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How to Get Rich Investing in Stocks by Riding the Electron Wave

The Problem Is the Stock Market Bubble, Not the Pin

Stock-Markets / Stock Markets 2020 Mar 04, 2020 - 01:27 PM GMT

By: Peter_Schiff

Stock-Markets

With the markets shell shocked by of the worst weeks on record, analysts are split on whether investors are simply overreacting to the coronavirus epidemic or if we are confronting an actual existential threat to the global economy. While most epidemiologists caution that the virus will be nearly impossible to contain, the good news is that it may be far LESS lethal than many of the contagions that we have comfortably lived with for years. When the panic and uncertainty subside, we may just end up with a new strain of influenza that will harass humanity seasonally, but will not meaningfully alter the course of global economics. But this is not really a story about a new biological disease, it's one about an old financial disease that is finally becoming symptomatic.

The truth is that the Dow at nearly 30,000 had been priced to perfection and was particularly vulnerable to any surprise "black swan" event, no matter how virulent. In this case, it's not the size of the pin that is causing the damage, but the size of the bubble the pin has pricked.


Up until the pandemic fears really took hold a few weeks ago, investors were largely unconcerned about the oversized increases that occurred over the prior 14 months. From a low in December 2018 to the high in February 2020, the Dow rose a stunning 35%. While it's true that this performance began after a sharp sell-off in November and December of 2018, it's important to recall that those declines were perfectly justifiable given the situation at the time. In October of 2018, yields on 10-year Treasury bonds had surged past 3%, the highest rate in nearly a decade. This forced investors to factor in the costs to over-leveraged businesses, consumers and federal and state governments of dealing with more expensive credit, a reality that had been hidden for years by ultra-low interest rates. It's not an accident that the decline only ended when investors were soothed by the Fed's total abandonment of its prior commitments to tighten policy.

Since then, the market has drifted upward sharply, buoyed by every seemingly positive development. Further dovishness from the Fed, in which it ended its balance sheet reduction campaign, injected hundreds of billions into the credit markets, and actively cut rates faster than the markets had predicted were the primary factors. But markets were also helped by some positive (but minor) resolutions in the trade war, and the failures of the Democrats' impeachment gambit, which made Trump's 2020 reelection more likely. Negative developments, like the spike in public debt and deteriorating global trade, were ignored.

But the surprise coronavirus, like the spike in long rates in 2018, forced investors to confront risks that were actually lurking in plain sight the entire time. Even if the virus scenario plays out to be relatively benign, the short-term hit to businesses that are increasingly dependent on global supply chains, travel, tourism, and transportation will be showing up very quickly and may likely make a meaningful impact on quarterly results. In a market priced as if nothing bad would ever happen, these questions are proving to be too much to bear.

And it's not as if the markets are expecting good news to come from other areas. There are no political, diplomatic, or economic breakthroughs that anyone expects anytime soon. Predictably, many investors may be assuming that the Fed will ride to the rescue as it has in the past. The current consensus, according to the Wall Street Journal's Daily shot Newsletter, is that the Fed will cut rates by a half point by its March meeting, and then follow that with another quarter point or two by September.

These expectations are fully justifiable. Since the Crash of 2008, the Fed has never failed to sooth market tantrums with fresh stimulus. But, as none of these prior efforts have been significantly reversed, the task of stimulating yet again becomes ever more difficult. The Fed has already cut rates three times in the past year, abandoned its policy of balance sheet reduction, and has actively injected hundreds of billions into the credit markets in the last few months. There's not much ammunition left in the chamber.

In his coronavirus press conference, President Trump himself jumped hard into the stimulus bandwagon, essentially demanding that the Fed add a new weapon to its arsenal: negative interest rates. Although Trump admitted that getting paid to borrow money is a bizarre concept, he urged the Fed to do it. No matter that negative rates have done nothing to fix economic problems in the countries where it has been used. In the coming weeks, I expect Trump's increasingly pointed rhetoric will have an effect and that the Fed will acquiesce and give Trump the cuts he wants. And while the Fed may never actually get to negative nominal rates, a return to zero will certainly push down the dollar and perhaps ignite a rally in gold, but there is no evidence that it will do anything to help the economy. And if the Fed does in fact go negative, the damages that such an insane policy could create are hard to quantify.

At his press conference Trump was also happy to put forward the idea that the market sell-off is not just a result of the virus, but also a reaction to the possibility that Bernie Sanders, an avowed socialist who plans to push policies that are overtly hostile to business owners and investors, could become the President of the United States. As unlikely as that outcome now appears, the possibility can't be dismissed. In fact, it could become a self-fulfilling prophecy.

The more the markets fall, the weaker the Trump economy appears, undercutting his biggest selling point for reelection. The President has done himself no favors by consistently taking credit for the stock market rise. So, any further stock market declines increase the likelihood that Sanders wins in November, which in turn pushes stocks down even further, creating a vicious cycle that could get very nasty.

Of course, the Fed's mandate says nothing about pushing up stock prices. Investors have reaped unprecedented paper gains in the past decade, and they should be prepared to give back some of this easy money. But the Fed knows that our economy is far more dependent on asset prices than it has been in the past. Steadily rising stock prices over the past decade, spurred by Fed stimulus, created a "wealth effect" that increased spending and heightened consumer and business confidence. Falling stock prices will create the opposite. Absent any other positive inputs, it's safe to assume that if stock prices continue to fall a recession is likely to follow. In the Fed's mind, moves to protect the stock market should be taken simply to prevent a broader economic contraction.

The big risk is that the markets keep falling despite dramatic action from the Fed. If that occurs, investors will finally realize that there is nothing between them and catastrophe. At that point, rather than let the economy enter a long overdue recession, look for the Fed to do even more of the things that have failed to work in the past.

If the U.S. economy really were healthy, it could shake off a case of coronavirus. But because the Fed has artificially stimulated so much during past recessions, I believe the economy is particularly vulnerable. By cutting past recessions short, the Fed prevented the resolution of the imbalances that caused those recessions in the first place. Instead, it made debt bubbles larger, so we will enter our next recession with unprecedented levels of debt.

In such a vulnerable position, the slightest downturn might be catastrophic. Any interruption in corporate earnings or weekly paychecks might lead to unprecedented debt defaults, and a worse financial crisis than 2008. So, the Fed will be doing all it can to once again delay the day of reckoning by making all the problems we need to reckon with larger.

As business revenue falls, variable expenses may have to be cut to meet fixed overhead and service excessive debt loads. Labor costs may likely be the first to be cut. But as workers living paycheck to paycheck lose theirs, they won't be able to pay their bills or service their debts either. A vicious cycle of default, layoffs, and bankruptcies might begin, plunging the economy into a worse recession than 2008, and perhaps putting Sanders in the White House to pour gasoline on the fire.

But the larger problem is that if the coronavirus ends up closing factories and disrupting supply chains, the quantity of goods produced and available for sale will decline. But since rate cuts and QE merely increase demand by increasing the supply of money and credit to buy goods, we will end up with much more money chasing a dwindling supply of goods. This is a recipe for inflation. As consumer prices rise, so too will inflation premiums on bonds. Instead of falling consumer prices and interest rates that have provided relief in prior recessions, rising consumer prices and interest rates will make the next recession that much more painful.

Read the original article at Euro Pacific Capital

Best Selling author Peter Schiff is the CEO and Chief Global Strategist of Euro Pacific Capital. His podcasts are available on The Peter Schiff Channel on Youtube.

Regards,
Peter Schiff

Euro Pacific Capital
http://www.europac.net/

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