Risk/Reward Vol. 359
THIS IS NOT INVESTMENT OR TAX ADVICE. IT IS A PERSONAL REFLECTION ON INVESTING. RELY ON NOTHING STATED HEREIN.
Each week the three major indices reach for new records. The NASDAQ was on a ten day winning streak until profit taking ended that run on Friday. As noted previously, the Shiller CAPE ratio ( an historical measure of price/earning ratios) is above 30 for only the third time in history; the others being just before the crashes of 1929 and 2000. Short selling interest is as low as it has been since May, 2007. Everyone is a holder or a buyer, and there is plenty of cash on the sidelines. Mr. Market is positively euphoric. In normal times, these are sell signals. But these are not normal times. Never before have the world's central banks been so laser focused on one metric to the seeming exclusion of others: achieving 2% inflation. Japan is so desperate to reach that goal it has maintained zero bound interest rates for several years. Originally believing its easy money monetary policy would achieve that number in 2011, Japan's lead central banker was quoted this week as predicting 2% inflation in 2020. (Hey, Mr. Kuroda, have you ever heard of Albert Einstein's definition of insanity? See Vol 358 http://www.riskrewardblog.blogspot.com/ ). On Thursday, European Central Bank President Draghi stated that due to low inflation the ECB would continue quantitative easing (purchasing 60billion Euro worth of government bonds each month) for the foreseeable future. And as we know from last week's Congressional testimony, due to her concerns about lagging inflation, Janet Yellen is rethinking the timetable of the balance sheet reduction and interest rate normalization that Federal Reserve intimated just a month ago.
Why the fascination with inflation? As highlighted last week, central bankers are almost all economists. One tenet of modern economics is the Phillip's Curve which, simply put, posits that there is an inverse relationship between the rate of unemployment and the rate of inflation. The theory is that the lower the unemployment rate, the higher the wages as employers compete for labor; the higher the wages the more disposable income; the more disposable income, the more demand for goods and services; the more demand for goods and services the more their prices inflate; the more prices inflate,the more manufacturers produce; the more that manufacturers produce the more the economy grows. So, following the above logic (synthesized from the Fed's FAQ page) , inflation resulting from higher wages should precede economic growth. Thus, if a central banker believes that his/her job is to grow the economy (and that is a questionable proposition) then he/she would want to see inflation before cutting back on accommodative policies. Seem simplistic? Scarily so, especially since it isn't working. Unemployment is at 4.4% which is below what was thought to be full employment (5%) just a few years ago, and yet the rate of inflation is falling; most recently measured at 1.4%. Central bankers everywhere are perplexed. Hey, Janet, wake up. Maybe the world's social programs are so "rich", people would rather retire or drop out of the work force than work. Take a look at our record low job participation rate---only 62.7% of eligible persons are in the potential work force. Oh, and maybe more disposable income does not equate to more demand. That is certainly true for those over age 65 which constitute an ever increasing percentage of the developed world's population. Look at Japan! Whatever the reason, the Phillip's Curve ain't working in real life. Meanwhile, accommodative monetary policies are inflating the value of financial assets worldwide.
Do you doubt this? Since 2008, central bank policy has mattered more than anything else when it comes to the value of financial assets; be they bonds, securities directly correlated to bonds (my favorites) or equities. With historic low interest rates (in the history of the world there have NEVER been negative interest rates until now) and a reckless bond buying programs (quantitative easing) central bankers everywhere have driven virtually every investor, be they pension plans or Ma and Pa, out of government bonds, money markets, etc. and into much riskier bonds and stocks. Put another way, does any reader of this edition believe that we are NOT in a stock market bubble? And look at commercial real estate. Thanks to the surplus of cheap credit provided by our central banks, some buyers of apartment complexes are now receiving 10 year interest only loans. This has caused a bidding war with buyers paying so much that they are left with a sub 5% yield. This is at least 50% lower than in "normal" times. (Remember lower yields result from higher prices.) With prices so high no wonder speculative developers are constructing apartments at an alarming rate; apartments that likely will remain empty. Think I'm nuts? Look around. All of this is a direct result of a surplus of money and historically low rates--- thanks to central banks. The above notwithstanding, so long as central banks continue to provide the punch there is no reason to stop drinking from the bowl.
So the obvious question is when will central banks forsake the Phillip's Curve and get serious about normalizing rates? Not the half hearted measures announced a few months ago by the Fed which take years to achieve and which can be derailed by any stock market reaction, but serious efforts to raise rates no matter how the financial markets respond. So long as the current lineup is in charge the answer is never (note Japan's sorry story alluded to above). But come February, 2018 a change can be expected. Chair Yellen's term comes to an end and the smart money is that she will be replaced by Kevin Warsh, Glen Hubbard or John Taylor--all of whom have been highly critical of our monetary policy. All three are more concerned by asset bubbles (like the stock market) and normalizing rates than with achieving an arbitrary inflation number. Some of these guys are more aggressive than others. Once the nomination process begins, let's see how the smart money reacts. That may provide a truer sell signal.
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