of widespread defaults was introduced into the economy as the result of the housing bubble collapse, it became futile to add more debt. At that point, the US entered the age of the Marginal Futility of Debt, in which it has been mired ever since.
In these economic circumstances, the response of politicians, but especially the central bankers, who are not politically beholden to anybody, is to step on the gas pedal. This is the classic response of a junkie hooked on heroin or crack; the body needs more and more of the drug to maintain equilibrium. In this case, the central banks, in tacit complicity with the politicians, find that the economy requires much more debt just to stand still.
The problem is that new debt cannot produce real growth, which comes from investment in new plants and equipment, and new products. All that new debt can do is create the illusion of economic growth, and it does so by producing asset bubbles, which are a form of inflation. If things really get out of hand, new debt can produce overt and extreme price inflation, known ever since the days of the Weimar Republic as hyperinflation. So far this has been avoided in the US, but there is no doubt the asset inflation which currently exists is a product of Fed money-printing, through its Quantitative Easing programs. Not only has such money printing created double-digit growth in a variety of markets (the US stock market finished the first quarter of 2013 up 11%), the Fed’s Zero Interest Rate Policy has telegraphed to investors a very specific message. Saving money in safe instruments is for fools; the Fed wants everyone to invest in speculative markets to earn any decent return. This is why stock markets, junk debt markets, commodities, luxury goods, and now speculative real estate, have done so well under Quantitative Easing.
Most people do not have access to the money created by Quantitative Easing. This money goes to the rentier class – the banks, financiers, hedge funds and other financial actors who make their living extracting a rent from the rest of the economy just for the privilege of using money as a medium of exchange. It is the rentier class which is raking in the profits from Quantitative Easing, while the great mass of the public watches from the sidelines and struggles to meet everyday expenses. This is very evident in the lamentations coming from Wal-Mart, which caters to the great unwashed of the economy – the poor and near-poor who increasingly suffer a Third World style of subsistence living, able to afford only basic food, heat, gasoline, and rent. Wal-Mart, which used to be a growth stock in the 1990s, has seen nearly three years of flat revenue, and has now been joined in this situation by a true growth stock of recent times – Apple. Executives of Apple are now experiencing a similar stall in growth, and this is a company which really has put money into successful new products. Apple is blaming its plateau in growth on the “frugality” of consumers, who can no longer afford the company’s pricy new products.
Apple’s assessment of the problem is quite correct. Consumers, other than the very wealthy members of the rentier class, are more and more slipping into a subsistence life-style in the US, and they are joining the millions in poverty, 50,000,000 of whom now eat only because they have access to Federal food stamps. The economic data bear this out, particularly the decline in GDP growth, which reached zero in the last quarter of 2012. The Fed, which is currently putting $85 billion into the economy every month through QE Eternity (as it is called in the markets), and which concomitantly is helping the US Treasury finance deficits of that amount, has produced absolutely no economic growth.
What’s a central banker to do in light of proof that the Marginal Futility of Debt is now the natural order of things? Print more money! We saw that this morning with the announcement out of Japan that the central bank is increasing its QE program to ¥ 5.2 trillion a month. In dollar terms this is double what the Fed is doing, and the Japanese economy compared to the US economy is considerably smaller. The new all-or-nothing approach of Prime Minister Abe in Japan to find some answer to chronic deflation is called Shock and Awe by the press – describing an attempt by the government to fatten the economy on so much debt that inflation will finally break out in the form of GDP growth.
Critics of this program suggest that the only thing Japan is going to achieve with its debt sugar bomb is a diabetic coma. This is a country, however, that has lived through two decades of deflation, relieved only by periods of intermittent returns to zero growth. This is also a country that is in an existential crisis of capitalism. Its population has now begun to shrink, because its birth rate is so low that deaths now outnumber births, and the country does not allow immigration to make up the difference. This is inimical to capitalism, which depends on population growth for its very existence.
If capitalism is ceasing to deliver the goods in Japan, you would expect to see that reflected in a stagnant to declining rate of economic growth, precisely the conditions Japan is experiencing and which it hopes to reverse with monetary Shock and Awe. The US has already shown, however, that nothing good will come of this but asset inflation or worse. This was exactly the market’s response last night to Shock and Awe – the Tokyo Stock Exchange increased about 2%, and the yen, which has already declined 20% in recent months against major currencies, fell a little bit more. The FX markets recognize that Shock and Awe has as one of its goals the depreciation of the yen as a means of stimulating export growth. Unfortunately all QE programs have the same effect, and now the major currencies, except perhaps the euro, are in a state of combat to determine which currency will depreciate the most. This is nothing more than a modern version of the Beggar thy Neighbor trade war that took place in the 1930s, the last time the world had to deal with global deflation and declines in growth.
The quite odd if not cynical thing about these asset inflations is that everyone knows their point of origin, and the money printing which fuels these bubbles. This is why the recent all-time record highs in the Dow Jones and S&P 500 indexes have been met with so much shoulder-shrugging from financial analysts. Almost to a man they agree investors have to be in the stock market; it is the only game in town in a world of zero percent interest rates. They themselves, however, with the possible exception of their computer algorithms that are programmed to follow all trends until the trend dies, would prefer not to be in the stock market. The commentary from analysts almost always mentions the underlying phoniness of these record highs, spirited as they are by money printing, but they end up nonetheless concluding that investors have no choice but to stay long the stock market.
This is reminiscent of the statement from Citibank CEO (at the time) Charles Prince, who at the height of the housing bubble said the bank had no choice but to continue dancing “until the music stops”. That didn’t work out very well for Citibank (Mr. Prince on the other hand retired with tens of millions of dollars of compensation for his trouble). Wall Street at the moment stands almost fully invested in the stock market. Mutual and hedge funds have only around 2% of their assets invested in cash, near an all-time low, just as the market is at all-time highs. This is one of those contra-indicators which tell us the market is dangerously exposed to a setback, since record low cash levels always accompany stock market peaks, and are definitely not a prelude to the sustained bull market many analysts are now predicting.
If the market is indeed at a peak, very much like we saw in 2000 during the NASDAQ bubble and 2008 at the height of the housing bubble, it will be necessary to burst the fantasy sustaining today’s lofty prices for equities. That fantasy is born of Quantitative Easing, and is resting on the myth that the Federal Reserve is all-powerful and has endless resources to prop up the stock market. That it does not have endless resources can be proven by a simple mental experiment, imagining that the Fed balance sheet was allowed to grow from its existing $3 trillion to $30 trillion. This amount would be twice the size of the US economy, and would expose the Fed, which has hardly any capital, to massive, trillion dollar costs if interest rates veered just a smidgen from where they are now on the ten, twenty or thirty year Treasury bond. Because the Fed has no capital, it would have to turn to the Treasury for a capital injection. Where, however, would the Treasury get the money? It would have to borrow it, since the US tax base is less than $2 trillion annually. This means the Fed would have to print more money to fund the debt necessary to sustain itself as an organization in trouble due to previous money printing. This type of existential contradiction can only wind up in a vicious implosion of the Fed, at great cost to the economy.
We already have at hand a real-world example of where excessive money printing leads, in this case with Japan, which has been engaged in this game for 20 years and has pursued a policy of zero interest rates for that long. Rates at zero percent are essential to continue the game of endless money printing, because interest payments at traditional market rates would otherwise bankrupt the government. As it is, interest payments on Japanese government debt are costing the government 25% of all of its existing revenue, and that is with interest rates on the debt already very close to zero percent. Imagine what would happen to Japan if the bond market starting dumping Japanese government bonds and pushing up long term rates by 2%. Interest payments would consume the entirety of the government’s budget, drowning out all domestic and military spending.
Where do you think the new Shock and Awe program is going to lead? It is going to worsen Japan’s dependence on zero interest rates and expose the nation to massive losses on its central bank balance sheet even from minor changes in market rates. This is the fate destined to engulf the Federal Reserve if it stays on its current path. There is, as the old dictum says, no free lunch. The Fed does not have the ability to print money endlessly and balloon its balance sheet to grotesque size.
A few professionals in the stock market already know this, and have kept their money out of equities. They prefer to stay in safe cash investments even if the interest return is zero. As another old saying goes, sometimes it is better to worry about a return of your investment rather than the return on your investment. These professionals are few and far between. If they speak up at all, they are drowned out by the chorus of cheerleaders encouraging everyone to dump everything they own into the stock market. That is the current situation in the US stock market, as reflected by so many technical indicators: volume is low because everybody is already “all-in”, option call volume vastly exceeds put volume because everyone expects the market to go only up, investor sentiment is once again extremely bullish just as we saw in 2000 and 2008 at the previous peaks, and breadth is worsening, meaning many more stocks are failing to achieve new individual highs despite the market’s record performance.
This is a recipe for yet another crash as we saw in 2008, only worse, because now the crash will be caused by a loss of confidence in the rescuer of last resort – the Federal Reserve and the US government. Once that prop is removed from the market, there is no other hero around who is able to pull the market back from a slump. A natural bottom will have to reached where selling exhausts itself, and the last time we saw that phenomenon, the Dow was at 6,600.
There are many different scenarios that come to mind to cause disillusion in the Fed’s omnipotence. Europe can continue to be engulfed by widening deflation, and nothing by the way is more deflationary than the government confiscating consumer deposits in banks. This is why the Cyprus situation is so worrisome – it shows the EU government being forced to do something highly deflationary, which is completely contrary to what the government is hoping to achieve. The US could easily be forced into a similar need to confiscate deposits, because none of the TBTF banks is entirely healthy, and all of them are exposed to a systemic crisis from Europe due to their interlocking derivative portfolios. The link among these portfolios are the collateral clauses that exist in every derivative contract, and which call for the seller to pony up liquid collateral in the event the financial product in the contract suffers a price drop in the market. Credit derivatives were the source of just such a problem back in 2008, and the problem hasn’t gone away. We learned in the MF Global collapse that the big banks “rehypothecate” their collateral, meaning they pledge the same piece of collateral over and over to different banks. The world is already facing a collateral shortage – this was very evident during the Cyprus crisis when the EU announced the banks in Cyprus no longer had enough high-quality collateral to be able to borrow from the European Central Bank. Where has all the collateral gone? Straight to the Federal Reserve, which has been vacuuming up Treasuries every time it does Quantitative Easing.
You can see the daisy chain of disasters that has been created here. A surprise bankruptcy of a medium size bank or of a hedge fund, leads to a repricing downwards of all credit derivatives. The issuers of these derivatives, which are almost entirely the large TBTF American banks, face unprecedented demand for more collateral in the form of Treasuries. The Fed, however, has been buying up over 75% of all new Treasuries for two years now, and does not dare sell them back into the market for fear of tanking the economy. One or more TBTF banks can’t meet their collateral obligations, and like AIG they are nationalized overnight by the federal government. And from there, all it takes is one individual in the government to hint that the solution to the shortage of liquidity can be found in the Cyprus crisis – in other words, it is time to confiscate deposits in the nationalized bank.
This is the point where panic steps in since everyone realizes their wealth is now in jeopardy. The banking system can no longer function due to the outpouring of liquidity by customers. We are right back to 1933 when a bank holiday had to be declared and everyone found themselves much poorer.
It is easy in this scenario to imagine the stock market at 6,600 Dow or much lower. You don’t need a financial crisis to get there, however. Any exogenous shock will do, considering how much the stock market is floating on nothing but thin air. Dear Leader Kim Jong-un, for example, might not be the rational, though puerile and petulant, actor everyone thinks he is. He may simply be a crazy person who gets his military to do his bidding by having any objectors shot. Let us hope, then, that the US Department of Defense has done some game-playing and is prepared to react to some form of complete lunacy out of North Korea, such as Kim deciding to drop one of his six nuclear bombs on Seoul, Tokyo, or even Beijing, which whom he is no longer on good terms.
It is always, always a feature of market tops that investors become extremely complacent about the risks they face. Risk always escalates when the market pushes higher based on the illusion of safety and security. Often the illusion consists of the belief that major market players are sound credits, or that the collateral that underlies so many transactions can never go down in price. An even worse illusion is the belief that government will always ride to the rescue. The worst illusion of all is underestimating the uncertainty that exists in the geopolitical realm, and overestimating the rational behavior of key players in that realm.
All these illusions are present in today’s market. The only thing that is absolutely certain in today’s market is that these illusions will at some point burst. We don’t know when, but it will happen. When it does, most everyone will be dancing while Mr. Market has been quietly removing all the chairs from the room, leaving no place to rest when the music stops.