Real Money Pro's Doug Kass on the Market: Back to the Future

(Editor’s note: This article was originally published on Real Money Pro Dec. 8 at 8:16 a.m. EST.)

-- George McFly: " Lorraine. My density has brought me to you."
-- Lorraine Baines: "What?"
-- George McFly: "Oh. What I meant to say was..."
-- Lorraine Baines: "Wait a minute. Don't I know you from somewhere?"
-- George McFly: "Yes. Yes. I'm George. George McFly. I'm your density. I mean, your destiny."

-- Back to the Future

Perhaps we are going Back to the Future sooner than anyone thinks!

We can argue if the U.S. economy has reached self-sustaining growth and escape velocity. From my perch, while the jobs data are healthy, the manufacturing sector activity remains subpar. Capital spending, in particular, is moribund. Auto and home sales (and housing prices) have flatlined.

We can argue whether or not there is a disconnect between asset prices and the real economy.

But what we can't argue about is that the Fed has made a mockery of fundamentals.

Central bankers possess a powerful tool that can be described as a monetary monopoly, as they fix (or influence greatly) most interest rates with monetary policy. This money creation influences portfolio balancing. Typically, if a central bank prints money and increases the money supply, the yield on money declines and investors rebalance their portfolios as they seek higher-yielding investments. When investors move out of money and into non-monetary assets (like stocks or real estate), it generally tends to raise the price and lower the yield on those non-monetary assets. The rise in price and reduction in yield boosts wealth and lowers borrowing costs, which should in turn boost investor spending.

But never before have investors (and global economies) been so dependent on extreme policy and have comfortably embraced their confidence in the Fed's ability to successfully extricate from that policy without any unwarranted and adverse consequences.

As a result, there is limited honest price discovery as the price of many asset prices has been distorted.

Every new crisis since 2008 has brought on a more radical Fed response. One has to wonder: What is next if the U.S. economy falters anew?

Money reaches for yield, and every asset class prices off a phony 10-year note's yield.

It is even worse outside of the U.S. For example, the two-year Swiss government note yields -11 basis points to maturity. The minus side on the yield means your principal shrinks, not grows. Continually invested, one should consider -11 bps in rates halves principal in 580 years. We might call this usury in reverse. In many countries in Europe the 10-year yields are below that of the U.S.' 2.30% yield. Are Italy and France -- which possess such low yields -- more creditworthy than the U.S.?

Of course not. And it is those countries bonds' and notes' yields (depressed owing to the belief that Draghi and the ECB mean business) that act with almost gravitational force on our yields.

But, as I have written, ultra-low interest rates are the father of malinvestment, and bubbles are the outgrowth and children of easy money.

Interest rates are the investment traffic symbols of a free economy. They set investment hurdle rates in which we value many different asset classes, like stocks.

The interest rate forms the basis on how we discount and value the estimated future cash flows of companies.

Stated simply, by maintaining zero interest rates and instituting quantitative easing, we have been in a central bankers-sponsored boom in asset prices. 

Shockingly, the Fed doesn't even resist the notion that it is sponsoring this boom. It seems to be extremely happy with the lift off in stock prices. Indeed, near the end of his regime, former Fed Reserve Chairman Ben Bernanke cited (under the questioning of CNBC's Steve Liesman) his satisfaction of the Russell 2000 Index's climb a few years back when he cited the "portfolio balance channel." 

The Fed's explicit experiment of fueling asset prices since the Great Decession is the most glaring and prolonged example of trickle-down economics in history.

Unfortunately, the boiling-frog story comes to mind. In that metaphor the premise is that, if a frog is placed in boiling water, it will jump out, but if it is placed in cold water that is slowly heated, it will not perceive the danger and will be cooked to death. This story is often used as a metaphor for the inability or unwillingness of people to react to significant changes that occur gradually. 

The message of the boiling frog is that investors should make themselves aware of gradual change, or else they will suffer eventual and undesirable consequences.

The Fed and investors are like the frog being boiled slowly. At some point both will be jumping out.

The last time our Federal Reserve raised interest rates was in June 2006.

I will remind all that at 3:05 p.m. on one day in 1998, the Fed cut fed funds by 25 basis points and, in the next 60 minutes or so, the Dow Jones Industrial Average rose by 7%. The Fed knew which buttons to press, and it continues to do so.

The unimaginable in Fed policy has become commonplace: government-sponsored asset booms superimposed by low interest rates.

But to what end?

The Federal Reserve and central bankers are frightened about deflation.

But should we trust the Fed's statisticians and econometric models on which to base policy on small increments of deflation and inflation when the same Fed failed to foresee the deepest recession since The Great Depression six years ago? Moreover, in a time of technological change (and globalization), shouldn't prices fall?

Curious minds can wonder how the Fed and central bankers see very far in the future on these data points.

I am going to guarantee you all that, 10 to 15 years from now, investors will be scratching their heads.

They will look back at the current levels of building malinvestment, and on The Crash of 2016-2017, and a the heavy-handed monetary policy that provoked it, with puzzlement and fascination.

They will look back in amazement, as Jim Grant recently said, that "our generation gave the former tenured economics professors (who formed our Federal Reserve) the discretionary authority to fabricate monetary policy and fix interest rates."

They will look back in amazement on policy that put the cart of asset prices before the horse of enterprise. 

They will look back in wonder that we entertained the fantasy that high asset prices made for prosperity, rather than the other way around.

They will look back in wonder that we actually worked to foster inflation

Finally, they will look back at the mounting levels of building malinvestment and to the Hyperflation of 2018-2020 and recognize that they have miscalculated, in the same way the private sector miscalculated The Great Decession in 2007-2009, when the financial industry packaged and exported toxic derivative products based on the notion that home prices would never ever drop on a yearly basis.

Where we are going, we don't need roads.

Albert Einstein wrote, "Once you can accept the universe as matter expanding into nothing that is something, wearing stripes with plaid comes easy."

McFly put it differently:

-- Marty McFly: "Mom. That you?"
-- Lorraine Baines: "There, there, now. Just relax."
[pats a damp cloth on Marty's forehead]
-- Lorraine Baines: "You've been asleep for almost nine hours now."
-- Marty McFly: I had a horrible nightmare. I dreamed that I went -- back in time. It was terrible.
-- Lorraine Baines: "Well, you're safe and sound now, back in good old 1955."
-- Marty McFly: [opens his eyes wide] "1955?"

-- Back to the Future

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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