The signs are everywhere, after years of central-bank collusion to douse the world with free money: historically low yields even on the riskiest cov-lite junk bonds; corporate profit margins at the upper extreme of the range; record valuations of stocks and other assets…. Heck, even startups: median Series A valuations – the first major VC money after seed money – have gone berserk and are now higher in inflation-adjusted terms than the median Series B valuations were 10 years ago!
And all this in a historically crummy global economy.
Valuations are going to revert to the mean. They always do. And when they do, they’ll overshoot in the process. The business cycle still exists. The great unwind will happen in an environment when nearly everything is overvalued. But those who have dared to stamp a near-term date on that event have gotten hammered by reality. Now, prudent wiggle room is getting built into the scenarios.
Junk bonds are enjoying the most extraordinary bubble ever, as investors – particularly bond funds – are desperate to get some yield in a world where central banks have moved heaven and earth to expunge yield. They’re stretching and reaching for it, and that has created demand that has driven down the very yield they’re so desperately reaching for. Their justification: junk-bond default rates hover near historic lows of about 2%.
Sure. As long as cheap new money is available to service or pay off old debt, defaults are rare. The issue arises when the new money gets more expensive and investors more prudent. Suddenly, new money won’t bail out old money. That’s when default rates soar. Investors will lose their shirts. It will happen. It always does, says high-yield expert Martin Fridson. The “next junk-bond implosion” will kick $1.6 trillion in junk bonds into default over a three-year period, he says. But not now. In 2016, he figures…. [“$1.6 Trillion in Defaults Coming,” Legend Says].
Jeremy Grantham, co-founder and Chief Investment Strategist of GMO, wrote of a similar scenario for stocks: a tough environment of crazy valuations where the future looks bleak – but that future hasn’t arrived yet.
Already a year ago, he saw the bubbly conditions in the US markets – “badly overpriced” is what he called them at the time in GMO’s third-quarter letter – and predicted that the US stock market would “work its way higher, perhaps by 20% to 30% in the next year or, more likely, two years….”
In the year since, the S&P 500 has gained 15%. Right on target. He added:
And then we will have the third in the series of serious market busts since 1999 and presumably Greenspan, Bernanke, Yellen, et al. will rest happy, for surely they must expect something like this outcome given their experience.
Ah yes, “we the people, of course, will get what we deserve.”
And he had an “Inconvenient Conclusion”: “Be prudent and you’ll probably forego gains. Be risky and you’ll probably make some more money, but you may be bushwhacked and, if you are, your excuses will look thin. Your call.”
This scenario of bubbly conditions, followed by some nasty downdrafts would create negative average returns over the next seven years of -2.1% for US large stocks and -3.5% for small caps per year (chart). Gloomy. But in the future.
So far, he has been right. GMO’s Q3 2014 newsletter, released on Tuesday, resumes the theme of party now, pay later, but not much later….
Stocks are supported for the moment by some positives, including the “Presidential Cycle,” but they also face some negatives: the end of QE, “talk of rate increases early next year,” a possible escalation of “several minor but intractable wars,” topped off by the Ebola outbreak. And then there’s “the very substantial overpricing of the US market,” though it may not have any short-term effect whatsoever.
And so he comes to this chilling conclusion:
My personal fond hope and expectation is still for a market that runs deep into bubble territory (which starts, as mentioned earlier, at 2250 on the S&P 500 on our data) before crashing as it always does. Hopefully by then, but depending on what the rest of the world’s equities do, our holdings of global equities will be down to 20% or less. Usually the bubble excitement – which seems inevitably to be led by U.S. markets – starts about now, entering the sweet spot of the Presidential Cycle’s year three, but occasionally, as you have probably discovered the hard way already, history can be a snare and not a help.
This is the new theme: we see the problems, they’re everywhere. We track them, we chart them, we understand them, we know they’re huge, and denying or rationalizing them would make us look silly, though plenty of folks are still denying and rationalizing them. There will be a reset of some sort, these crazy valuations will unravel, corporate profit margins will revert to the mean by overshooting it, defaults will cascade through the system, trillions will go up in smoke.
This will be a rough time for unprepared investors, the meme goes, but for now, the party is hopping. Money is still free and plentiful. Times are still good. Profits now. Apocalypse later.
But does the smartest guy on the block really want to party till the last minute, whenever that may be? Perhaps not. Warren Buffett impeccable sense of timing has apparently kicked in, but he doesn’t want to spook the markets. Read… Buffett Is Dumping Stocks out the Backdoor
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Wolf, as per Wikipedia,
“the crisis was avoidable and was caused by: Widespread failures in financial regulation, including the Federal Reserve’s failure to stem the tide of toxic mortgages; Dramatic breakdowns in corporate governance including too many financial firms acting recklessly and taking on too much risk; An explosive mix of excessive borrowing and risk by households and Wall Street that put the financial system on a collision course with crisis; Key policy makers ill prepared for the crisis, lacking a full understanding of the financial system they oversaw; and systemic breaches in accountability and ethics at all levels”.
Some of this was fixed since then, I read. What could be the trigger for the next bubble burst?
The trigger will be the republicans extending the debt limit to the point they can’t pay the interest and using the money to expand their war machine.
I don’t think these folks are worrying about a financial collapse of the kind we had during the financial crisis where just about all the major banks were toppling and where credit froze up. Nobody wants to even think about this sort of scenario.
They’re more worried about reality setting in on asset prices, with stocks dropping sharply and perhaps for years, and with investors fleeing the junk-bond market, which would send these companies, when they run out of money, into default and restructuring.
These types of changes don’t need an event-like trigger, or a specific catalyst – though that would certainly help speed things up. The money flow just reverses, risk perception changes, investors become more prudent, leverage gets cut…. It could be gradual, and it could be rapid.
The trigger will be the US population continuing to accept lower living standards and therefore extending the extend and pretend game to who knows when. Oops, I mean there will be no trigger.
Apocalypse later. I love it….
There need be no trigger. CNBC is the apotheosis of the notion that events “happen” and then the shamans and witch-doctors examine the economic entrails to determine what caused the events.
This is identical to noticing a rain storm and then looking around to see who was dancing (and thus caused it.)
Human beings haven’t changed a bit in 10,000 years. Instead of gathering around the fire to be told by the tribe elders why the thunder gods were angry and caused last week’s flood, we figuratively gather around the Tee Vee to be told by our tribe’s “experts” why IBM’s share prices cratered (on the same news as caused a rally last time.)
If you want to “see” reality, imagine the news anchors are all wearing grass skirts and have earrings made out of human finger bones.
Trigger? Ten sigma, rogue wave or tsunami? It will most likely be something nobody is looking for. Or I guess it could be a general erosion of confidence where the market just rolls over with no real event. If it can’t go higher, then it will go lower.. And once that starts, margin calls come in and it goes down some more causing derivatives to be called and then another leg down… until all the selling and covering has run out of momentum.
Deflation has already set in as in lower gold, corn, iron, copper etc. tell us that the production/demand curve has broken down. This has already cost some large players a lot. It should be helping the bottom line of some other companies but in our economy where 70% of the driving force has been consumer spending, the only real benefit to the consumer so far has been lower gas prices. Food certainly hasn’t gone down at my local stores. And neither has any of my insurance costs or maintenance costs or paper or ink.
I for one am sorely tired of looking and waiting for something to happen. Not that I am dumb enough to buy any more stocks or bonds until things do revert. But this run up is ridiculous.
I do think that this time it will be different though with all the debt and leverage out there. I worry that things could be so chaotic that even the trucks might stop running as the ATMs may no longer function. That was one of the fears last time, way back in 2009, when GS and JPM threatened to crash the economy then. Seems that if the TBTF did fail and there wasn’t some pre planning by the government, which I doubt there is, then who runs/funds the credit card systems without which trucks don’t get fuel and then don’t run. I’m probably just being silly and stupid.
Stocks to the Moon! Get on board the train. The ride over the cliff will be such a rush!
Well, I have been wrong thinking the market will crumble in Sept or Oct this year as these 2 months are the worst for stocks historically not to mention the bubble which appear to pop. Nov and Dec are seasonally strongest time. Market appears to highs recently and bears like me feel dumber by the day.
That said who knows when the bubble will pop as black swan moments appear out of blue. The market’s long and strong momentum may take some real external shock(s). Looking back to 2008 – who though the bankster stalwarts like Lehman and Bear Stearns would go under not to mention AIG?
Sure would like to know everybody’s definition of “bad economy” is? I can’t see how it could possible get any better. What exactly is wrong? The top 1% are doing fantastic, the management-class (say the top 10%) is doing great, the introverted engineering-class (say the top 20 – 10%) are doing well enough, the bottom 80% haven’t mattered for generations but they are happy with their debt-fueled bling and blaming others for their miseries. How exactly can this be called “bad”? What would a “good economy” look like?
You are exactly right, but the methods used to achieve this nirvana are what’s wrong. The financial and corporate systems are corrupt with the justice system failing at the same time. The political system is a joke, the republicans and democrats are the same. All markets are manipulated. The police state is in full force. Our freedoms are being eroded daily.
If any person or group attempts to fix the broken pieces they are discredited, marginalized or eliminated.
Yes indeed, “EAT, DRINK AND BE MERRY FOR TOMORROW WE DIE.”
One small correction –
“after years of central-bank collusion to douse the worldrich with free money::
“I’m afraid that things could become so chaotic that even the trucks might stop running…” Ah my area of expertise. Truckers are the first to notice the sea change in an improving economy. Haven’t seen it yet- my company hunkered down, closed several terminals, reduced the remaining satellite terminals to skeleton crews and changed to serving big corporations that make necessities. Nothing has really changed since 2009 except the massive regulatory changes I noted earlier. We have stabilized for the moment. The drivers are getting older as a group as are all the blue collar trades. I keep emergency cash on hand in case the fuel cards we use go down, but if the whole net goes down the truckstop operators won’t be able to sell me fuel because the pumps are all computer controlled. The warehouses can feed a city for 3 days or so- if they run dry its Katy bar the door. Be afraid. Be very afraid.
Been thinking about rates, and I think with global growth slowing down (japan, Germany, perhaps England not raising rates). The Fed will never raise rates anytime soon, or if they do it won’t be a good idea (they can do that, bad ideas).
I think that 2016 bond implosion was based on raising rates setting the cascade off. But if growth keeps low, it might set off the implosion. Of course that will take some time, for it to continue to degrade.
Of course with the auto loan scheme could set off the American economy as well.
With banks getting their profits from mergers and acquisition as well as bond sales. They are tied to business and with growth slowing and the auto going bust business will be bad
The only thing that the central banks can’t control it seems is currency for the most part, it keeps slipping out when they try to print money to save the economy. So that could be the way things unravel as well, otherwise central banks will prop up the economy.
So perhaps, slow globa growth, auto loans popping, or currencies sliding out of control and hitting other currencies and what not.