I was listening to one of my favourite bands, The Smashing Pumpkins, over the weekend. And it struck me that the opening chorus to “Bullet With Butterfly Wings” is probably how noted stock market bears around the globe feel right now after the massive rally from the October lows and the BoJ’s extra stimulus on Friday which sent stocks and the US dollar much higher.
In “Bullet With Butterfly Wings” lead singer Billy Corgan opens up with haunting lyrics:
The world is a vampire, sent to drain
Secret destroyers, hold you up to the flames
And what do I get, for my pain?
Betrayed desires, and a piece of the game
So I wondered what John Hussman would have to say in his weekly market commentary today and how he might deal with the obvious correlation between free money and the stock market rally.
Hussman may be a noted bear but that doesn’t mean he is wrong.
Indeed, when you’re writing about macro issues, which take months and years to play out in a micro time frame such as every seven days, as Hussman is, your message will be received according to the latest market moves, trends and fashion.
So even cogent arguments for the future can be lost in the noise of the present.
Which brings me to Hussman’s Ponzi argument.
At present, the entire global financial system has been turned into a massive speculative carry trade. A carry trade involves buying some risky asset – regardless of price or valuation – so long as the current yield on that asset exceeds the short-term risk-free interest rate. Valuations don’t matter to carry-trade speculators, because the central feature of those trades is the expectation that the securities can be sold to some greater fool when the “spread” (the difference between the yield on the speculative asset and the risk-free interest rate) narrows. The strategy relies on the willingness of market participants to equate current yield (interest rate or dividend yield) with total return, ignoring the impact of price changes, or simply assuming that price changes in risky assets must be positive because low risk-free interest rates offer “no other choice” but to take risk.
The narrative of overvalued carry trades ending in collapse is one that winds through all of financial history in countries around the globe. Yet the pattern repeats because the allure of “reaching for yield” is so strong. Again, to reach for yield, regardless of price or value, is a form of myopia that not only equates yield with total return, but eventually demands the sudden and magical appearance of a crowd of greater fools in order to exit successfully. The mortgage bubble was fundamentally one enormous carry trade focused on mortgage backed securities. Currency crises around the world generally have a similar origin. At present, the high-yield debt markets and equity markets around the world are no different.
It might be easy to dismiss the above theory as the thesis of a perma-bear but the economic reality in which it is grounded is far more solid.
Think of the slow pace of economic transition in Australia at the moment, think Japan for two decades and think Europe’s present and future.
As the central bank creates more money and interest rates move lower, people don’t suddenly go out and consume goods and services, they simply reach for yield in more and more speculative assets such as mortgage debt, and junk debt, and equities. Consumers don’t consume just because their assets have taken a different form. Businesses don’t invest just because their assets have taken a different form. The only activities that are stimulated by zero interest rates are those where interest rates are the primary cost of doing business: financial transactions.
To reiterate Hussman says:
What central banks around the world seem to overlook is that by changing the mix of government liabilities that the public is forced to hold, away from bonds and toward currency and bank reserves, the only material outcome of QE is the distortion of financial markets, turning the global economy into one massive speculative carry trade. The monetary base, interest rates, and velocity are jointly determined, and absent some exogenous shock to velocity or interest rates, creating more base money simply results in that base money being turned over at a slower rate.
Now, Hussman might be writing about how stock valuations are stretched and cannot be sustained in the longer term but the economic thesis which he has discussed in this week’s article is exactly the issue Japan has faced for decades and which Australia and the rest of the developed world may be facing.
You can read the entire weekly commentary here