Mr. Market, Meet Mr. Trouble
Dow down 35 yesterday. Gold up slightly. A dull day on Wall Street, with investors holding onto most of Tuesday’s gains.
Here’s another record that was broken recently…
In the late 1970s, Michael Milken persuaded his boss at Drexel Burnham to let him start a high-yield bond trading department. (High-yield bonds are non-investment grade bonds that carry high default risk. Hence their nickname: “junk bonds.”) Soon, Milken’s trading department started earning a 100% return on investment.
The junk-bond market was tiny – with total issuance only rising to about $30 billion in the mid-1980s. Milken was right about junk bonds being hugely profitable. But that didn’t stop the feds from putting him in jail in 1990 on six counts of securities and tax fraud. (Milken didn’t just stop at legitimate means of making money in the high-risk world of junk bonds.)
Nevertheless, the junk-bond market continued to grow. At the end of the 1990s, issuance was hitting new records – at about $150 billion. Then junk-bond issuance collapsed with the tech bubble.
But unlike tech stocks, junk bonds were soon flying higher than ever. In the middle of the 2000-07 period, annual junk-bond issuance rose above the $150 billion mark. But in 2013, the junk really topped the charts – with about $330 billion of new bonds issued.
Dumpster Diving for Yield
Why so much junk?
Ah, for that… as for so much else… we have a central bank to thank. Lower yields on Treasury bonds and investment grade corporate bonds, as a result of Alan Greenspan’s driving down the federal funds rate in the wake of the tech-wreck and the 9/11 attacks, encouraged investors to stretch beyond their comfort zone for higher rates of return in lower quality issues.
By 2007, they were driving into bad neighborhoods to get what they needed. And by 2013, they were dumpster diving for a measly 5%.
Can you blame them, dear reader?
With the Fed holding down interest rates, there was less and less reason for anyone to default. A mismanaged zombie business didn’t need to stop paying its coupons; it just had to rollover its debt. Borrowers and lenders were deceived. The former found lenders unusually motivated; the latter believed borrowers were uncharacteristically solvent.
All of which just serves to highlight our latest dictum: The Fed’s $4.1 trillion balance sheet is a standing invitation to trouble.
Mr. Trouble walks through the door every morning and into a party every night. But he is a master of disguise.
One day, he comes with the healthy mien of a robust high-yield debt market. The next day he is crumpled over, as if depressed by unusually low consumer price inflation. And on the weekend here he is again – a big shot from Wall Street with the highest profit margins in 60 years.
Yes, dear reader, trouble comes in many guises and disguises. An honest, properly functioning economy spots him immediately and promptly shows him the door. But a trumped-up, highly manipulated and mountebank economy is like a carnival hoedown. You can find anything you want… but nothing is exactly what it appears to be.
Economists refer to this as the problem of “distortion.” The real cost of real capital is usually set by the prevailing interest rates. When the Fed permits Mr. Market to function normally investors can take the facts at face value. When the Fed intervenes the effect is to distort the economy and the markets.
Artificially sending interest rates lower makes capital too cheap. It is borrowed too easily and spent too readily. The result is over-speculation… and over-investment.
That is why we have a record issuance of junk bonds in 2014. It is just one more of the many drag queens and carnival kings that have been corrupted by the Fed’s heavy-handed meddling in the markets.
On display, too, is the US “recovery” – the weakest ever in postwar history! Never before has such a strong recession been followed by such a weak bounce back. Quarter after quarter, job growth, GDP growth and consumer price growth substantially underperform every other recovery since World War II.
Another record! And just one of the many jolly revelers who opens the door for Mr. Trouble when he shows up.
P.S. If you’re worried about the worst US economic recovery on record… and the effects on the dollar of rampant Fed money printing, maybe it’s time to get out of Dodge. Our colleagues at International Living magazine have just published a book on retiring overseas on a budget. Here are details of how to pick up a copy at special pre-order price.
Five Years of Bull
From the desk of Chris Hunter, Editor-in-Chief, Bonner & Partners
Today, we doff our cap to the wizards of central banking at the Federal Reserve.
As you can see from the chart below, the remarkable 181% rally in the S&P 500 that started this day five years ago, has moved more or less in lockstep with the expansion of the Fed’s balance sheet from about $1.5 trillion to $4 trillion.
Although correlation and causation are two different things, this chart raises an interesting question: If the correlation between the size of the Fed’s balance sheet and gains on the S&P 500 holds… and the Fed’s commitment to shrink its balance sheet stays firm… where will this leave the S&P 500?
We don’t know the answer…
But we’re reminded of Rule No. 2 of former Merrill Lynch technical analyst Bob Farrell’s 10 “Market Rules to Remember”:
Excesses in one direction will lead to an opposite excess in the other direction.
What Farrell meant was markets that shoot higher on the upside will also shoot lower on the downside. Think of a pendulum: The farther it swings in one direction, the farther it swings in the other direction. [par break] The fate of the US stock market relies on breaking its five-year correlation with the size of the Fed’s balance sheet. If it can, then US stocks could continue to rally.
If not, look out below…