As America Burns, Market Irrationality Reaches New Highs

Originally published June 2:

The U.S. is experiencing widespread violent protests, riots, and looting across dozens of major cities, with thousands of arrests.

The country hasn’t seen unrest like this since the assassination of Dr. Martin Luther King Jr. in 1968.

Yet the impact on the markets has been negligible.

Speculators continue building their risk-on exposures with wild abandon. Stocks continue to rally. They’ve surpassed the highs of the market when the first several Covid-19 deaths in the U.S. were announced.

Likewise, investors are ignoring our country’s heightened tension with China. In fact, the relationship with China is devolving more and more into a Cold War. The world’s two largest economies are no longer even pretending to get along.

We’ll examine all that, and the market’s disconnect, in this week’s update below.

Let’s start with the U.S.-China tensions…

Tensions Ramp Up at Home and Abroad

China is exercising its muscles, and the U.S. is not reacting well.

The removal by the U.S. of Hong Kong’s special rights is just the tip of the iceberg. The relationship between these two great nations is getting more and more tense.

The President has blatantly accused the Chinese of unfair trade practices, corporate espionage and technology theft, fraudulent accounting practices, flagrant violations of human rights, and a host of other unpleasantries.

He’s even claimed China willfully spread the coronavirus to the west, causing hundreds of thousands of deaths.

Sanctions against leading Chinese companies and individuals, including blacklisting and blocking from access to the U.S. capital markets, are likely to follow. There is even talk about blocking access to China from the U.S. dollar system, a very serious move.

The Chinese have responded to America’s “interference in its domestic affairs” by canceling a number of agricultural purchases. This puts the Phase I Trade Deal at risk.

Still, the market is shrugging it all off as irrelevant.

The 45 million unemployed workers in the U.S. are also irrelevant to the market. The 40% economic collapse in the second quarter is irrelevant. The 105,000 U.S. deaths from the coronavirus are irrelevant.

The only thing that seems to be relevant is the de facto put option from the Fed, so the gulf between Wall Street and Main Street continues to widen. In the minds of stock buyers, the Fed is going to continue providing support and economic stimulus.

In reality, the economy is a mess, and the civil unrest is only going to hinder the recovery. Damage to property and extensive curfews are not helpful to economic growth, to say the least.

The idea of the President actually calling in the Army to squash the protests is something that I hadn’t formerly considered, but I guess I have to add that to the equation.

Moreover, the mass riots and protests provide a perfect breeding ground for the virus to spread, as tens of thousands of shouting people are bunched together for many hours.

The likelihood of a second wave of Covid-19 infections is growing stronger by the day… even if that’s something people don’t want to consider.

Something else people don’t want to think about is higher taxes. But the fact is that tax rates will absolutely go up sharply over the coming years.

None of these things seem to matter to the markets, however.

People are relying on the astonishing assurances of Jerome Powell, the Chairman of the Federal Reserve, that the Fed is not going to run out of ammunition… and that the Fed will provide essentially unlimited lending to support the economy.

Hmm. Let’s put this in perspective…

Federal Reserve’s Sleight of Hand

If the Fed’s support for the economy is essentially unlimited, why should the government bother collecting any taxes?

That seems like a gigantic waste of time and effort, not to mention a huge bother for those of us who pay taxes. Why not let the Fed just cover any and all obligations and allow us to not pay taxes?

Yes, eventually this logic breaks down into a stinky pile of nonsense. In fact, the rights and powers of the Federal Reserve Act have been codified into law.

The law is clear that the Fed is allowed to make loans against collateral to avoid losses to the American taxpayer. But nothing more.

There is nothing in the law to suggest that the Fed is allowed to make purchases of anything, let alone junk bonds and junk bond ETFs.

The Fed’s emergency lending authority was outlined in the original Dodd-Frank legislation from 2010. It said emergency funds have to be broad-based. According to Dodd-Frank, they should be used to provide liquidity to the financial system… not to aid failing financial companies.

The law also restricts the Fed from establishing “a program or facility that is structured to remove assets from the balance sheet of a single and specific company.” It also mandated that any Fed facility “be terminated in a timely and orderly fashion.”

Since Trump came into the White House, there have been some changes to Dodd-Frank.

The Fed’s wishful interpretation of the changes is that as long as Treasury Secretary Steve Mnuchin gives the green light for what the Fed is doing, none of the other prohibitions apply.

But that’s not how the law reads. The law clearly indicates that all of the prohibitions apply and, on top of those, the U.S. Treasury Secretary must also give his approval.

You should note that $500 billion of the Treasury’s recent funding package were earmarked for the Fed. Why? Because Mnuchin and Powell agreed that the Fed would leverage up that $500 billion ten-fold and create an additional $5 trillion of funny money.

But how can the Fed get around that law? Well, with a little sleight of hand.

It’s going to make a loan to an entity called a Special Purpose Vehicle (SPV). That entity will buy the corporate bonds WITH OUR MONEY. That’s how the Fed will get around the prohibition that it can only make loans, not purchases.

Again, our money will underwrite the purchase of these risky assets. And the restrictions are frankly a little frightening.

The SPV can purchase up to 130% of the issuer’s maximum outstanding bonds and loans on any day between March 22, 2019 and March 22, 2020. Really? Here’s an example…

Say a company had $200 million of outstanding debt. Recently, this company lost the ability to tap the bond market for funding.

The SPV can be the sole investor in a bond issuance of $260 million – WHEN NO ONE ELSE WILL LEND THE ISSUER ANY MONEY. Remember, they’re investing in that bond issuance with taxpayers’ money.

Call me crazy, but that sounds very dubious, to say the least.

Distorting America’s Economy with Funny Money

Clearly, the Fed has not reduced its emergency lending facilities in anything remotely timely or orderly.

In fact, as you will see in a moment, it just keeps blowing out its balance sheet, pumping ever more money into a weak economy to trick people into thinking that things are alright.

In any event, counting on the Fed to keep up the stimulus indefinitely is a very foolish proposition that is doomed to fail.

The system is not seizing up right now. The banks are working efficiently. No, they are not lending easily, but they always prefer to lend to companies and people who don’t need the money.

If companies don’t have the strength to survive a few months of limited income, it is clear that they are not very strong. Companies that are weak can realistically be expected to go out of business, not get bailed out by taxpayers. That is not the function of government in a capitalistic, democratic society.

Those companies’ liquidity issues have become insolvency issues, and those companies can be expected to go bankrupt. That is how the system clears out the dead wood in a capitalistic society.

That is why stocks are theoretically considered “risky” assets. Companies can go out of business and fail. They aren’t supposed to get propped up and supported due to some sort of shady cronyism.

So, instead of following Dodd-Frank’s requirement that loans have to be collateralized “sufficient to protect taxpayers from losses,” the SPV will be established with $50 billion of taxpayer money. The other $450 billion will be used to provide massive amounts of suspect, or at least unnecessary, loans.

The express purpose of using those taxpayer dollars is to absorb the first $50 billion of losses in this gambit. This is not supposed to happen. In fact, it is a clear violation of our rights as citizens and taxpayers.

Alright, let’s have a look at the real economic growth in the U.S. since 2007. I think you will find some of this information quite interesting.

Illusions of Prosperity

In 2007, the nation’s GDP was $14.45 trillion. It rose to $14.75 trillion in 2008, and then dropped back to $14.45 trillion in 2009. That doesn’t look so bad.

By 2019 the U.S. GDP had grown to $21.4 trillion. That seems alright, although it is probably on pace to generate about $20 trillion in GDP by the end of 2020. That means the annual GDP has increased by $5.2 trillion.

The Dow Jones during this period hit a high of 13,924 in 2007, then dipped to a low of 6,470 in 2009, before surging to 29,568 in 2019.

Wow! The U.S. economy must have been doing great during this period. But was it?

In 2007, the Fed’s balance sheet was $870 billion. Then the Great Recession struck, and the balance sheet quickly ballooned out to $2.2 trillion.

The Fed was pumping money into the system like crazy. It didn’t stop there though.

By 2015 the Fed had blown out its balance sheet to $4.7 trillion. Why? Well, the economy wasn’t really growing very well, so the Fed kept pouring in money to give the appearance of growth.

The balance sheet got reduced to $3.76 trillion in 2019 when the Fed tried raising rates. That didn’t last long. Since the onset of the coronavirus, the Fed has grown the assets in its balance sheet to $7.1 trillion. Yes. $7.1 trillion!

So the economy’s annual growth rate has grown by $5.5 trillion during this period, while the Fed’s assets have grown by $6.2 trillion.

Interest rates have been driven down to 25 basis points, and the economy is in shambles. (The last time rates went this low was in December 2008, during the financial crisis.)

So the apparent growth in GDP is clearly not as strong as it seems. But there is more to consider. Let’s look at the federal deficit during this period.

In 2007 the Treasury owed $8.9 trillion. The total federal debt now stands at $24.9 trillion! The Federal deficit has ballooned out by $16 trillion.

The Fed has increased its assets by $6.2 trillion, the nation’s annual GDP has grown by $5.5 trillion, and the federal debt has grown by $16 trillion.

That sounds a bit scary. If I just keep borrowing money so that my balance sheet is getting bigger and bigger, am I getting wealthier?

Of course not. That is not a creation of true wealth. It is a creation of true debt.

Borrowed Money = Market Bubble = Growing Wealth Gap

This is what I am referring to when I talk about funny money.

The huge injections of borrowed funds simply pushed up the value of assets like stocks, without the underlying economic growth that should really be driving the stock market.

It led to the bubble conditions of the stock market as well as a massive increase in wealth inequality. What do I mean by that?

Only 53% of Americans own stocks, and the greatest percentages of stock ownership are concentrated in the wealthiest 10%. So the giant rally in the stock market since 2007 only helped out a very small segment of society.

Today, the stock market’s valuations are truly extraordinary. The P/E ratios – which measure how much investors are paying for each dollar of a company’s earnings – point to fantastic growth rates and an economy that is humming on all cylinders.

They are not discounting an economy that just needed over $5 trillion of emergency bailout spending. They are not discounting an unemployment rate that will still be in double digits at year end.

For example, take employment in New York City, the hub of the largest metropolitan economy in the country. The only industry that will see an increase in net employment over the next 18 months is the education/health industry.

By the end of 2021, leisure and hospitality employment rates will still be 30% lower than in January of this year, according to Alexandre Tanzi from Bloomberg.

Manufacturing will be about the same as leisure and hospitality. Mining will be down by about 15%, transportation will be down by 13%, IT will be down by 6%, and financial services will be down by 6%.

This means that consumption will be better than today for sure, but it will be much lower than at the end of 2019.

Borrowing Has Limits… Avoid the FOMO

In closing, the central bank and the Treasury do have limits, as much as they may not want to admit it. At some point borrowers will resist any further debt issuance by the Treasury, and that would be a very scary point.

Savings rates will be higher, consumption lower, and taxes higher. Unemployment will remain stubbornly high.

Federal borrowing will start to crowd out money that would otherwise go towards investment. The Fed will finally have to restrain its balance sheet and start to reduce its size. And the trajectory of long-term economic growth will be more modest.

This is not a great environment for risky assets, so please try to be patient. Try to avoid the FOMO, the fear of missing out.

At a minimum, we will see a correction of 10% from current levels in the S&P 500. Potentially, we will see a second wave of violent selling that will melt down to new lows.

The currencies should eventually start to behave more rationally as well. They are stretched out to ridiculously mispriced levels, but we need to respect the market – even when it is irrational.