Color me dubious

 

On 18 October 2024, the following commentary was in Bloomberg News:

 

For Wall Street skeptics and diehard members of Team Recession, there’s always some evidence to support their grim prognostications. And while they’ve been proven wrong time and again by an effervescent US economy, right now equity valuations are indeed stretched, corporate bond spreads are tightening and gold is at a record. As a result, there’s been a rush of late to options and other instruments designed to protect gains. But alongside this burst of prudence is a vocal subset of managers who… say there’s reason to believe it’s still early in the bull run for risky assets.

David E. Rovella

 

As an unabashed member of “Team Recession” – and, more accurately, “Team Asset Bubble” – I confess it has been difficult to stay the course since the summer months when my tea leaves first signaled a market correction was in the offing.

I first sounded alarm bells in my 27 June 2024 article published by ECAEF under the title, “Irrational Exuberance,” which highlighted what I believed were troubling trends surrounding market valuations in general, and consolidation among the “Magnificent 7” – Apple (AAPL), Microsoft (MSFT), Google parent Alphabet (GOOG), Amazon.com (AMZN), Nvidia (NVDA), Meta Platforms (META) and Tesla (TSLA) – specifically.1

In my previous article, I argued that the market was entering (if not already in) an AI-bubble because of cheap money (aka, lose monetary policy), the herd mentality of Odd-Lots suffering from “FOMO” (fear of missing out), and the fact that investors were failing to fully price in the pernicious threats of inflation and high global debt balances. Since I wrote that article, my views haven’t changed.

It bears mentioning that my previous article wasn’t an attempt to “call the top.” Rather, it was intended to be a proverbial shot across the bow for investors who were taking on inappropriately high levels of risk2 – risk that not only remains, but is also rapidly increasing. With the benefit of hindsight, it is obvious that Mr. Market wasn’t ready to capitulate this summer. The bulls simply had too much momentum behind them.

While much of that momentum remains, the blush is beginning to come off the rose – the U.S. 10-yr Treasury Bond’s yield has risen 15% over the last month alone. And, of course, as has been widely touted across the popular press, the S&P 500 is up 11% from the beginning of July and 23% YTD. But, like any devoted near-perma-bear and eternal skeptic, I am unfazed by the recent months of stock euphoria. In fact, I’m doubling down. A crash is waiting at the end of this AI-fueled lovefest, not a pot of gold.

Actually, gold may be the only asset worth owning when all is said and done. Pundits are calling $2,700/oz just the beginning, with luminaries such as Peter Schiff talking about $4,000/oz being realistic. Maybe. Maybe not. Given the upward pressure central banks are putting on spot prices, it could happen – especially since inflation is lurking. Still, $4k seems a bit of a stretch.

“Calling the top” – like “calling the bottom” – is all but impossible except in hindsight. Just as I didn’t intend to make that call in my previous ECAEF article, I am not doing so here. I’ve been around markets for more than a few years now, and I’m neither stupid nor arrogant enough to plant a flag and announce, “The end is nigh.”

What I am more than comfortable doing is to highlight certain trends – various data points – that should cause even the most ardent bull to question how sustainable the current slough of uninterrupted gains can last. Evidence continues to pile up in support of an upcoming pull-back. Maybe not tomorrow. Maybe not next week. But with each tick higher, the probability of a downward move increases ever so slightly, as does the potential damage resulting from a correction of significant magnitude.

I won’t presume to speak for all of Team Recession – or Team Asset Bubble – but for me, the most telling evidence that the emperor is naked involves the vicious combination of the weak state of households’ finances and macroeconomic factors.

Household balance sheets have rarely looked worse. Individuals are holding much higher levels of unsecured debt with far lower savings than they historically have. Adding additional risk to this already tenuous situation, individuals are showing a greater appetite for equities than usual, even though nearly 60% of Americans apparently believe the economy is already in a recession.

According to the Federal Reserve Bank of New York (FRBNY), credit card debt now totals $17.8 trillion, having increased by $77b in 2Q 2024.3 At the same time, “approximately 9.1% of credit card balances and 8.0% of auto loan balances transitioned into delinquency.”4 In concert with the decline in credit health, household savings balances and rates have declined precipitously – the Bureau of Economic Analysis (BEA) reports that U.S. savings rates have fallen by more than 85% since 2Q2020.

So, where has the money gone? Why are individuals seemingly having such trouble with their finances? There are three primary underlying causes, none of which is encouraging, and one of which is both particularly germane to this article and downright frightening.

The first cause is debt service: Americans are being forced to spend increasing amounts of their income and savings on debt service (and occasionally, debt retirement). Second, inflation has hit consumers particularly hard, with medical care, transportation (although not energy), and housing leading the way, followed closely by food.

However, the third cause is perhaps the greatest reason for concern: Americans are investing more of their money. There are many arguments why increased equity ownership is a good thing… However, buying into a bubble when equity prices are at elevated levels is dangerous, full stop. And that is exactly what households across America have been doing. Over the last two years, the number of households that own stocks (including ETFs, mutual funds, and the like) has increased approximately 10%. Today, slightly over 60% of U.S. households have direct exposure to the stock market.5

Naturally, such enthusiasm meets with very willing enablers, as headlines trumpeting “Market Hits Record High” helps attract viewers and financial advisors/RIAs eager for fees/commissions are only too happy to parrot the standard lines about how AI is going to remake the world, that “this time really is different,” and that investors shouldn’t worry about fundamentals and macroeconomics because “the ‘old rules’ no longer apply.” If all this sounds very familiar to you, it should… This is not the first time investors have clamored for a ticket to this show, and it won’t be the last.

The situation is, in short, one where the Joneses are leveraged to the hilt and heavily invested, which is just peachy, right up to the point where asset prices begin to fall and investors panic and run for the exit simultaneously.6 Naturally, of course, the Joneses have a well-diversified portfolio that is not too overexposed to the Magnificent7… Oh, wait…

As if individuals weren’t putting themselves in precarious enough positions, the American government seems to be doing everything it can to make matters worse. The combination of protectionist posturing by presidential candidates who seem to be in a race to show which one of them can be crowned the most xenophobic isolationist and a Congress bent on doling out pork is adding gasoline to the catastrophe of Jerome Powell’s FOMC reactionary, hummingbird- on-amphetamines decisions. And of course, these glorious trends are taking place while the U.S. government – to say nothing of China’s – is running frightening deficits with staggeringly unbalanced budgets.

There is, of course, considerable debate about the relationship – particularly the causality – between politics and the performance of asset markets. To be sure, there is considerable variance of such a relationship over time. But it is undeniable that both government fiscal and
trade policies, and monetary policy enacted by the Federal Reserve, have a marked impact. As Ludwig von Mises poignantly noted:

 

The boom brought about by the banks’ policy of extending credit must necessarily end sooner or later… The longer the period of credit expansion and the longer the banks delay in changing their policy, the worse will be the consequences of the malinvestments and of the inordinate speculation characterizing the boom; and as a result the longer will be the period of depression and the more uncertain the date of recovery and return to normal economic activity.7

 

Or, as Auburn University Professor Roger W. Garrison summarized, “The Austrian theory of the business cycle emerges straightforwardly from a simple comparison of a savings-induced boom, which is sustainable, with a credit-induced boom, which is not.”8 Friends, as I highlighted earlier, we are most decidedly not in “a savings-induced boom” – household savings are far too anemic.

The distinction between a credit- and savings-induced boom is critical, not only with regard to macroeconomics, but also for financial markets. While equities are booming, bond markets have been waving caution-flags for some time, with the sell-off in U.S. Treasuries (and other dollar-denominated bonds) recently picking up steam. The U.S. government’s 10 Year Bond is yielding nearly 4 ¼%, an increase of 11% since the beginning of October, with term premiums moving higher and the MOVE Index spiking. Perhaps even more troubling for households/consumers, U.S. 30-year fixed mortgages are now over 7%, the first time they have been that high since April of 2002.

To be sure, companies are posting healthy profits. The recent batch of earnings announcements by large-cap financial firms is but one indication – Goldman Sachs (GS), Morgan Stanley (MS), Synchrony Financial (SYF), and U.S. Bancorp (USB) all reported double-digit YoY growth of net income, as did Discover Financial Services (DFS) and AmEx (AXP). And everyone on the planet is of course familiar with the great AI miracle, which is lifting the likes of NVDIA, APPL, AMZN, and others to market caps that deserve a new moniker for whatever comes after “mega-cap.”9 With unemployment seemingly under control, and market momentum only pointing up, it is not surprising that so many people are so very bullish.

The simple fact is that this party can’t last forever… The path that America is going down – and, in fact, most of the rest of the world’s developed economies – is simply unsustainable. To employ the oft-used-but-still-apt metaphor, the hangover from drinking too much spiked leverage punch is going to be damned awful.

Whether a market correction leads to an actual recession is another, larger question. But, given the number of troubling macro trends and household poor financial situations, it seems likely that a significant market pull-back will have disproportionately broader ramifications than messing up the Joneses’ Holiday plans for a vacation in Italy or Junior’s 529-plan. Just how robust do we think the “Powell Put” is? Will Jerome and his fellow governors be able to deliver given where rates currently stand and the size of the Fed’s balance sheet? Color me dubious.

 

ECAEF Ambassador William (Bill) Waite is an investment banker specializing in private and public company valuation.


 

 

1/ As of the date of this article, the ten largest stocks in the S&P 500 constitute 36% of the index’s value, with the largest stock (AAPL) a whopping 750x larger than the 125th company’s market cap, a substantial increase from what I previously assessed – and still certainly believe – were dangerously high levels of concentration.
2/ Many investors unknowingly have taken on elevated levels of risk resulting from owning ETFs or mutual funds that are intended to provide “broad exposure to ‘the market,’” but are now, because of the way the S&P 500 is constructed, causing disproportionate exposure to technology.
3/ Quarterly Report on Household Debt and Credit. https://www.newyorkfed.org/microeconomics/hhdc
4/ https://www.newyorkfed.org/newsevents/news/research/2024/20240806
5/ https://news.gallup.com/poll/266807/percentage-americans-owns-stock.aspx
6/ There are hundreds of books that deal with the dynamics of asset bubbles, from how they form, to why they burst, to the steps governments take to intervene and attempt to stave off a bloodbath. And of those hundreds, there are many that a very good. One of the better ones that I recommend is Robert Bruner and Sean Carr’s book, The Panic of 1907: Heralding a New Era of Finance, Capitalism, and Democracy.
7/ From the Mises Institute’s recent publication, The Austrian Theory of the Trade Cycle and Other Essays, which is an excellent collection of material edited by Richard Ebeling. (https://mises.org/library/book/austrian-theory-trade-cycle-and-other-essays)
8/ https://webhome.auburn.edu/~garriro/a1abc.htm
9/ Tesla’s (TSLA) stock rallied 14% after its FY3Q earnings call – a response that typifies the kind of wild, reactionary market environment we’ve in. For perspective, TSLA’s 14% move translates into more than a $100 billion (from $735b to $838b) increase in market cap, an amount approximately equal to the 2023 GDP of either Angola or Guatemala.

 

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