Why Liquidity Is No Longer the Mother’s Milk of Stock Prices

As a currency trader, I need to follow all the markets closely, including stocks. And even though the S&P 500 stock index is up 11.5 percent for the year, it feels more like it’s down 20 percent.

From a trader’s perspective, it sure seems that price action is very different than it has been in the past. I’m not sure why. But I have my suspicions. Let me explain two of them …

Suspicion #1 —
Stocks Ignoring Economic Disappointments

A key premise I used to have faith in goes something like this: Stock prices ultimately have a direct relationship to the underlying economy. I am talking about the real economy, the place we all work and live.

The reason for this belief is because financial theory tells us a stock’s intrinsic value is a reflection of discounting all the future cash flow estimates into the current price. And the key factor in this discounting equation is future earnings.

Going to the point, future earnings are based on a company’s ability to perform and grow within the real economy (not the financial economy where financial engineering games are played).

Granted, this theory is a bit hazy at times. And sure, stocks and all other traded asset classes can remain seemingly unhinged from underlying fundamentals for longer periods than we expect. But at some point — and I keep thinking we are well past such a point — the real world must start to be reflected by the financial world.

Think of it as a Wily Coyote moment when you discover there is nothing but air below and you can’t fly.

And yet, there seems no such reflection of the continued drip of slower and slower global growth prospects onto stock prices.

I won’t go into the litany of economic disappointments, except to say the three major drivers of the global economy: The U.S., Europe, and China are all slowing at the same time, yet stocks look right past it all.

I realize what you may be thinking: As long as central banks of the world continue to pump more and more liquidity — quantitative easing — out the door, stock prices will remain supported. Interestingly, it may be just that simple.

But it may only be that simple if the following two tenets hold tightly together: 1) Liquidity is the mother’s milk of stock prices, and 2) money has to go somewhere as only so much can hide at zero or negative interest rates.

I’m not sure anything in the investment world is that simple.

I do believe liquidity is the mother’s milk of stock prices. But embedded in that belief is the implicit expectation liquidity will positively impact the real economy through a feedback loop with  rising stock prices stimulating consumer wealth. Therefore consumers start consuming and GDP growth and corporate earnings rise accordingly.

I think there is a major flaw in this reasoning because …

Suspicion #2 —
This Is Not a Normal Business Cycle;
We Are Caught in a Balance Sheet Recession

In order for the consumer wealth effect to work, it must be a normal business cycle. I am here to say that this is not your father’s business cycle. This is something very much different, more dangerous, and potentially much longer lasting.

I believe this is a balance sheet recession that has very much in common with some of the worst long-term economic cycles in history — 1873, 1929, and 1989 (Japan). In fact, we could be traveling right down the same path as Japan — locked in a deflationary bear hug for the last 20 years! Let me provide some evidence …

I draw much of this evidence from an excellent piece by Hoisington Investment Management, from their Quarterly Review and Outlook: Second Quarter 2012.

Why is this business cycle so dangerous?

Public debt is soaring in the major industrialized economies as well as in the developing world. The two major economic down cycles that were not considered normal and had major implications for interest rates, inflation, and debt were the bust of 1873 and panic of 1929.

In the chart below, Hoisington shows the very outsized level of gross debt (private and public) to GDP during those periods.

Click the chart for a larger view.

Interesting how debt levels — considered “off the charts” — in past cycles don’t hold a candle to where we are now.

Next, consider Japan where public and private debt surged from 357 percent of GDP in 1979 to above 540 percent in 1989. This 183 percentage point rise made the U.S. look like pikers in comparison, as U.S. debt to GDP rose 100 percentage points from 1998 to 2008.

Stay with me, here is where it gets interesting …

According to Hoisington, in the aftermath of these debt-induced panics:

• Long-term Treasury bond yields declined from 3.5 percent, 3.6 percent, 5.5 percent (Japan) to the extremely low levels of 2 percent or less in all three cases.
• The low in interest rates in these cases occurred almost fourteen years after their respective panic years.
• Amazingly, twenty years after each of these panic years, long-term yields were still very depressed, with the average yield of just 2.5 percent!

So much for the much reported but missing in action “bond bubble.”

Though we all like to blame the Fed for our ills, keep in mind the 1873 panic happened well before the Fed was established — in 1913, as a result of the panic of 1907.

Now the payoff point: Reinhart, Reinhart, and Rogoff — highly respected economists who seem to understand the real world — examined 26 advanced economies with public debt levels above 90 percent for at least five years (U.S. not quite there) since 1800.

They found these economies had 1.2 percent lower GDP growth rates than they did during low debt periods. And incredibly, the duration of this subpar growth averaged 23 years!

Who would have believed when Japan was about to “take over the world” back in the late 1980’s, the bubble it created would soon lock them into 20+ years of economic hell.

So just maybe it is not as simple as central banks providing continuous liquidity making all things better.

There will be an ebb and flow in stock prices, as always. I think sharp rallies predicated on liquidity dumps provided by desperate central banks will continue. But as I said, this is a very different business cycle. And as we move along since the crisis year measured as 2007 — now five years in — it increasingly appears we have a model to guide us: Japan.

Notice the path of Japanese stock prices since the crisis year of 1989 and the strengthening currency to boot!

Let’s see how we are doing to pave the same path as Japan:

  Massive fiscal stimulus pushing public debt/GDP toward 100 percent … check!

  Zero rate money to anyone who dares take it, with real rates negative … check!

  No inflation to speak of, proving monetarism is a dead letter when debt/GDP ratio surges toward 100 percent … check!

  Rising currency on global money flow and institutional retrenchment … check!

Mr. Bernanke confidently told us a few years ago we would never follow down the path of Japanese deflation; the Fed would be able to create inflation with all the tools at their disposal.

Well Mr. Bernanke, we are still waiting.

Best wishes,

Jack

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