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Trading Lessons

Stocks Bull Market or Hyperinflationary Market?

Stock-Markets / Stock Markets 2018 Jan 31, 2018 - 04:26 PM GMT

By: Raymond_Matison

Stock-Markets

More than a decade ago several insightful people recognized that the bond market as it related to the then AAA rated mortgage backed bonds was a well-crafted illusion.  The eventual default in these bonds fostered a market meltdown which was within hours of totally freezing up markets, creating a global financial crisis.  The stock market reflected this crisis by the Dow Industrial Index declining from 16,437 in October of 2007 to 8,207 in February of 2009, a 50% decline in less than a one and half year period.


There were many prudent observers who, after the fact, brilliantly explained the reasons building up to the crisis.  It was observed that incomes for workers, on an inflation adjusted basis, had not gone up since the early 1970’s.  For people to maintain their expenditure level and previous life-style, it was argued, consumers borrowed money from equity in their homes.  Alas, when the borrowing reached a certain limit, they could neither borrow more nor service that debt, and it started mortgage defaults and its resulting crisis in the mortgage bond market, eventually spreading and encompassing broader markets.

In order help recover from this financial abyss, the Federal Reserve flooded banks with an unimaginable amount of fiat money.  The banks themselves were failing and needed bailing out, and the FED did not disappoint.  Indeed they created so much liquidity, that they even bailed out major banks in Europe – in total creating trillions of dollars.  The stock market started recovering, and over time reached into record price territory.  The long-held market wisdom of “don’t fight the FED” was reaffirmed once again.

Central bank intervention in our economy now spans more than a century.  One constant of their policy is to print more money every year.  While the annual rate of such inflation over a few short years appears hardly worth paying attention to, the power of compounding these rates since its inception has reduced the original purchasing value of a dollar in 1913 to just about three cents today.  It was understood that accelerating money growth generally brings lower interest rates, which with easier access to credit then provides stimulus for an economy.  Contrariwise, a slowdown in money expansion, or a rare decline in money supply, would raise interest rates making credit more expensive, and slow an economy.  This has been the FED’s standard policy since its founding, and our economy generally has tended to respond more or less in expected fashion to their actions. 

But this time it is different!  The continued policy to encourage people to borrow more money, start some business venture or otherwise spend savings, thereby stimulating the economy, only works when people are not at or beyond their financial capacity to assume additional credit.  The FED can create all the money it wants, lower interest rates to or below zero, but if consumers are at or beyond their limit to take on more debt, then the FED’s policies cannot and will not work.  That is where we have been over the last decade, and where we remain today.

The consumer could not take on more debt in 2008, and therefore he could no longer spend as much, nor help to stimulate our generally acknowledged consumer-driven economy.   To avert an economic recession, the government had to pick up the slack in consumer expenditure by increasing government spending.  Our government does not have any savings of its own, so when it spends more than it receives in taxes, which essentially is every year – it can only do so by borrowing that money by issuing more debt.  So over the last decade the government has borrowed and spent at a level which now places every citizen in debt bondage – since sovereign debt is serviced and repaid by taxing citizens.   This debt has been increased without the acquiescence or approval of the common citizen, and is now also at a level that even limits the government’s ability to borrow in the future.  The government will find that the interest rate to their increasingly less secure debt will rise dramatically, and eventually it will not be able to borrow at all - requiring a financial reset of the dollar, or a change in our monetary system.

In their book published in 2009, “This Time is Different” authors Carmen Reinhart and Ken Rogoff did an exhaustive study of covering 250 external sovereign country and 68 cases of domestic public debt defaults in the 1800-2009 period.  Their data showed that “default often occurs at levels of debt well below the 60% ratio of debt to GDP enshrined in Europe’s Maastricht Treaty, a clause intended to protect the euro system from government defaults.”   More recent defaults covering the 1970-2008 period showed that the average ratio of debt to GDP was 69.3%.  At this time all developed countries are substantially above this ratio, including the United States.  With and expected GDP for 2017 of about $19 trillion, and a debt of over $21 trillion, that ratio for the U.S. is in “danger alert” territory.  Acknowledging the effect of Federal Reserve’s persistent increase in the nation’s money supply over long periods on destroying consumer purchasing power, the authors observe that “Following the rise of fiat (paper) currency, inflation became the modern-day version of currency debasement.”

It is interesting that the Chinese rating agency Dagong has recently awarded U.S. Treasury securities an investment bond rating of BBB+, two notches above noninvestment or junk bond grade.  Of course our politicians point out that such a rating is “politically” motivated.  Moody’s and Standard & Poor’s ratings rate our own Treasury debt as AAA and AA+ respectively, essentially their very highest rating.  Of course Moody’s rating of Chinese debt as A1 is also likely politically motivated.  Indeed Moody’s and Standard and Poor’s ratings of our own Treasury debt may actually be politically motivated.  These agencies exist at the licensing pleasure of our government, and if they rated Treasury debt as their rating formulas really call for, they could endanger losing their license to remain in business.  So don’t wait for the rating agencies to warn you as to when our Treasury debt is no longer investment grade.

Since those now seemingly innocent years of the last financial crash, most of the financial metrics are worse than they were ten years ago!  However one metric, that of the stock market, apparently suggests that our economy is just booming.  Yes, the Dow Jones Industrial average is rising into ever higher record territory, now exceeding 26,000 - and this market is called a bull market.  A bull market?  Really?  More likely, that is just a bunch of bull.  Would investors still call it a bull market if the Dow rose to 50,000 by the end of 2018?  What if it rises to 100,000?

With regards to the real economy, it truly is consoling to see that our current president is not only intent on improving citizen job opportunities and wages, but has the skill to actually deliver on those goals.  It is equally great to see him engaging world business leaders at the Davos conference, and selling America as a great place to do business.  His actions will have positive consequences for our economy.  

More business means higher incomes, and results in higher government tax revenue. This is what can be referenced as elements affecting the income statement side of the country.   America is moving in the right direction.  But then there is also the balance sheet side to this consideration.  Our debt is expected to increase another $10 trillion over the next decade because of tax reduction legislation, and increased military and infrastructure spending.  That will continue to raise the debt/GDP ratio to an even more dangerous level.

So as the market is responding to all the positive things this well-intentioned and successful president is doing for America, the stock market should continue to rise.  So is this still a bull market?   At what time do investors start to conceive that the rise in the stock market is not due the nation’s improving income statement, but rather that our dollar currency is rapidly losing its value?  So if the stock market were to rise to 50,000 by the end of the year, one could argue that it is not a bull market but a dangerous signal of an emergent hyperinflationary market.  It would mean that the ebullient feeling from a record high Dow, is likely mitigated by a reality that your favorite serving of cappuccino or latte now cost more than twenty dollars.  Caveat emptor!

The FED has already raised interest rates modestly, and has signaled its intent to raise them even more over time.  Remember that the effect of such a policy would be to slow an economy, raise the cost of credit, and thereby reduce the value of our bond and equity markets.  In addition, higher interest rates would likely crash financial derivatives which together with the higher rates would undermine faith in our fiat dollar system, evaporate bank capital making them once again insolvent or bankrupt.  Our modern electronic financial interconnectedness will add a new meaning to the words “global crisis”.  This is a good time to remember that sage advice of not fighting the FED.  Tighten your seat belts, it is going to be quite a ride.

Raymond Matison

Mr. Matison was an Institutional Investor magazine top ten financial analyst of the insurance industry, founded Kidder Peabody’s investment banking activities in the insurance industry, and was a Director, Investment Banking in Merrill Lynch Capital Markets.   He can be e-mailed at rmatison@msn.com

Copyright © 2018 Raymond Matison - All Rights Reserved

Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilizing methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a

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