NOT INVESTMENT ADVICE

• Has the Federal Reserve inadvertently created the perfect conditions for a stock market crash? Over the past few years, many market commentators have accused the Fed of “blowing bubbles”, i.e. using monetary policy to feed the speculative market environments that enabled both the Nasdaq bubble of 1999-2000 and the US housing bubble of 2006-2007. But has the Fed’s experiment with quantitative easing set up equity markets for a historic fall in the next few years? Will the Fed be held responsible for the next share market crash?

• The view of The Money Enigma is that the Federal Reserve has backed itself into a corner, at least in regards to financial market conditions.

• If the Federal Reserve makes any concerted attempt to reduce the monetary base, then this will raise the required rate of return on capital across all global markets, triggering a major sell off in both bond and equity markets. Just as quantitative easing drove down the cost of capital (as explicitly desired by Ben Bernanke), so reversing quantity easing will drive up the cost of capital, thereby placing downward pressure on the price of all risk assets.

• Conversely, if the Fed does not reduce the monetary base, then high-single digit inflation will return, an event that will create chaos in markets that are priced to achieve very low rates of nominal returns. The view of The Money Enigma is that inflation has been kept in check over the past few years because the increase in the monetary base has been perceived as “temporary”. However, if market participants begin to believe that the US economy is addicted to these higher levels of base money, then confidence in the long-term economic future of the United States will suffer and inflation will return.

The Recipe for a Stock Market Crash

While every commentator will have a slightly different view on the exact mix of conditions that are required for a stock market crash, the basic recipe is fairly straightforward.

As a general rule, in order set up the right environment for a stock market crash, you need to create a situation of extreme overvaluation across a fairly broad range of stocks: certainly not all stocks, but enough to matter.

This is harder than it sounds.

While overvaluation in certain segments of the stock market is a fairly routine occurrence, extreme overvaluation of large portions of the stock market is not. While there is much debate in academic circles about whether “markets are efficient”, there should be no doubt that markets are efficient in the sense that people aren’t stupid. Very few people will intentionally rush out to buy a business for more than it is worth. Therefore, in order to convince lots of people to buy a wide range of businesses for more than they are worth (at least, more than they are worth in retrospect) requires a special set of conditions.

First, you need a strong fundamental catalyst: a new “reality” that forces investors to think differently either about the future prospects of a wide range of businesses, or justifies, at least temporarily, a lower required rate of return on risk assets.

Second, you need to create a set of flawed expectations: a series of new “myths” that allow investors to justify ever-increasing valuations. These myths encourage new investors to buy into the excitement and lull existing investors into a false sense of complacency.

In this sense, the recipe for a stock market crash nearly always involves a mixture of “myth” and “reality”. The recipe for a market crash of historic proportions requires a small dose of reality and a large dose of myth. It is this potent mixture that allows stock market valuations to climb to extremes. Moreover, it is the large helping of “myth” in the mixture that sets up the perfect conditions for a sharp reversal of fortune.

A classic example of this phenomenon is the technology bubble of the late 1990s.

There is no doubt that the technology bubble of 1990s started with a set of important realities: dramatic advancements in semiconductor and computing technology that enabled a corresponding advancement in software and networking technology. These advancements reached a critical tipping point when they enabled the development of the Internet.

The Internet represented an important paradigm shift not just for the technology industry but for the way all businesses operate. Looking back today, some of the early projections about how business would migrate to the Internet were quite conservative. In this sense, the technology bubble of the 1990s was born of an important reality.

While this reality may have set the foundation for the rise in technology stocks, the mania that developed in technology stocks required the invention and propagation of several myths. Basic finance theory was thrown out of the window, as new myths developed regarding how business model success should be measured and how such “success” should be valued. Suddenly, “eyeballs” mattered more than sales and sales mattered more than profits. Moreover, many investors seem to feel that the paradigm shift was so strong that basic business cycles were a thing of the past: demand for networking equipment and IT services would grow at double digit rates every year.

At some point in the year 2000, the myths began to pop. At first it was recognized that a few very silly Internet-based business ideas wouldn’t make it. Then, the realization began to hit that the panic spending on IT would, at some point, begin to subside.

The Nasdaq lost over 80% of its value from peak to trough. All this time, the “reality” never changed: the Internet has dramatically altered the way we all live and do business. But the myths that surrounded the early development of the Internet and began to implode.

Today, global markets are caught up in what I believe is another highly speculative environment. This speculative environment is more insidious than the technology bubble of the late 1990s because it involves far more assets classes: sovereign bonds, corporate bonds, equities, venture capital, private equity, real estate and fiat currencies. In this sense, it makes it much harder to identify the “bubble” because it is harder to see the bubble in any given asset class on a relative basis: it is not clear that stocks are dramatically overvalued compared to bonds or that private equity is any more speculative than venture capital.

However, the view of The Money Enigma is that there is a high level of broad based speculation across all asset classes. This speculative environment has been generated by the actions of the Federal Reserve and the other major central banks. In particular, it has been created by the reality and the myths that surround the now widely adopted program of quantitative easing. The key for investors today is being able to distinguish between the important reality that drove markets higher initially and the myths that are sustaining current speculative conditions.

Quantitative Easing: Distinguishing between Myth and Reality

The current speculative environment in global markets is a function of one reality and two myths regarding the massive expansion of the monetary base otherwise known as quantitative easing.

Let’s begin with the reality: a massive and sudden expansion of the monetary base that is used to buy sovereign bonds will drive down the required rate of return across all risk assets and, all else remaining equal, will drive up the price of those same risk assets.

For those not familiar with how financial markets operate it may seem surprising that buying government bonds will force up the price of equities. After all, what does the price of government bonds have to do with the price of stocks? The answer is “everything”.

There are two ways to think about this: we can think about it in theoretical terms or in more practical terms.

In theoretical terms, the market value of a business is determined by the net present value of future cash flows that investors expect to receive from that business. Note the use of the term “present value”: $100 in ten years is not worth the same as $100 today. Therefore, we need to discount expected future cash flows using a discount rate to covert those future cash flows into their present value equivalent.

While the discount rate that we use to calculate net present value will vary between one business and another, depending upon the nature of that business, the discount rate is always some function of the “risk-free” rate. The “risk-free” rate is the required rate of return from a risk free investment. Theoretically, the calculation of a discount rate for a business always begins with this “risk-free rate” which acts as the foundation rate upon which other discount rates are built.

In our modern society, it is widely accepted (at least at the present moment) that the risk-free rate is best proxied by the interest rate on government bonds. Therefore, if central banks create money and use this money to buy government bonds, then this forces down not only the interest rate on government bonds, but forces down the risk free rate which is used as the baseline for all risk asset valuations.

The valuation of a long-duration risk asset is highly sensitive to the long-term discount rate and, therefore, the risk-free rate. Moreover, the valuation of the stock market is much more sensitive (at least in principle) to the risk-free rate than to near term business conditions. This is an important point that we will return to shortly.

We can also think about this issue from a more practical perspective.

Government bonds, corporate bonds and equities are, at least to some degree, substitutes for each other. They are not perfect substitutes, but they are substitutes.

If the Federal Reserve begins to buy lots of government bonds and forces down the interest rate on government bonds, then this will induce investors who invest in both government and corporate bonds to seek higher yields in corporate bonds. At the margin, the Fed’s “investment” in the government bond market crowds out private investors in the government market. These investors turn to the next best substitute: corporate bonds.

In turn, this forces down the yield of corporate bonds. Those investors who invest across the corporate spectrum (corporate bonds and equities) will now, at the margin, chase the higher expected return in equities, forcing up the price of equities.

In this way, the Fed’s actions create a domino effect across all asset classes: investors shift from government bonds to corporate bonds, corporate bonds to low-risk equities, low-risk equities to high-risk equities, high-risk equities to venture capital.

In more technical terms, the massive expansion of the Federal Reserve’s balance sheet lowers the required cost of capital across all asset classes, stimulating higher prices across the entire spectrum of risk assets.

At the margin, this whole process has had a positive effect on the economy. By lowering the required cost of capital for all investments, more investment activity has been stimulated: the shale oil boom, the biotech boom, the pick up in small business activity are all, in part, a function of a lower cost of capital.

This is the reality of quantitative easing.

Now, let’s discuss the myths.

The market has created two myths regarding quantitative easing that have been absolutely critical in sustaining the positive momentum that the equity markets have enjoyed over the past few years. So, what are these two myths?

Myth #1: If the Federal Reserve begins to reverse quantitative easing (reduces the monetary base), then the underlying strength in the economy at that time will offset any weakness that occurs because of tightening “liquidity conditions”.

Myth #2: If the Federal Reserve does nothing and leaves the monetary base at the current exceptional levels, then there will be no adverse inflationary outcome. More specifically, inflation is caused by “too much demand”, so it doesn’t matter if the Fed leaves the monetary base where it is, as long as the economy doesn’t “overheat”.

The Federal Reserve has done little to discredit either of these myths. The reticence of the Fed to even discuss a significant reduction in the monetary base suggests that the Fed understands that the first myth is a falsehood. The Fed seems desperately keen to invent new reasons for why a “normalization” of monetary policy is not required “at this time”. (Ever notice how the Fed’s “natural rate of unemployment” target keeps getting lowered?) I doubt there is one single member of the FOMC who wants to be on the FOMC the day that a surprise reduction in the monetary base in announced. After all, “you break it, you own it” and who wants to “own” a broken stock market?

More worryingly, the Federal Reserve has done nothing to dispel Myth #2. In regard to this point, it may be that the Fed really believes its own myth. The notion that “money doesn’t matter” and that “inflation is caused by too much demand” is a fashionable idea in mainstream economics. The view of The Money Enigma is that this New Keynesian approach to the issue of inflation is fundamentally flawed and that if the monetary base is allowed to stay at these levels, then inflation will surely accelerate.

We have discussed the relationship between money and inflation at length over the past few months (for example, see “Does Too Much Money Cause Inflation?” or “Why is There a Lag Between Money Printing and Inflation?”) and we will touch on it again in a moment. But before we do, let’s discuss Myth #1.

Myth #1: Stocks Won’t Fall if the Fed Reverses QE

Myth #1 is a favorite of the chattering class on CNBC who don’t understand the fundamentals of equity valuation. In essence, their argument is that when the time comes to reduce the monetary base (by the way, when is that?) the economy will be strong enough that investors will look past the fact that long-term interest rates are rising: rather, investors will focus on strong near-term earnings.

So, here is a simple theoretical question? Is the value of a long-duration asset more sensitive to (a) changes in near term cash flows, or (b) changes in the long-term discount rate?

The answer is (b).

Clearly, the answer depends slightly on definitions (e.g., how do we define “near-term”?) but the principle is simple. The value of a business depends upon the sum of an expected stream of discounted future cash flows. The net present value of a business is only marginally impacted by a 10% change in the expected cash flows that will be produced in the next one or two years.

However, what happens if the discount rate rises by 10%? A rise in the discount rate impacts the present value of all future cash flows, not just the value of future cash flows that are expected this year and next, but the value of cash flows that are expected to be received 10, 20 and even 30 years from now.

If the Federal Reserve reverses quantitative easing, then, all remaining equal, the interest rate on government bonds will rise, the risk-free rate will rise and the required cost of capital for all risk assets will rise. The negative impact this will have on the valuation of risk assets will far outweigh any marginal benefit to near-term earnings from a strong economy.

Discussion regarding “tightening liquidity conditions” miss the point: yes, it won’t help the stock market when bond and equity investors suddenly need to sell a trillion or two in corporate debt and equity in order to buy government bonds from the Fed. But more fundamentally, the issue is one of valuation. As the Fed reverses QE, the required rate of return on capital will rise across the entire spectrum of risk assets and, all else remaining equal, the net present value of stocks will fall.

Myth #2: The Size of the Monetary Base Doesn’t Matter to Inflation

Myth #2 is more pernicious than Myth #1 and, unfortunately, is much harder to debunk. Dissecting and dismantling Myth #2 requires us to revisit the very foundations upon which the science of economics is built. More specifically, we need to fully reexamine (a) how prices are determined, and (b) the nature of money. The Money Enigma is dedicated to both of these topics and we have explored each at length over the past few months. Clearly, we don’t have time to cover all this ground today, but we shall touch on a few core concepts.

Before we do, let’s start with a simple observation: “money isn’t free”.

Government and it agencies, most notably the central bank, are empowered by our society to “create money” (expand the monetary base). In this sense, the central bank can create something of value “out of thin air”. However, this does not mean that creating money has “no cost”.

If there was no fundamental economic cost associated with the creation of money, then there would no constraint on how much money our society creates and no limit to our prosperity: we would simply keep the printing presses rolling until everyone had everything they ever wanted.

So, what is the cost associated with money creation? At the most basic level, the economic cost associated with creating money is a decline in the value of that money and a commensurate rise in the price of all goods as measured in terms of that monetary unit.

Now, this is not a simple process. While the long-term relationship between the “money/output” ratio and the price level is well established, there is no simple or predictable short-term relationship between the size of the monetary base and the value of money.

For example, over the past six years, the Federal Reserve has quintupled the monetary with little to no impact on the value of the US Dollar or consumer prices in the United States.

Many commentators seem to believe that since the expansion of the monetary base in the past six years has not produced high levels of inflation, we are safe to assume that the link between the “money/output” ratio and the price level is “broken”. In other words, many seem to believe that the quantity theory of money, one of the strongest long-term empirical relationships ever demonstrated in economics, is now defunct.

The view of The Money Enigma is that the long-term relationship between money and prices is well and truly alive. Moreover, the longer the Federal Reserve delays a “normalization” of monetary policy, the greater the risk that inflation accelerates.

So, what explains the subdued levels of inflation that we are currently experiencing? Why does inflation lag monetary expansion, in some cases by many years?

In order to understand why the price level doesn’t immediately jump as soon as the Fed prints money, we need to understand a couple of key concepts.

First, we need to understand how the price of a good, in money terms, is determined. The view of The Money Enigma is that every price is a relative expression of market value. The price of a good, in money terms, depends upon (1) the market value of the good, and (2) the market value of money. The price of a good, in money terms, can rise either because (1) the market value of the good rises, or (2) the market value of money falls.

For example, if one apple is three times more valuable than one dollar, then the price of an apple, in dollar terms, is three dollars. This relative value differential can be impacted by a change in either the value of the apple or the value of the dollar. All else remaining equal, if the value of one dollar falls, then one apple will become more valuable relative to one dollar (even if the value of the apple itself has not changed when measured in absolute terms) and the price of one apple, in dollar terms, will rise.

[Economics struggles with this simple concept because economics has not developed a “standard unit” for the measurement of market value and, consequently, doesn’t appreciate the difference between the absolute and relative measurement of market value. This issue is explained at length in a recent post titled “The Measurement of Market Value: Absolute, Relative and Real”, a post which I strongly encourage everyone to read.]

We can extend this microeconomic theory of price determination to a macroeconomic theory of price level determination.

The view of The Money Enigma is that the market value of money is the denominator of every money price in the economy and hence is the denominator of the price level. All else remaining equal, as the market value of money falls, the price level rises.

This raises the next obvious question: what determines the value of money?

This is a complicated subject and one that has been discussed at length in two recent posts: “The Evolution of Money: Why Does Fiat Money Have Value?” and “What Factors Influence the Value of Fiat Money?”

The view of The Money Enigma is that fiat money is a financial instrument and, in common with all financial instruments, derives its value from its contractual features. More specifically, fiat money is long-duration, special form equity instrument that represents a proportional claim on the future output of society.

Consequently, the value of fiat money is primarily dependent upon expectations regarding the long-term path of both real output and the monetary base. If the market expects long-term real output growth to be strong, then this supports the value of the fiat money issued by that society. Conversely, if the market expects long-term monetary base growth to accelerate, then the value of fiat money will fall.

Now, let’s think about what this theory might mean in the current environment.

The view of The Money Enigma is that an increase in the monetary base that is perceived to be “temporary” will have little to no impact on the value of fiat money. Why? The value of money depends upon expectations of the long-term path of real output relative to the monetary base. A change in the current level of the “real output/monetary base” ratio only impacts the value of money to the degree that it leads to a shift in long-term expectations regarding that ratio. Conversely, an increase in the monetary base that is perceived to be more “permanent” in nature will have a considerable impact on the value of money.

The reason that QE has not triggered a fall in the value of money and a rise in the price level is because the market perceives QE to be a “temporary” phenomenon. Over the past six years, quantitative easing has been routinely represented as an “emergency measure”: an extraordinary policy for an extraordinary time. Almost by definition, emergency measures are temporary actions (we can’t live in a permanent state of emergency).

Despite the many delays in “normalizing” monetary policy, the markets still seem to be convinced that the recent expansion in the monetary base is “temporary” in nature.

The question that no one wants to discuss is what happens if the “temporary” expansion in the monetary base becomes more “permanent” in nature? Moreover, what happens if instead of reducing in the monetary base, the Fed is forced to further expand the monetary base?

The view of The Money Enigma is that either of these scenarios will lead to a loss of confidence in the long-term prospects of the US economy, a fall in the value of money and a significant rise in the price level.

A return to high single digit inflation rates would represent another bad scenario for global stock markets: risk assets that are priced to achieve low nominal rates of return don’t respond well to a sudden acceleration in inflation.

In summary, the Federal Reserve has backed itself into a corner. If it reverses quantitative easing, then risk assets are likely to perform poorly as the required return on capital rises across the entire risk spectrum. However, if the Fed fails to reverse quantitative easing, then inflation will accelerate, a scenario for which global investors are not prepared.