Kass: Too Much Confidence

This column originally appeared on Real Money Pro at 8:51 a.m. EDT on Sept. 23.

NEW YORK ( Real Money) -- There is a growing and consensus view that there are no meaningful risks to the U.S. stock market and that the conspicuous P/E multiple expansion (from under 14x to over 16x) seen thus far in 2013 may have room to further expand.

This optimistic view permeates the business media and has been embraced by most Wall Street strategists, by retail investors and by many hedge funds and other institutions.

We are, it seems, in a bull market in confidence as well a bull market in complacency.

Indeed, several weeks ago CNBC's Simon Hobbs asked his guests whether there was any argument whatsoever against a continuing bull market. (Note: I have no idea whether Simon was serious or facetious in his questioning.)

To me, the only certainty is the lack of certainty. (My guide is the history of the ups and downs of markets.) Those that hold to certainty of belief (whether it be bullish or bearish) should be hidden in a closet away from children and from money managers that behave like children.

Today's opening missive will question the unwavering bullish self-confidence that always seems to appear at or near the end of a maturing bull market as well as the rising belief that there is no downside risk to the U.S. stock market.

Stability Itself Is Destabilizing

The emerging view of limited/no downside risk almost presages an upcoming "Minsky moment." For those who don't know the term, the Minsky moment was coined by Pimco's Paul McCulley in describing the Russian financial crisis in 1998 and was named after economist Dr. Hyman Minsky. A Minsky moment is a sudden major collapse of asset values that is part of the credit cycle or business cycles. Minksy moments occur because of long periods of prosperity and increasing asset values typically fueled by borrowed money. It starts with a major selloff, leading to a sudden and precipitous collapse in market-clearing asset prices, a sharp drop in market liquidity and a severe demand for cash. Some say the financial crisis of 2007-2009 was a Minsky moment. ( Here is a crash course on Minksy's theory and Krugman on after the Minsky moment.)

Back prior to The Great Decession of 2007-2009 the Minsky moment was momentous. While market highs were being achieved in late 2007, an unthinkable 30%-plus drop in home prices was about to be triggered, and financial weapons of mass destruction were being launched around the world. There is no such undercurrent today that would produce a deep global recession, but, at the very least, there are a number of risks being glossed over by the markets that could qualify today's market condition as being a Minsky moment "lite."

Below are some of the most disturbing conditions that are seemingly being ignored.

  • Our global society/economy is based on short-sighted markets. Throughout this morning's opening missive, there is a common thread - namely, that the fever of short-term thinking nearly always masks the emergence and addressing of intermediate-term problems. The immediate world is one comprised of tweets (though not for me!) and instant messages. We are addicted to the moment (and our smartphones). And short-term market performance is cheered while many ignore the long term (and its consequences). It is also the case that, in our economic and monetary policy, business planning and investing that (with apologies to Warren Buffett) there is no long-term plan either. History shows that ignoring structural issues and emphasizing short-term performance (and solutions) almost always ends badly.
  • The U.S. economy is a stone's throw from recession. We face subpar economic growth for as far as the eyes can see. Four years after the global economic near-collapse, the foundation of business activity remains unstable and dependent upon continued ease in monetary policy. Though the Bureau of Economic Analysis has changed the calculation of GDP, the trajectory of growth is weak -- and this was confirmed by Ben Bernanke's commentary in his press conference following the decision by the Fed not to taper. Monetary policy (namely, quantitative easing) has, by most measures, lost its effectiveness, and zero interest rate policy has also exhausted its benefits as the federal funds rate can't be lowered into negative territory. The Fed has recently endorsed and underscored the view that U.S. growth is slowing and that prospective growth is uncertain. Yet, the markets have cheered. I recognize that the market correlates better to money growth than earnings. As the spread widens between P/E multiples and stock prices, however, at what point does the market recognize that our economic problems are more deeply rooted, that low interest rates is not a permanent condition and that profits are vulnerable with profit margins about 70% higher than the mean percentages achieved over the past 50 years?
  • Monetary policy is shouldering the responsibility of generating growth. The U.S. remains trapped in subpar 2% real GDP growth, and the job market remains weak relative to past recovery cycles (as, among other issues, the structural disequilibrium in the employment market remains unaddressed). While most believe the Fed and other central bankers will remain easy, easy is a finite state that cannot be open-ended. And end it will -- and so will Mr. Market discount the conclusion of an unprecedented period of cowbell.
  • Easy monetary policy is in the later innings, and Mr. Market will begin to discount this. Last week, Stanley Druckenmiller provided a clear explanation of the other side of an expansive policy on CNBC and on Bloomberg: "The average investor who is 'forced' to sell them the bonds and take on more risk ... this has forced us to buy securities at subsidized prices, and when they adjust, at whatever point in the future, they will adjust immediately and on no volume."
  • Easy monetary policy holds unintended consequences. A half decade of excessive ease is like "it's Chinatown" -- in the classic movie, when they try to make things better, they somehow make them worse, in spite of the best of intentions. Monetary policy is in a place, like Chinatown, where the biggest consequences (U.S. dollar degradation and inflation) are always unintended. Chinatown is where corruption was the status quo and where regular people are forced into silence. Monetary easing and QE effectively stabilized the domestic economy, but, in its extreme, it is to be avoided, like Chinatown, at all costs.
  • "Bubbles Ben" is Being Replaced by "Calamity Janet." The last two years of massive and daily injections of monetary ease have proven ineffective. We are stumbling into the end game of the misbegotten spree of QE and ZIRP and massive manipulation and artificiality of the financial markets. The monetary bureaucrats (then Bernanke, soon Yellen) in the Fed have no idea how to wean Wall Street from easy-money policy -- their only prescription is more cowbell. As it seems to have been written in the monetary bible, Greenspan begets Bernanke who begets Yellen. As Einstein is reported to have said, "Insanity is doing the same thing over and over again and expecting different results."
  • Thoughtful fiscal policy aimed at addressing a $17 trillion debt load is nonexistent. Our leaders in Washington, D.C., still don't get it, and based on the continued rhetoric (surrounding the debt ceiling debate), they appear unlikely to ever get it. A government shutdown is survivable, not addressing our deficit/debt load may not be.
  • The screwflation of the middle class is approaching the dangerous stage. The expected trickle down in the appreciation of home and stock prices has failed to improve the stead of the average American. As Warren Buffett commented last week, "We have learned to turn out lots of goods and services, but we haven't learned as well how to have everybody share in the bounty.... The obligation of a society as prosperous as ours is to figure out how nobody gets left too far behind." Stanley Druckenmiller also chimed in on the subject, calling monetary easing "the biggest redistribution of wealth from the middle class and poor ever." The middle class continues not only to be relatively unaffected by asset appreciation but, as the costs of the necessities of life rise and wages and salaries stagnate, there are emerging social consequences. (In yesterday's New York Times, Thomas Friedman reminds us that the consequences of an oppressed middle class extend to the Middle East.)
  • Sales and earnings are deteriorating, and the prospects for 2014 are not improving. Second-quarter 2013 top-line revenues were barely positive, and profits (excluding financial companies) were negative year over year. The third quarter looks no better.
  • The eurozone's recovery is unsteady. Many are taking "a leap of faith that the European economies will experience a steady improvement in fortunes. Not so fast!
  • Geopolitical risk remains elevated. Unfortunately, violence is a mainstay in our future, whether it is domestic or overseas (e.g. Syria and Kenya). No longer are complicated plots (e.g., Sept. 11, 2001) the mainstay of acts of terrorism; they are increasingly (as recently witnessed in Boston, the Navy Yard, Damascus or Nairobi) random acts of violence.
  • The argument that "there is no alternative" will diminish as interest rates rise. For three or four years, a zero interest rate policy has enforced stock prices, as the stock market has won by default. But the bond vigilantes appear to have come out of hibernation lately. And with the yields on the five-year and 10-year U.S. notes more than doubling in only a few months, the "no alternative" argument has weakened. Any further rise in interest rates will reduce the argument further.
  • The market has gotten lopsided. A small group of anointed stocks -- including Tesla (TSLA), Netflix (NFLX), Amazon (AMZN), selected biotech stocks and the like -- have attracted traders and investors. When this happened in other asset classes before (gold two years ago) or in individual stocks (Apple (AAPL) a year ago), it ended badly, as greed overcame sensibility. History rhymes; it will occur again -- maybe sooner than later!
  • Market watchers, commentators and investors are unquestioning. Investment performance pressures and human instinct result in too many worshiping at the altar of price momentum. As a response and complement to record market highs, optimism is being lifted, and price targets are being raised as skepticism dissipates.
  • We've got black swans aplenty. Whether it is the pension problem, a student loan problem, natural disaster, geopolitics, "the new normal" of terrorism or the potential risk of social uprising (not only around the world but on our shores), these are fragile not durable times, and our markets and economy remain vulnerable to exogenous and unexpected shocks.

Summary

In 2013-2014, the global economy and the world's capital markets are not poised to experience a 2007-2009 collapse.

Focusing on our current issues (and ignoring, for the moment, the need for intermediate structural reform), valuations rising, social unrest increasing, the global economic recovery weak, rates on the ascent, risks of policy (monetary and fiscal) mistakes rising, the artificiality of policy (and lack of real price discovery), and so on have made the market's reward vs. risk unattractive.

Investing with blind faith is often a recipe for disaster.

Even Warren Buffett, the Oracle of Omaha, seems to be concerned that stocks are fairly valued (as expressed at his Thursday evening appearance at Georgetown University):

Humans, they all think they're Cinderella at the ball, and they think, as the night goes along, the music gets better and the drinks flow, they all think they're going to leave at two minutes to 12 and of course there's no clocks on the wall and they're still dancing, so it will happen again.

Dr. Minsky teaches us about warnings and to be wary when all seems certain and good. Minsky points out that in what appears to be a stable environment, our confidence is heightened and we are inclined to take increasingly risky positions in assets (such as stocks). Over modern financial history, the Big Bank (our Fed) consistently has intervened and gotten us quickly out of crisis, but it causes us not to learn much and we continue a path toward increased fragility. With increasing amplitude of crises (as seen in 1966, 1970, 1974, 1980, 1982, 1987, 1990-1991 and on to the 2000-2009 crisis), we are experiencing not a Minsky moment but a Minsky half century.

Somewhere above, Hyman Minsky might be looking upon Mr. Market and saying what we have learned from history is that we haven't learned from history.
At the time of publication, Kass and/or his funds had no positions in the stocks mentioned, although holdings can change at any time.

Doug Kass is the president of Seabreeze Partners Management Inc. Under no circumstances does this information represent a recommendation to buy, sell or hold any security.

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