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This time it is unlikely that the US Fed will ride to the rescue

By David Scott | Monday 12 February 2018


Despite the current correction, the market is still in a tremendous bubble that is nowhere close to being fully unwound. Your Pension portfolio and therefore your retirement remains at risk.

New US Federal Reserve Chair Jerome Powell had quite an eventful first week on the job. It coincided with the worst week for the stock market in two years, which saw the S&P 500 fall 5.3%. The changing of the guard was just one way in which a new era for America's central bank started — one that made investors uncomfortable. Through most of former Fed Chair Janet Yellen's term, market participants could count on a stable interest rate environment: no increases in rates, or at most, a very gradual pace of hikes. This assurance was one of three legs that supported the stock market — until now. Improving global growth and the consequent rise in corporate earnings were the other two. But as soon as you begin to throw that uncertainty into the equation, you erode one of the cases for the valuations that equities had reached globally as well as in the United States. A world in which central banks previously not thought to be in play come into play becomes a much bigger issue for markets.

This time it is highly unlikely that the US Federal Reserve will ride to the rescue as the new Chairman Powell will let the stock markets sweat out the mini-crash until the storm has passed. At the back end of last year the US Federal Reserve released minutes from its October 2012 meeting, where the launch of QE3 was being discussed, and the following transcript quote from the now incoming Fed chair, Jerome Powell, is illuminating:

“I think we are at a point of actually encouraging risk taking and that should give us pause. Investors really do understand now that we will be there to prevent serious losses. It is not that it is easy for them to make money but they have every incentive to take more risk, and they are doing so. Meanwhile, we look like we are blowing a fixed-income duration bubble right across the credit spectrum that will result in big losses when rates go up down the road. You can almost say that is our strategy”.

Thus the new Fed Chair understood five years ago that they are perverting incentives to take more risk, as they “prevent serious losses” but that in time their behaviour assures “big losses when rates go up down the road”.

In 2013 the Fed reversed course swiftly when hints of monetary tightening by Ben Bernanke set off the ‘taper tantrum’, leading to an emerging market bloodbath and a mortgage squeeze at home. The Yellen Fed acted in much same way in early 2016 when the China scare combined with an oil price crash to set off violent falls in global equities. The Fed dialled back its rhetoric and froze plans for interest rate rises, greatly helping the Chinese authorities to regain control over capital flight then running at $100bn a month. On both occasions there was something nasty and potentially dangerous going on in the world. Stock markets had fallen to levels that threatened serious macro-economic damage under the Fed’s ‘wealth effect’ economic models and The ‘Fed Put’ was triggered as an insurance policy. This time the falls have merely wiped away the froth of recent weeks, which Fed officials never deemed healthy in the first place and which risked turning into a toxic bubble. The correction does the Fed’s work for it in a sense by tightening financial conditions and stopping the economy from running too hot. Particularly as US taxpayers will see a 2-4pc bumper rise in their take-home pay checks this month as a result of the Trump tax cuts, making it almost impossible to imagine a contraction in the economy.

What would change the benign picture for equity markets is if the authorities in any major country or region seemed to be losing control of events - as with China in early 2016, and with the Eurozone in the 2012 debt crisis - or if the US dollar suddenly surged and sent a monetary shock through the world’s highly leveraged financial system. None of this is currently happening, but the situation needs watching slowly. Outgoing New York Fed President William Dudley hasn't helped matters by dismissing the week’s stock market selloff as "small potatoes," and saying that four rate hikes in 2018 were possible if the economy continues to improve. Meanwhile, Philadelphia Fed President Patrick Harker also recently conveyed a hawkish message, saying the Fed could raise interest rates as many as three times in 2018. President Trump has taken full ownership of the current bubble economy. In doing so, he’s setting himself up as the fall-guy when things turn sour.

What we accept as "normal" now may have been considered bizarre, extreme or unstable a few short years ago. If someone had announced to a room of economists and financial journalists in 2006 that interest rates would be near-zero for the foreseeable future, few would have considered it possible or healthy. Yet now the Federal Reserve and other central banks have kept interest rates/bond yields near-zero for almost nine years. The Fed has raised rates a mere .75% in three cautious baby-steps, clearly fearful of collapsing the "recovery." What would happen if mortgages returned to their previously "normal" level around 7% from the current 4%? What would happen to car sales if people with average credit had to pay more than 0% or 1% for a car loan? Those in charge of setting rates and yields are clearly fearful that "normalised" interest rates will kill the recovery and the stock bubble for very fundamental reasons - they will.

In classic economics, massive money-printing (injecting trillions of dollars, yuan, yen and euros into the financial system) would be expected to spark inflation. But as many of us have observed, "official" inflation of less than 2% does not align with "real-world" inflation in big-ticket items such as rent, healthcare and college tuition/fees. A more realistic inflation rate is 7%-8% annually, especially for the not well off. There is a puzzling symmetry between low official inflation and the unprecedented expansion of money supply, debt and monetary stimulus (credit and liquidity). So far most of this new money appears to be inflating assets rather than the real world, But can this continue for another 9 years? Everyone knows central banks are still pumping billions of dollars per month into the financial system, with only the first signs of withdrawal starting in the US. This (coupled with central bank purchases of stocks and bonds) has been pushing stocks sharply higher for the past 9 years, with only a few hiccups along the way. This has pushing valuations out of alignment with traditional metrics of valuing assets such as sales and profits - a process known as "price discovery." Investors have rolled over to central banks driving private-sector markets higher, not because the assets are generating more value or profits. But simply as a function of centralized money creation and asset purchases.

All of these extremes generate mal-investment, diminishing returns and perverse incentives for ramping up unproductive and risky speculation, leverage and debt. Yet the central banks have trapped themselves in this risky trajectory because they've pushed the accelerator to the floorboard for 9 years. Any extreme held in place for 9 years has long slipped from "temporary" to permanent. Most investors and commentators (but not here at AG) have now given in to central banks extreme stimulus of financial markets, and in a sense they've forgotten how to price assets based on real-world private-sector measures. Can central banks "retrain" participants while maintaining their extreme policies of stimulus? The only possible answer is: they can't. Here are two noteworthy pronouncements about bubbles.

“Prices have reached what looks like a permanently high plateau.” That was Professor Irving Fisher in 1929, prominently reported barely a week before the most brutal stock market crash of the 20th century. He was a rich man, and the greatest economist of the age. The great crash destroyed both his finances and his reputation.

“We are currently showing signs of entering the blow-off or melt-up phase of this very long bull market.” That was investor Jeremy Grantham on January 3 this year. The normally bearish Mr Grantham mused that while shares seem expensive, historical precedents make it plausible that the S&P 500 will soar from present levels of around 2,700 to more than 3,500 before the crash occurs.

Mr Grantham’s speculation is striking because he has tended to be a savvy bubble watcher in the past. But as any toddler can attest, it is not an easy thing to catch one before it bursts. There are two obvious ways to diagnose a bubble. One is to look at the fundamentals: if the price of an asset is unmoored from the cash flow it is likely to generate, that is a warning sign. (It is anyone’s guess what this implies for bitcoin, an asset that has no cash flow at all.) The other approach is to look around: are people giddy with excitement? Can the media talk of little else? Are taxi drivers offering stock tips?

At the moment, however, these two approaches tell a different story about US stocks. They are expensive by most reasonable measures. But there are few other signs of speculative mania. The price rise has been steady, broad-based and was hardly the leading news of 2017. Given how expensive bonds are, it is hardly a surprise that stocks also seem pricey. No wonder investors and commentators are unsure what to say or do. Around the world but particularly in the US The Establishment and their financiers at the Fed and Too Big To Fail /Trust Wall Street banks have supported and propelled a debt saturated financial system with tens of trillions in additional debt, that is failing. By artificially suppressing interest rates; rigging stocks, currencies and precious metals through the shadowy derivatives market and dark pools; and providing free money to Wall Street bankers, they have purposely created the largest bubble in world history in stock, bond and real estate markets simultaneously. The “Everything Bubble” puts all other bubbles to shame. But now the slowing of debt creation is beginning to reveal the cracks in a very fragile system.

The average American has been led to believe that the current bull market is due to an improving economy and the magic of Trump. Like elsewhere in the world this delusion is built on a foundation of unpayable debt and has the backing of relentless corporate media support. This debt based paradigm is mathematically unsustainable. A 1% increase in interest rates blows the entire Ponzi scheme sky high – and now rates have begun to rise. The ten year Treasury breaching 2.8% last week which led to sharp equity falls in the blink of an eye. When greed turns to fear, look out below. Debt is the key focal point. Leverage is a beautiful thing during a debt induced up boom, as speculators who believe they are brilliant investors appear to get money for nothing. During the inevitable bust the highly leveraged “investing experts” see their faux wealth evaporate in an instant, while the debt remains and must be serviced. When the average man on the street sees his pension obliterated for the third time in the last two decades, they will be enraged and susceptible to the rants of the latest politician promising an easy quick and painless solution - a dream in it’s very self. When people lose it all, they also easily lose control of their reason. Once financial hardship sweeps over a society the civil decay and global disorder will fuse with the anger of the populace and thrust the coming financial crisis into a new dimension. The use of debt has disguised the rot at the heart of the global monetary system. It will also turbocharge the downside as financial hardship and dismay with those in power leads to violence with the creation of new economic and military global alliances. If you think the current environment is hostile, you haven’t studied history.

The 1987 stock market crash, better known as Black Monday, is frequently deemed a historical anomaly. Unlike the crashes of 1929, 2000, 2008 and other smaller ones, many investors are under the false premise that the stock market in 1987 provided no warning of the impending crash. On Black Monday, October 19, 1987, the Dow Jones Industrial Average (DJIA) fell 22.6% in the greatest one-day loss ever recorded on Wall Street. Despite general perception, there were clear fundamental and technical warnings preceding the crash that were detected by a few investors. For the rest, the market euphoria raging at the time blinded them to what in hindsight seemed obvious. As of just last week, the market was in a state of euphoric complacency, donning a ‘what could go wrong’ brashness and extrapolating good times as far as the eye can see. I’ve been saying for quite some time that investors were not properly assessing fundamental factors that overwhelmingly argue the market is grossly overvalued. Whether prices revert to more normal levels via a long period of market malaise or a single large drawdown as we are going to see. Historically situations with the largest fundamental imbalances end with the most powerful failures that quickly erased years of gains. History provides us with the gift of insight, and though history will not repeat itself, it may rhyme. Market tops are said to be processes. Currently, there are an abundance of fundamental warnings.

It is particularly worth noting that longer-term interest rates, a key driver of economic activity, have begun rising while shorter-term rates have been rising since late 2015. Given the role debt has played in economic growth and in supporting stock buybacks, it is likely that equities will not take kindly to further increases in interest rates. Those looking back at 1987 may blame the tax legislation and warnings of a weaker dollar as the catalysts for the severe declines. In reality, those were just the sparks that started the fire. The market was overly optimistic and had gotten well ahead of itself. When the current market reverses course, investors are also likely to blame a specific catalyst or two. Like 1987, the true fundamental catalysts are already apparent; they are just waiting for a spark. History also shows that more often than not, investor expectations fail to accurately anticipate the future reality. In the week as markets wobbled and robo-adviser websites crash from activity, it was a reminder that investor behaviour is frequently the most dominant influence on return outcomes especially in the short term.

There are few statements in the pantheon of investment management clichés that ring truer than these words of Benjamin Graham: “The essence of investment management is the management of Risks, not the management of returns. Well-managed portfolios start with this precept.”

This is the same basic message as my favourite cliché that “defence wins championships.” At Andrews Gwynne we have and are continuing to build an investment business around this principle. One doesn’t prioritize risk management over long-term compound returns; the two priorities are very much one-in-the-same.

David Scott is an Investment Manager & Market Commentator at Andrews Gwynne

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