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January 2021
Financial market tops always exhibit elevated valuations (check) typically combined with weak or deteriorating economic conditions (check) and a backdrop of investor complacency (check). But the greatest bubbles exhibit far more than such excess; they exude exuberance. Are the financial markets in a current state of euphoria with a commensurate risk of a market downturn? Various metrics strongly indicate as such.
Citi provides their own proprietary index: the Citi Panic / Euphoria Model. This index utilizes multiple sentiment and trading indications to assess investor mentality. “Euphoric” measures exceed 0.41 on their scale. The market rarely reaches such levels: over the last 20 years, it breached this level only five times. Three of those were but brief touches before receding in quick order.
But two times, the market was solidly deep within the “euphoric” area of the index: 1999 to 2000 and 2020 to 2021. At the height of the technology bubble, the index neared 1.50. What does the index indicate today? In January 2021, the index sits solidly at 1.80 having gone hyperbolic over the last several months.1
Another commonly accepted signal of extreme bullish sentiment is the increased acceptance of and demand for riskier assets; for example, initial public offerings (“IPOs”). During such times, companies oblige by increasing the number of IPOs to avail themselves of such demand in raising capital. The following chart demonstrates the number of IPOs in 2020 exceeded even that of the technology bubble.2
Curiously, of the 480 IPOs in 2020, fully 248 of them were Special Purpose Acquisition Companies (SPACs).3 A SPAC is often called a “blank check” shell corporation because it pools investor funds together to finance an unknown acquisition within a future timeframe (generally two years).4 Investing in a SPAC is like paying to sit at the chef’s table in an unknown restaurant with an unnamed chef at some point in the future. Even the most fervent foodies would choke on the idea.
But not investors – not only were 248 SPACs debuted in 2020, but already to date in 2021, another 59 launched which tied the previous, pre-2020 high set in 2019. And prior to 2019, SPACs averaged less than 17 per year during the previous ten-year period (2009 to 2018).5 If the Citi Panic / Euphoria Model seeks corroboration, IPOs and SPACs provide it.
While “euphoria” is a state of intense excitement and happiness, “phoria” is a misalignment of the eyes which breaks binocular vision. Investors are moving from euphoria to phoria: unable to focus on sound investment principles and blind to economic dangers.
As long the Federal Reserve continues aggressive monetary expansion, investors may continue to fuel financial markets to loftier valuations and higher euphoria. However, many variables could work to undermine or overwhelm the Federal Reserve’s efforts. If that happens, investor sentiment and demand may plummet, for their feelings are usually fickle. Financial markets will move accordingly.
1. “A $13 Trillion Crisis-Era Debt Bill Comes Due for Big Economies” Bloomberg News. 04 January 2021
2. Citi Research.
3. Stock Analysis. 20 January 2021 https://stockanalysis.com/ipos/statistics/
4. Special-purpose acquisition company 20 January 2021 https://en.wikipedia.org/wiki/Special-purpose_acquisition_company
5. SPACInsider. 20 January 2021 https://spacinsider.com/stats/
6. Ibid.
And the Election Winner is . . . Inflation in a Landslide!
August, 2020
In terms of magnitude and shortness of time, the stock market rally since its March lows has been unparalleled. Yet it is especially notable given negative economic reality (an annualized second quarter GDP plunge of 32.9%) and diminished company earnings (S&P500 earnings down 50%).1 Will this rally continue? If not, what stops the stock market rally?
Numerous threats exist: continued economic deterioration (a case can be made a recession hit before the lockdowns) and bankruptcies, trade and geopolitical strife with China, civil unrest and mass unemployment, renewed lockdowns due to a Covid resurgence, the loss of hope for a timely vaccine, and a negative economic viewpoint of a very possible Biden presidency.
Either mitigating or masking these risks stands the Federal Reserve’s unprecedented actions since March. Although it intervened with numerous programs and purchased a multitude of assets, its actions can be neatly summarized as having massively increased the money supply. Measured in M2 (a commonly cited definition of money) year-over-year growth since the end of the last recession, the money supply has exploded.
Monetary expansion is singularly responsible for the stock market rally. As such, to ask what stops the stock market rally is to question what stops the Federal Reserve.
Chairman Powell is unlikely to voluntarily withdraw monetary stimuli. He learned that lesson (it is no coincidence that the late 2018 stock market decline occurred after a long-term slowdown in monetary growth).
So short of this development, what external factors may prevent the Federal Reserve from pursuing its current monetary course? Theoretically, why is it that central banks cannot forever increasingly print money to ensure ever higher equity prices?
Murray Rothbard, the Austrian school economist and monetary expert, addressed this issue:3
. . . the boom is kept on its way and ahead of its inevitable comeuppance, by repeated doses of the stimulant of bank credit. It is only when the bank credit expansion must finally stop, either because the banks are getting into a shaky condition or because the public begins to balk at the continuing inflation, that retribution finally catches up with the boom. As soon as the credit expansion stops, then the piper must be paid . . .
The “shaky condition” of banks may derive from low absolute interest rate spreads and unsustainable financial leverage alongside increasing bad loans. It will develop with sustained negative real rates (as it has in other parts of the world).
Assuming a banking crisis is averted, what about inflation? Few under 50-years old can remember, let alone experienced, an inflationary environment as a consumer, but could one be starting now? According to the August 14th issue of Barron’s magazine:4
A trifecta of inflation numbers came in hotter than expected this past week, with consumer prices, producer prices, and import prices for July all rising at faster paces than economists anticipated. Notably, consumer prices – excluding the more volatile food and energy categories – rose at the quickest clip since 1991.
It may not be starting now, but it could be. And unlike the 1970’s, the Federal Reserve will be unable to deflect blame at greedy business owners or higher oil prices. What they once could play off as coincidence will now reek of causality. And if they stop inflating, then any rally could turn to rout.
1. S&P500 Down Jones (95% of companies reporting)
2. Federal Reserve Bank of St. Louis
3. Rothbard, Murray N. Economic Depressions: Their Cause & Cure. Ludwig von Mises Institute. 2009.
4. ‘Stagflation’ Looms Over This Market. Why Some Analysts are Worried. Bellfuss, Lisa. Barron’s. 14 August 2020
April, 2020
By late January, the die was cast: the virus had a name, it had reached our shores, travel screenings and restrictions were in place, and while not yet declared a pandemic, the World Health Organization declared COVID-19 a “Public Health Emergency of International Concern.”
Yet complacency reigned within financial markets. The stock market continued its march to new highs (reached on February 19th). The Federal Reserve, in its January 29th press release, failed to mention coronavirus in the list of variables it “will continue to monitor” save for a generic nod to “global developments.”[i] It began the missive by mentioning recent data “indicates that the labor market remains strong and that economic activity has been rising at a moderate rate.” Famous last words.
It was not until a full month later, and only after the U.S. stock market suffered its worst week since the Great Recession, did the Federal Reserve act. It was rather weak work. On February 29th they issued a statement describing how they were “closely monitoring . . . the evolving risks of the coronavirus to economic activity.”[ii] On March 3rd, they cut interest rates by a not uncommon 50 basis points.
But on March 15th, the Federal Reserve completed its year-to-date journey from satisfaction to concern to sheer panic. That Sunday’s emergency announcement marked the first of several major measures meant to stop the bleeding on Wall Street and stem the tide of anticipated economic hardship.
The Federal Reserve’s actions are unprecedented in both magnitude and breadth and will generate serious repercussions for investors down the road.
While the financial media widely reported how the March 15th actions lowered the federal funds target rate to 0.00-0.25%, it missed the far more drastic action of eliminating bank reserve requirements. Previously, banks had to retain 10% of demand deposits which meant they could theoretically increase the money supply by ten times. Now no limit exists to their monetary expansion.
March 23rd brought more unprecedented action when the Federal Reserve announced it was buying $375 billion in Treasuries and $250 billion in mortgage backed securities that week. For comparison, 2008’s QE1 was $700 billion (comparable in size) and it took months to deploy. It also announced it would continue buying assets “in the amounts needed” to support the economy. It started buying, for the first time ever, corporate and short-term municipal bonds.
Then, on April 9th, the Federal Reserve announced $2.3 trillion in loans to “support the economy.” Not content with corporate and municipal, it started buying junk bonds. It could have saved itself the trouble of buying various bond sectors by simply writing a check for most of the office real estate ($2.5 trillion), farmland ($2.7 trillion), or multi-family housing property ($2.9 trillion) in the U.S.
The Federal Reserve’s substantial and sustained efforts to pull the economy out of the 2008 Great Recession increased its balance sheet by $3.6 trillion in just over six years. It just added $2.3 trillion to its balance sheet in a month.[iii] This isn’t throwing the kitchen sink at a problem – it’s lobbing in the entire kitchen.
Even if the Federal Reserve stopped further actions and ceased its announced programs, its balance sheet will continue to swell as it finances proliferate spending by the U.S. Treasury. Given such actions as the CARES Act and its Paycheck Protection Program, the Congressional Budget Office estimates the 2020 deficit will reach $3.7 trillion – a multiple of anything seen in the wake of the 2008 Great Recession.[iv] This estimate will only increase with any additional spending initiatives by Congress.
Money supply has already exploded and is at the fastest rate in 92 months.[v] It is just getting started.
In response to 2008, the Federal Reserve increased the money supply dramatically, but much of that was held by commercial banks in excess reserves at the Federal Reserve where they earned some small, yet risk-free, interest. This time is different. Not just in magnitude, but in breadth, which is to say by recipient. No longer will money be injected into banks and primary dealers, but to companies and individuals who make up the economy as whole.
Inflation will ensue. Not right away, for the deflationary forces of loan repayments and defaults will counteract and potentially overwhelm inflationary forces. But that will be somewhat temporary.
Until then, it is an opportune time to build up inflation protections for an investment portfolio: certain types of real estate (e.g., farmland and some residential rental property), precious metals, and cryptocurrencies.
[i] Federal Reserve Bank of St. Louis. Timeline of Events Related to the COVID-19 Pandemic. https://fraser.stlouisfed.org/timeline/covid-19-pandemic#14
[ii] Federal Reserve Press Release. 29 Jan 2020. https://fraser.stlouisfed.org/title/federal-open-market-committee-meeting-minutes-transcripts-documents-677/meeting-january-28-29-2020-585165/content/pdf/monetary20200129a1
[iii] Federal Reserve Bank of St. Louis. Federal Reserve Total Assets. https://fred.stlouisfed.org/series/WALCL
[iv] “Coronavirus Relief Pushing U.S. Deficits to Staggering Heights” Associated Press. https://www.pbs.org/newshour/politics/cbo-says-deficit-to-reach-3-7-trillion-in-economic-decline
[v] “Money Supply Growth Surges to 92-Month High” McMaken, Ryan. Mises Institute. https://mises.org/wire/money-supply-growth-surges-92-month-high
