People like stories that start with ‘once upon a time’ and lead up to the present. They are a pleasing way to explain how things came to be the way they are and if they strike a chord these stories find their way into the public consciousness. This is how myths develop and it is universal in humanity. Not all myths are true of course and the unscrupulous can create their own versions as the Nazis did with their tales of Aryan heritage and other leftist demagogues do when they explain how we are all victims of exploitation.
But it doesn’t take deliberate malice for a story to take on the status of myth – there is plenty of yearning for explanation in the world and any half-plausible idea is a candidate. There is one in current circulation right now about markets – it’s an origin myth and like all good ones it is appealing and is generally believed:
In the aftermath of the 2008 financial crisis, central bankers persuaded politicians of the need to flood the marketplace with money to avoid a repeat of the great US depression of the 1930s. In the years that followed this became a habit and today, 8 years later the tepid pace of economic activity has only just been maintained by repeated applications of tons of cheap money – mostly in the form of the giant open-ended ‘repos’ that are ‘Quantitative Easing’or ‘QE’.
Now it is thought, the positive effects of this have been getting less and less with each repetition and yet it is the only tool in the box so is used more and more bluntly around the world. In the meantime the reasons given for its continued use have shifted from saving the financial system to stimulating employment growth to encouraging a bit of inflation, which is apparently a healthy thing.
There has actually been plenty of inflation already, say critics but not the monetary sort – instead the price of financial assets has soared which explains why stock, bond and real estate prices are so high. This is the embedded assumption that we are here to question – stock and real estate markets have been so pumped up by central bankers that they are vulnerable to a big drop when this stage ends.
That’s the point - when does this end? What if it doesn’t?
For a while it looked as though various parts of the world were at different stages of the co-called economic cycle and so cracks began to show. The US stopped QE in 2014 and this was a sort of tightening. The UK had already stopped and both economies experienced some growth – nothing as spectacular as at the end of prior recessions but some nonetheless. The Fed hiked rates once late last year and the head of the Bank of England mused aloud that the UK might do the same. The dollar soared while stocks dropped sharply for several weeks.
Now, that tightening trend in the Anglosphere is in doubt. No-one cares much what the Bank of England does but the Fed has clearly been rattled and has recanted from its earlier position of wishing to keep raising rates. The international situation is cited as a major reason for this hesitation and the Fed has now specifically acknowledged that it is ‘behind the curve’ of economic developments. This is extraordinarily dangerous as it is precisely this inaction that has led to bubbles in the past. When the central bank to the world (which is what the Fed must now be considered, as so much international debt is denominated in $) allows itself to be swayed by poor economic performance outside the borders of the US then the world should worry. The function of the Fed is to act in counterpoint to the markets – to be encouraging when there is gloom and restraining when there is too much enthusiasm. See our various videos for how this translates into cycles, particularly the one linked here. When a feedback mechanism like this is removed, great pressures are unleashed.
There is a bigger point here and it is to do with weakness of resolve. The process by which free market capitalism has created so much wealth and freed so many from desperate penury is well-known to be one of creative destruction. Competition is at its heart and so there must be winners and losers. These come in bunches and the closure of failed businesses happens late in the downswing of the economic cycle. Their departure clears the way for newcomers with fresh vigour who then thrive and grow in the next upswing. Interfering with this by misguided attempts to avoid the painful part of the cycle puts the whole process at risk. This is why we hear so much about ‘Zombie’ companies that are staggering along with huge debt burdens that they can only support because of ultra-low rates. They should have vanished by now to make way for a new generation.
This reluctance to inflict pain even on these diseased remnants is at the heart of the Fed’s reluctance to raise interest rates to an appropriate level. This might be understandable if the US economy were faltering but it is growing fairly well – the weakness is elsewhere and so the Fed dithers. There will probably be more problems in the months and year to come – much of Europe is burdened with a dysfunctional currency and worse governance, China is struggling to keep growth going without unleashing their new middle class as a political force and the Middle East is already in flames. Japan seems incapable of renewal and South America remains South America. None of these looks likely to experience brisk economic recovery at any time soon, so we should probably look forward to yet more excuses for keeping rates low from the Fed. Other central banks are already persuaded that only they can save the world by keeping rates effectively negative, so maybe the Fed will not be the odd one out for much longer.
So, what happens next? A bubble now seems likely to form. Despite some alarmism, equity prices in the US are not dangerously high as measured by the 10-year trailing P/E method endorsed by Robert Shiller so there is room for some upward movement. Even if prices were very high they can still go higher of course - that is the nature of a bubble.
We have been neutral about the medium and long-term prospects for equities for some time. Our shorter-term view is conditioned by the daily-scale signals that we see and interpret, the most recent of which have all been top extensions, starting in early March and continuing until just over a week ago – see the HEDlines archive. These have all pointed to a short-term pause or reversal of the uptrend but there are conflicting signals at longer time-frames. Briefly, prices have broken up from weekly-scale compressions in several important indices but have been restrained from further gains by these daily-scale top extensions and by some older weekly-scale compressions just around here that have provided resistance:
There is little more resistance available to restrain further upward movement so we will be looking to cover existing tactical shorts and find places to position on the long side for this possible bubble. We regard this as a high-risk strategy as the increase in volatility that will probably accompany a new bubble could be extreme, especially as (and if) it reaches the later stages.