The Asset-Driven Economy
We live in an asset-driven economy.
The typical economic cycle during the post-WWII period followed a certain playbook. When demand started to accelerate and capacity tightened, inflation would rise, as there is a response-lag between accelerating demand and additions to supply capacity. In response to accelerating inflation, the Fed would increase interest rates, causing a decrease in demand for credit and thus for goods. Because supply growth lags demand, supply would build as demand was decelerating. Inventories would build up as demand slowed, and companies would cut back production, laying off workers. Economic activity would contract and the economy would enter a recession. In response, the Fed would cut interest rates, and the cost of credit would fall, making it cheaper for companies to finance capital projects. Excess inventories would be cleared away, economic growth would resume, and laid off employees would be called back to work. This is the inventory/credit cycle, and it best represented the dynamics of the economy from 1945 through 1998 (though some might say it ended in 1987, not 1998).
The inventory/credit cycle is still in force today, of course. However, since 1998 (or 1987), the asset-driven economy has become far more important.
In 1998, the Federal Reserve organized the rescue of Long-Term Capital Management, a highly-leveraged hedge fund that speculated primarily in fixed income products. In addition, the Fed cut interest rates three times in six weeks, igniting the final stages of the Tech Bubble. The Nasdaq went up 87% from the bottom on October 8, 1998 to the near-term top on February 1, 1999. The Naz consolidated into the summer before doubling into March 2000, signaling the top of the Tech Bubble.
I mark 1998 as the end of the post-war period, but one could also mark October 1987 when Greenspan slashed interest rates in response to the stock market crash. That was the beginning of the Greenspan Put, whereby the Federal Reserve would bail out asset markets when they were under extreme duress. However, 1998 marked the beginning of the systemic excesses of the asset-driven economy, beginning with the Tech Bubble. For the past 12 years, unlike any time in history, the Federal Reserve has been targeting and responding to rolling asset bubbles, of which it is a prime culprit for creating. This is the era of the asset-driven economy.
Not just the Fed, mind you. Though there was no fiscal response to the collapse of LTCM, the 2001-02 fiscal response by the government and the monetary response by Federal Reserve to counter-act the asset-driven recession caused by the collapse of the Tech Bubble was the biggest stimulus ever up to that time.
As we all know, the Tech Bubble begat the Housing Bubble. Cheap money fueled an orgy of real estate speculation unlike anything seen before, easily surpassing the Tech Bubble, with far more widespread affects to the economy.
Unsurprisingly to anyone with an understanding of valuation and history, the Housing Bubble collapsed. In response to the even bigger economic fallout of the even bigger collapse of the even bigger housing bubble, the government responded with an even bigger stimulus package. Jim Grant of Grant’s Interest Rate Observer estimates that the current stimulus is 10x larger than the average stimulus relative to GDP since WWII, dwarfing the stimulus following Tech Bubble collapse, which Grant estimates was 4x bigger than the post-war average.
See the pattern? Larger problems create larger responses that create even larger problems creating even larger responses. If the pattern is to continue, the government is creating the liquidity for the next bubble. Why should we expect anything different?
The market goes up every day, even after stocks have had one of the best trailing year’s performance ever. Is there precedence for this?
“Yes,” is the answer, at least to some extent.
The S&P 500 rose 28% in three months off the March 2003
bottom, consolidated for six weeks, then rose 7% over the next three-and-a-half
months. In mid-December, at the
52-week high, stocks took off, with the S&P 500 melting up 9% in five
weeks. The index registered gains
in 20 of 27 days.
This is not dissimilar to the current environment, though the return off last year’s bottom is greater. From the March 2009 bottom to October, the S&P 500 rose 65%, then moved sideways with an upward bias, ending with a correction in January and February. Since the reverse pivot low on February 5, the market is up 9%, and stocks have risen 16 of the past 22 days.
In 2004, stocks consolidated with a downward bias from January through November, trading in a 9% range before resuming their climb into 2005 as the economic recovery strengthened. If this year is similar to 2004, we will hit a near-term top soon, consolidate in a range for most of the year, then start moving higher as the economy picks up steam.
Some caveats, however.
- Simply because that is what happened off the last bottom does not mean it will happen again.
- The stimulus in the economy today is much greater than it was 6-7 years ago. Ergo, the affects on asset markets may be even greater.
- The transmission mechanisms that fueled the Housing Bubble have been destroyed. The Fed was not solely responsible for the creation of excess liquidity which fed the Housing Bubble. Wall Street and the banking system created the shadow banking system and structured products markets to facilitate the flow of liquidity into asset markets. That transmission mechanism is effectively irrelevant.
- The markets began rising again at the end of 2004 because the economic recovery strengthened. However, much of the economic recovery was driven by the Housing Bubble. Some have estimated that housing accounted for 40% of the growth during the last economic expansion. What new bubble is going drive the economy higher this time? The economy can still grow, but it may grow below trend.
- There are still tremendous headwinds and imbalances in the economy that were not as prevalent seven years ago.
My thesis is that we are likely to trade in a wide range for 2-5 years, and that we are approaching the highs of that trading range. What the range will be – 1150-1250 on the S&P 500 at the top-end and 900-1000 at the bottom-end? – I have no idea.
There are still tremendous imbalances in the world. I believe we are at the beginning of sovereign defaults. But there is an unprecedented amount of liquidity making its way primarily into financial markets instead of the real economy.
We are in unprecedented times. I believe it will end badly, but that does not mean it will end soon.