There Is No Asset Bubble?
As I was researching, and writing, this past weekend's weekly newsletter entitled "The Bernanke Factor" what really struck me was the universal belief by the majority of analysts, economists and commentators, that there is currently "no evidence" of an asset bubble. This idea was further confirmed by Bernanke's testimony last week he explicitly stated:
"I don't see much evidence of an equity bubble"
His prepared statement also touched on the same:
"Another potential cost that the Committee takes very seriously is the possibility that very low interest rates, if maintained for a considerable time, could impair financial stability. For example, portfolio managers dissatisfied with low returns may 'reach for yield' by taking on more credit risk, duration risk, or leverage...Although a long period of low rates could encourage excessive risk-taking, and continued close attention to such developments is certainly warranted, to this point we do not see the potential costs of the increased risk-taking in some financial markets as outweighing the benefits of promoting a stronger economic recovery and more-rapid job creation."
The common theme between Bernanke's comments, and the majority of analysts and economists, is corporate profitability. As Neil Irwin recently penned:
"But there's good evidence pointing to this [an equity bubble] not being the case. The key thing to know is that American businesses have spent the last four years becoming much more profitable."
However, looking at corporate profitability in a vacuum can be a bit misleading. Today, there are contributing factors to corporate profitability that did not exist previously such as the change to FASB Rule 157 which changed mark-to-market accounting, the excessive use of loan-loss reserves and other accounting gimmickry. Regardless, what is more important than the level of profits is the relative growth trend of those profits. The chart below shows top line sales versus reported and operating earnings. The last two major market peaks have coincided with earnings topping, and beginning to weaken, much like we are seeing currently.
While the level of corporate profitability is certainly important - corporate profits are more of a reflection of the issues that have historically led to asset bubbles. Increases in leverage, speculative investing and the push for yield, as identified in Bernanke's testimony, are more attributable to historic asset bubbles from the peak in 1929, the technology bubble in 2000 or the housing bubble in 2008. For example, the housing bubble that started in 2003, which was built around excess credit and leverage as homes were turned into ATM's - led to a surge in corporate profitability and economic growth. However, the growth of corporate profitability did little to deter what happened next.
Following The Sign Posts
So, instead of corporate profitability, which is already showing signs of stress, we should be focusing on the areas identified by Mr. Bernanke in his recent testimony: leverage, speculative risk taking, and the reach for yield. These data points could provide much needed clues as to where, as investors, we are in the current cycle and what the potential risks are that lie ahead.
Sign Post #1 - Leverage
The downfall of all investors is ultimately "greed." Greed can be measured not only emotionally by looking at bullish versus bearish sentiment indexes but, more importantly, how much leverage investors are taking on. The chart below is the amount of margin debt by investors overlaid against their relative positive or negative net credit balances.
With both margin debt and negative net credit balances reaching levels not seen since the peak of the last cyclical bull market cycle it should raise some concerns about sustainability currently. It is the unwinding of this leverage that is critically dangerous in the market as the acceleration of "margin calls" lead to a vicious downward spiral. While this chart does not mean that a massive market correction is imminent - it does suggest that leverage, and speculative risk taking, are likely much further along than currently recognized.
Sign Post #2 - High Yield Chase
When investors have little, or no, fear of losing money in the market they begin to seek the things with the greatest returns. Over the last few years the chase for yield, due to the Bernanke's consistent push to suppress interest rates, has driven investors into taking on additional credit risk to increase incomes. The chart below is the BofA Merrill High Yield (aka Junk Bond) Index.
The chart shows that, as opposed to Bernanke's statement, investors are rapidly taking on excessive credit risk which is driving down yields. With those yields now at historic lows there is little margin for error either in the credit markets or the economy.
Sign Post #3 - Reduced Translation Into Economic Growth
While Bernanke is hoping for stronger economic growth in the near future his real concern has been the effect of diminishing returns on each monetary program.
Since Q4 of 2008 the real economy has grown from $12,883.5 billion to $13,656.8 billion as of Q4 2012. This is a total of $773.3 billion in growth over the last four years or $193 billion per year or roughly about a 1.5% growth rate. During this same period, the Fed has injected roughly $5 for each dollars' worth of economic growth. This cold hardly be considered a great return on investment.
As opposed to Bernanke's statement that increased risk-taking are okay as long as such risks are outweighed by"the benefits of promoting a stronger economic recovery and more-rapid job creation," it appears that such a progression is not the case. As we have seen with virtually every indicator - economic activity peaked in 2010. Since then, even with the input of global stimulus, the rate of economic growth has weakened as shown in the chart below.
Risks Of Recession Have Increased
With Q4-2012 GDP running at statistically zero - the impact of the payroll tax hike (effectively about a $125 billion hit to consumers), higher gasoline and energy costs, and the impact of further cuts to government spending due to the sequester, put an already weakening economic growth trend at further risk.
Don’t misunderstand me. As we wrote last week - it is certainly conceivable that the markets could attain all-time highs. The speculative appetite combined with the Fed’s liquidity is a powerful combination in the short term. However, the increase in speculative risks combined with excess leverage leave the markets vulnerable to a sizable correction at some point in the future.
The only missing ingredient for such a correction currently is simply a catalyst to put "fear" into an overly complacent marketplace. There is currently no shortage of catalysts to pick from whether it is further fiscal policy missteps stemming from the upcoming "Debt Ceiling" debate, a resurgence of the Eurozone crisis, or an unexpected shock from an area yet to be on our radar.
In the long term it will ultimately be the fundamentals that drive the markets. Currently, the deterioration in the growth rate of earnings, and economic strength, are not supportive of the speculative rise in asset prices or leverage. The idea of whether, or not, the Federal Reserve, along with virtually every other central bank in the world, are inflating the next asset bubble is of significant importance to investors who can ill afford to once again lose a large chunk of their net worth.
It is all reminiscent of the market peak of 1929 when Dr. Irving Fisher uttered his now famous words: "Stocks have now reached a permanently high plateau." The clamoring of voices that the bull market is just beginning is telling much the same story. History is repleat with market crashes that occurred just as the mainstream belief made heretics out of anyone who dared to contradict the bullish bias.
Does an asset bubble currently exist? Ask anyone and they will tell you "NO." However, maybe it is exactly that tacit denial which might just be an indication of its existence.