Alan Greenspan, and the Rise of Asset 'Bubbles'

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You have to marvel at the asymmetry of the asset bubbles. I can use the plural since the number has greatly expanded ever since Greenspan was the maestro. That affords a greater sample size and thus more extensive conclusions can be drawn from them. The obvious downside to that is in the rest of the world's combined experience of all the experimentation.

That phrasing isn't quite right, however, as experiment suggests that there was intent and control. Bubble experimentation would lead one to believe central bank intent and control, but while the first part may have been present the latter is nowhere to be found. The common convention points to "ultra-low interest rates", but the FOMC didn't get that far until the middle of 2003. By that time the dot-coms had already gone bust and only the true mania in housing remained.

But even here, convention gets it skewed. The real debasement, the true froth and frenzy came as Greenspan's Fed was raising rates! Maybe it took two years for the Fed's new-found discipline to finally "pop" the bubble, or maybe the banking system wasn't so bothered by the posted cost of overnight federal funds. At the same time maestro's FOMC was increasing its federal funds target one-quarter point by one-quarter point, credit default swap issuance and gross volume of subprime mortgages blew by all bounds of sanity. The Office of Comptroller of the Currency, which tabulates domestic issued exposures to such derivatives, puts total credit derivatives (the vast majority CDS) at the time Greenspan started "tightening" at just $1.5 trillion notional; by the time the housing bubble popped in the middle of 2006, just as Greenspan was hitting his ceiling, credit derivatives were $9 trillion on their way to a peak of $16.4 trillion as Bear failed. So much for control; even the housing bust wasn't so much a complete limitation.

In terms of stock prices, Ben Bernanke recently assured the world that the Fed was, at best, only aiding stocks back toward their trend. In June, he wrote:

"Stock prices have risen rapidly over the past six years or so, but they were also severely depressed during and just after the financial crisis. Arguably, the Fed's actions have not led to permanent increases in stock prices, but instead have returned them to trend. To illustrate: From the end of the 2001 recession (2001:q4) through the pre-crisis business cycle peak (2007:q4), the S&P500 stock price index grew by about 1.2 percent a quarter. If the index had grown at that same rate from the fourth quarter of 2007 on, it would have averaged about 2123 in the first quarter of this year; its actual value was 2063, a little below that. There are of course many ways to calculate the ‘normal' level of stock prices, but most would lead to a similar conclusion."

We can reasonably infer from this that Bernanke views such a trend, 1.2% per quarter, as the natural setting ("normal" as he put it). And his numbers work out exactly as he purports; starting in late 2001, you can draw a straight line that intersects with the S&P 500 at its peak in October 2007 and then again (nearly) this year. Therefore he expects solid if unspectacular returns to equate to a solid if unspectacular market, which wouldn't be a bubble.

In the context of ultra-low interest rates and the Fed, however, the implication is that solid stock market coincides with the "extreme" of monetary policy. Since that all occurred in the aftermath of the dot-com bust, we are again forced to reckon without explanation for where it came from in the first place. In Bernanke's construction, the Fed was only reactionary, providing appropriate aid to the "market's" mess.

Even if your experience of stocks is limited to that view, you still have to account for the other extremes. If we instead extrapolate Bernanke's 1.2% per quarter returns starting in 1995 rather than late 2001, that produces a "normal" and solid expectation on the S&P 500 for 1236.09 as of Q3 2015, almost 40% below the current level.

Even a casual glance at a longer-term chart for any of the major stock indices reveals a clear inflection in 1995. The secular bull market was already impressive by then, but for the next five years it outdid everything (except Japan in the late 1980's; or the US in the late 1920's). Bernanke's calculation is thus targeted; if you are going to lay blame for stocks at the Fed, then the lack of correlation with "ultra-low" is a big problem in doing so. After all, his numbers check out. The problem for him, and us in 2015, is that doesn't really matter since ultra-low was never really the primary problem.

I hate to keep recycling this Greenspan quote, but given our current circumstances it demands overemphasis. The world remembers "irrational exuberance" but that wasn't the real message of the "maestro", as what he was really describing was two separate, related and historically significant trends. The first was that "money supply" was already then, in 1996, out of control. The second was that he was confident the Fed could restore order:

Unfortunately, money supply trends veered off path several years ago as a useful summary of the overall economy. Thus, to keep the Congress informed on what we are doing, we have been required to explain the full complexity of the substance of our deliberations, and how we see economic relationships and evolving trends.

There are some indications that the money demand relationships to interest rates and income may be coming back on track. It is too soon to tell, and in any event we can not in the future expect to rely a great deal on money supply in making monetary policy. Still, if money growth is better behaved, it would be helpful in the conduct of policy and in our communications with the Congress and the public.

The simple act of interest rate targeting in the post-1980's Fed regime side-stepped that evolution. The economists at the Fed decided that by targeting the overnight federal funds rate it would be "good enough" as derivative and indirect control for the money supply. That Alan Greenspan, Fed Chair, in early December 1996 felt compelled to make such a claim while startling the world with the words "irrational exuberance" suggests, at best, a tenuous grasp of this post-money "supply" framework. It also, in light of the dot-com era, proves it didn't really work, certainly not as a limiting factor on the growing and assertive financialism of the eurodollar.

But there is more here to the debasement than just raw asset prices. The asset bubbles themselves are much more multifaceted than is commonly appreciated. Economists project their certainty about monetary neutrality even here, taking them out of the search for actual truth and sense, but in openness you can easily observe several real economy effects. The first was straight away a direct link between the dot-com bubble (in isolation, while still factoring that the housing bubble was already in its early stages concurrent with the dot-coms) and the productive sectors of the economy. In other words, financial resources (created ex nihilo and mostly, at first, offshore eurodollars) that flowed into dot-com startups and IPO's of all kinds had the more efficient effect of increasing what looked like productive capex, creating real employment growth and measurable efficiencies.

That trend was so strong that it produced a lasting, comparative disparity for calculated statistics like productivity. So much so, that by May 2007, FOMC member Janet Yellen was still trying to figure out what happened to all the "productivity" a decade later on the cusp of the next bubble cycle's fulfillment (that she never saw coming).

"But the hypothesis that the recent decline in productivity growth is mainly structural does not seem to me to square well with the broad range of available evidence. Recall that in the 1990s there was a whole constellation of evidence-including a booming stock market, robust consumption, and rapid business investment-that was consistent with a hypothesis of a lasting increase in the rate of productivity growth."

In reality, dating the economy instead by bubble phase, we can see the obvious and detectible incongruence between the combined dot-com and housing bubble of the late 1990's with the pure, housing mania of the decade that followed. The FOMC could not account for the shift because monetary neutrality prevents a great deal of common sense from being deployed in the state of inquiry. Outside of orthodoxy, it is easy to understand how a massive surge of "money creation" in the eurodollar system flowing through capex and new businesses (even though most of them weren't worth the cash that was thrown away in them; that only suggests the temporary nature of monetary bubbles rather than their economic pathology) was much more efficient than one flowing almost exclusively through mortgage debt.

Even though, as described above via just credit derivatives, the housing bubble of the 2000's was exponentially larger it had the dual task of supporting not just some economic growth but the tremendous swing in asset prices where churn was high and credit stock was all that mattered for support. To the real economy, what flowed to GDP was really just a trickle of leakage as asset price appreciation from all that credit produced just some unsatisfactory consumption (the impetus to ultra-low in the first place).

That was more than enough, however, for places like China where a wave of eurodollar-born investment would flow to build out manufacturing capacity to service that consumption alone. Again, the asymmetry where the US would be missing the full cycle of productive investment that instead flowed across the Pacific, "filled" artificially by the debt. In that sense, you can appreciate how the world is so far off in 2015 - the eurodollar was maintaining the gap at both ends. That disparity becomes so many intriguing imbalances in economic results, most especially how labor utilization here (total hours worked) stopped rising altogether (as did population participation in full-time employment, which peaked, coincidentally or not, in March 2000) while GDP only slowed.

The staggering inefficiency of that economic/financial arrangement goes a long way toward explaining 2008 and the Great Recession. Without any organic means for self-regulation, there was no way to tie that back to the whole economic cycle (where capex creates wealth and new jobs, bringing up consumption with it; rather than what happened with both sides of the cycle just growing separately, on different continents, and using pure financialism to hold the breach). It also placed the eurodollar at its center, making "money growth" as the centerpiece of continued sustainability.

You might think that after the great economic and financial crash, the economy and monetary system would better align toward a more harmonious and justifiable future. Obviously, since we are in 2015 and still awaiting recovery, that never occurred. Further, economists are still puzzling about productivity; this time it is all but gone. I should point out that there are numerous problems with the productivity estimates (the greatest being the BLS's continued assignment of tremendous employment growth when nothing else anywhere, especially wages and spending, can confirm it) but in general terms it is essentially the continued reductionism of bubble efficiency from one to the next.

The location of the current bubble is vastly different than either of the last few. This time, corporate junk suffices where subprimes once were. That is more than a financial reallocation it is an economic re-characterization. The main projection of that has been junk corporates, of high yield bonds but also CLO's and especially leveraged loans. Leveraged loans are the bank-syndicated cousin of junk bonds, both of which more than suggest the ultimate problem. This is all debt of obligors that fall outside (and many, perhaps far too many, as we may be about to find out, way outside) the traditional strictures of "good standing." In other words, these are troubled companies that are lucky to find debt-liquidity.

In transiting from one bubble to the next, these businesses are thus conceding debt where profit and even revenue was once derived. In other words, generically and generally speaking, these are companies that in the last decade were kept alive and growing by the last bubble's leaking of debt into mortgages and thus consumer spending as their revenue. In this bubble, leveraged loans take the place of even the last bubble's marginal revenue stream as not even revenue but a further blight on their balance sheet (the broad cascade of serial bubbles is literally degrading).

And so these businesses are not borrowing to expand and grow, but simply to (hopefully) maintain what they have or avoid the fullest weight into bankruptcy. All forward momentum, debt-driven as it may be, is run out of the system at these financial margins. In short, the current bubble is doing little more than holding steady the lingering deficiency of the last. These companies do so, and the banks and "investors" that provide the credit resources do so, because Janet Yellen (as did Ben Bernanke) continues to claim the great resurrection is right around the corner. Thus, if these low-grade companies can hold on for a little longer, go that much further down into indebtedness, salvation is just in reach.

The problem, then, for 2015 is that recovery and rebirth is perhaps farther away now than ever. It wasn't supposed to be that way, as this year was described continuously beforehand as "it." The large economic stumble was termed "transitory" in order that the general economic perception would remain within the trance.

Beyond the idea of "transitory" no longer applying, this disparity in indebtedness was never limited to our own struggle (and I haven't even described corporate debt among the investment grades going to stock repurchases almost to the full exclusion of capex growth, especially after 2012). Just as this corporate bubble has attempted a bridge for US businesses deprived of their "expected" revenue more aligned with the housing bubble, the "other" side of the economic equation globally has been counting the same. The Chinese were clobbered in the Great Recession, too, and responded just as was done everywhere else. They grew their own internal bubble in order to fill the same gap; expecting in short order that US (and European) "demand" would easily and quickly return to 2007 levels without factoring how the end of the mortgage bubble might prevent that. They have had further difficulties in addressing that financial transition between bubbles especially this year; a renminbi-bubble assumed connectible and sufficient to await further eurodollar "flow."

The Chinese bubbles since 2009 have thus been as inefficient as the US corporate bubble, doing little good other than keeping structural "overcapacity" standing still in place. The numbers in China are staggering in raw, overall magnitude (the Chinese have added the equivalent of the US banking system since 2009). Here, they may be less directly impressive, but seeing $3.46 trillion in just junk corporates is no less astounding. That total represents gross issuance in junk bonds, CLO's and leveraged loans just since 2012! While it does not represent the full and carried levels of current junk indebtedness (since it does not distinguish new issues from refunding) it is still an immense debasement that far surpasses anything of subprime mortgages in the last bubble.

Economically speaking, a great deal of that financial mess was thrown at the energy sector, but it wasn't exclusive to that artificial trend. What is really worrisome about the junk bubble this year is its last, potential asymmetry. In other words, if the corporate bubble had very little positive effect on the economy these past few years on the way "up", it would likely have a devastating impact should it fall apart. There is little economically to be gained from artificially entailing weak companies their continued existence (especially, for efficiency's sake, where resources might have been much better utilized elsewhere all this time rather than holding steady businesses awaiting an economic revival that will never come or overproducing energy upon unsupportable prices) but there is a lot to be lost when they are no longer so financially "lucky." Once the "market" sees that endgame, the flow stops and so do those firms.

It is here that the "dollar" is perhaps most economically acute. Junk bond prices and leveraged loan yields have been pressured as "dollar" liquidity continues to recede. That makes sense since financial resources of the eurodollar are the primary mechanism for that debasement in the first place, but to see the scale so far in just what is likely the opening act toward a durable downturn pushes the downside into seriously troubling. Junk bond issuance is only a few billion less so far in 2015 than 2014, but that overstates the resiliency as issuance has truly fallen recently. Gross CLO issuance is down 15% YTD, while leveraged loan gross issuance is down from $447 billion to just $352 billion, or 22%!

The bond turmoil and state of its current bubble has gotten so bad that even the blinding repurchase trend is in serious danger. The S&P 500 Buyback Index has declined more than 12% from its February high, suffering as much in the August 24 global liquidation as other stocks (contrary to its run-up, which had seemed to make buyback-heavy stocks invulnerable). Economically speaking, even the FOMC appears to have noticed the gathering slump, postponing their exit from ZIRP time and again. If the act of starting a regime of rate increases is confirmation of their thoughts on the recovery and its certainty, what might the bond bubble think of its constant delay?

We already have a partial answer, as junk is selling off heavily once more this week (some views are already worse than August 24; and the S&P/LSTA Leveraged Loan 100 has yet to update past last Friday, as irregular pricing schedules have become far too common and thus perhaps should be interpreted as another part of the alarm) while money market indications continue in turmoil. In that respect, the FOMC's federal funds target still doesn't matter in direct proportion to the bubble, but only as an indirect confirmation of the fact the "dollar" has been both right about what was coming (so far) and the very means to enforce that belated discipline (again).

As stated at the beginning, you can't help but marvel at the asymmetry. The bubbles get bigger (including China and foreign versions connected to the eurodollar) especially in their worst parts; total subprime mortgage balances in March 2007 was about $1.3 trillion, total gross issuance of junk bonds, leveraged loans and CLO's has been just less than $3.5 trillion and only since 2012. Even factoring a generous 50% refunding rate, that would mean a $1.7 trillion explosion in junk corporates in the past three and a half years. From all that, the economy derived so very little from it.

That seems to be the bubble lesson here and everywhere, as asymmetry is really, as always, boiled down to raw risk/reward. In progression, the bubbles have become less economically effective with greater risk presented each time, and spreading that risk globally. This latest, especially when adding the credit base of stock repurchases, has seen very little economic gain but as-yet unexplored potential of price overreaction. What has been subject to actual market inquiry so far this year does not express much confidence on that score - and that was before "transitory" lost so much charm. Like subprime mortgages and their ABX prices in 2007, leveraged loan prices may tell us a great deal about where this is all going. I can already hear Janet Yellen pleading her continued assertion of "resilience", that no investor should fret what is surely "contained."




Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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