Trapped in a Bubble

When in a hole, stop digging. But when in a bubble, keep blowing.  -  Not very ancient proverb.

I think our ruling and wealthy elite are worried that they are  stuck in their own ponzi scheme or bubble and are suffering from the general problem of all ponzis and bubbles – how to get out.

You see bubbles and Ponzi’s are fine as long as they keep going. As long as there are ever more suckers to recruit and as long as enough of those already in, remain confident and choose to stay in, there is no real reason a ponzi cannot go on and on.  A perfect example is Madoff’s scheme. The weakness of all bubbles, ponzi or otherwise, is that all it takes is a rumour that it might be time to get out,  that it might soon get difficult to get out, or that someone ‘in the know’ wants out, and a ponzi scheme pops like a soap bubble. They are notoriously unstable.

So if you are in one how do you get out?

I think this question is worrying our wealthy Over Class because stock markets around the world are over-valued and its their wealth which is most  tied up in the markets. I think some of them are now rather worried that they have built themselves a luxury tower of paper wealth from which, when it catches fire, they will not all escape. I think they are right.

So, first, are the markets a bubble or ponzi?

Well if we look at the real economies of the West and then at the stock markets, the later have the look of a ponzi. I’m certainly not alone in thinking this. In Europe, the U.S. and Japan, over the last 6 years, in what we might call the ‘real economy’ of people making things, earning money and spending it to buy things other people have made, we have had either anaemic growth, no growth or outright contraction. And yet all the time the stock markets have roared ever higher. 

On the ‘real’ side of things lets look at Caterpillar (CAT), the american heavy construction equipment manufacturer. It is often seen as a bellwether. CAT, as recently reported over at ZeroHedge, is now in its 28th consecutive month of declining sales. 

And yet its share price is $86 not far off its record highs, up from a low of $23 to which it fell in March 2009. $86 or thereabouts  ever since 2010 despite 28 months of declining sales. 

Is this supply and demand? I think not. Part of an explanation for this levitating share price is, as the ZeroHedge article points out, that the corporation has been buying back its own shares.

CAT had been using more and more of its cash (the red bar) to buy back its own shares inflating the apparent demand for them and therefore their price. It’s not illegal, but what does it do for the idea that share price indicates what a company is worth? And where was CAT getting the money with which to buy those shares?  I doubt it was from profits given the long cumulative decline in sales. More likely it was from selling bonds i.e. using borrowed money.  And indeed that seems to be the case. In May of 2014  CAT sold $2 billion of debt some of it dated as long as 50 years.

So let’s take a look at what we have. In May of 2014, despite having already suffered a year of declining sales, CAT shares were the second best performing shares on the Dow Jones. Who was so keen to buy all their shares? Who knows. But CAT itself had just spent 175 million in buying their own shares in the first quarter (when it was the second best performing share on the DOW) and in the last quarter of the year went on to buy another 250 million dollars worth. In fact, and perhaps most critically,  in January the CAT board had authorized $12 billion for buy-back. So the market know that a lot of shares were going to be bought up…by CAT.  And not at bargain basement price either. Take a look at the record of their share price above and you’ll see that the board had authorized using borrowed money to buy their shares at around the highest price they had ever been.  Hmm. Did buying all those shares encourage others to do likewise, especially knowing that CAT had a war chest of $12 billion earmarked for buying shares?  Any ‘investor’ would know there was a buyer in the market who would be ready and willing to buy them back from him. The upshot would be a guaranteed buoyant market in CAT shares at a time when without such a buoyant demand a year of declining sales might just possibly have led to a steep decline in share price.

Of course the official rationale for taking on debt to buy back shares is that debt costs are now low so its a good time to do it. The problem is that while in the short term it improves the look of the company’s share price and things like return on equity, it locks CAT, and any company that does the same, in to paying out interest on debt over the long term.

The systemic problem

If CAT were alone in being the only company whose share price looks to be over-valued based on actual profitability  it wouldn’t matter and we’d be fine. But it isn’t.

Here is what a recent note from Goldman Sachs chief equity strategist, David Kostin says – as reported at Zerohedge.

… in his latest weekly note to clients he said that “by almost any measure, US equity valuations look expensive.”

In other words almost everything looks over valued.

Mr Kostin goes on to suggest one reason for the inflated prices is that

Corporations have so far used record profits to return cash to shareholders. S&P 500 firms have spent more than $2 trillion repurchasing shares during the past five years.

The key for me is he puts share buy back and returning money to investors together. Companies buy back their shares. This keeps their share price inflated in a market that has forgotten to worry about underlying profit and is fixated instead on short term ‘what someone will pay me for this bit of paper’.  So the share price remain high and the experts tell us all is good. Wonderful in fact. But the money, some of it alt least, is being sucked out and given to those ‘investors’ who sold and cashed out. Now who are those people?  Well we know that the wealthiest 10% own about 75% of all measured wealth and that the bulk of that wealth is not physical stuff but held in the form of financial products

So it looks to me that as share prices are being kept high some are cashing out. Those who stay in are feeling happy because their shares keep going up in ‘value’. But of course its not that simple because someone has to keep buying in the market. So I suspect much of the cashed out money is still flowing back in to other shares to keep the market buoyant. Plus people will look at even a rigged market and say to themselves – “hey I’m missing out if I duck out of this bull market too early.” So they stay in even knowing the risks of a rigged market. Telling themselves there will be a better time later to cash out.

And therein lies their danger. As Mr Kostin notes,

In 2007, companies allocated more than one-third of their cash use to buybacks ($637 billion) just before the S&P 500 plunged by 40% during the following year.

Seems like this was a strategy they tried before. And it is not just CAT and a few others it is market wide. Mr Kostin one more time

We forecast buybacks will surge by 18% in 2015 exceeding $600 billion and accounting for nearly 30% of total cash spending.

I think that is a systemic problem. $600 billion keeping stock prices buoyant and above any profit based valuation.

And I’m not alone. Nobel laureate economist Robert Shiller of Yale University in a recent interview said, referring to the persistent bubble-like pricing in not just property but in stocks and various commodities,

“I call this this the ‘new normal’ boom — it’s a funny boom in asset prices because it’s driven not by the usual exuberance but by an anxiety,” said Shiller.

The fact that Schiller thinks this bubble is driven by anxiety is, to me, very significant. I think he is right of course. I do think there is a palpable anxiety driving this bubble rather than the exuberant ‘animal spirits’ that Greenspan so famously identified as the cause of bubbles.  Schiller goes on to say,

“This is an anxiety driven world — the whole world is driven by anxiety. It is anxiety about the aftermath of the global financial crisis, it’s anxiety about inequality and about computers replacing jobs,” he said.

I agree with all those sources of anxiety. But I think he is missing out on possibly the major source which, as I’ve argued, is the anxiety of keeping your money in the market so as to maintain the inflated share prices, while at the same time trying to figure out how to get out, again, without popping the bubble. So – maintain and get out at the same time – no wonder they’re anxious.

Round and round. Up and up.

If you can’t get out and you are afraid there are not enough new buyers to keep your ponzi/bubble going what do you do? I think the answer is you and your friends do the buying yourself. If you and your friends are big enough players with enough to lose that defecting is really dangerous, then you actually have a workable incentive to keep playing. You buy the shares I sell and I buy yours (It doesn’t just have to be just buy-backs as per the CAT example). And I think this is what has been happening.

Of course it only works of you are able, as a group, to have a really serious effect on the over all market. But if you think of the top 10% they certainly have that. I buy your shares and pay you your asking price. You do the same for me. Tomorrow we do it again and each time we ramp the price a little.

The limiting factor, of course, is that we will not have enough money to buy all the shares as their price goes up and up. But that little problem can be easily solved if we have a friendly banker who will accept our shares as collateral for a loan. If our banker will extend us a loan and increase that loan periodically in line with the increase in value of the shares then all is good. Because the bank can just magic new money in to existence.

And if anyone get a creeping feeling that the banks are getting stretched a little thin or their margins – the interest they charge us for our loans above what they pay for borrowing – are too small for their comfort, then we all just tell the central bank that some new very low interest money is needed to juice the whole system. And since most of them are former us (bankers and financiers) they will understand. Plus they don’t want a systemic crash. It’s bad for their reputation and their personal wealth.

So with help from bankers and central bankers our cash supply will keep pace with the bubble inflation. Let’s be clear the markets tell central bankers what is needed not the other way around. It is a myth that central bankers call the tune. They don’t. Certainly central bankers sit in their central banks board rooms and ‘make’ their decisions but it is what the private banks do, how much they loan, how much they inflate the credit supply, that has the whip hand in dictating what the central banks are obliged to do in order to keep the music playing.

Of course if everyone knows the whole thing is a bubble it might seem insane. But if your alternative is to see the bubble burst then its still a rational decision to keep playing. It will pop one day and all that paper will turn to ash. But if, in the mean time you have been siphoning off some wealth to buy up actual stuff then when the ash settles you will still own stuff. So keep playing.

I wonder if this is why there is such a political push in the US and Europe to privatize anything and everything still in public hands?

And this argument doesn’t even take in to account that the vast preponderance of the wealth of the top 10% is tied up in even more remote-from-reality paper. Certainly the wealthiest 10%, 5%, 1% 0.1% and 0.01% own mines and factories and land. But even those things are dwarfed by how much of the wealth is tied up in the paper wealth of derivatives, securities, loans, bonds piled on top of the inflated asset and share prices. You just have to think, for example, of the size of the OTC derivatives markets whose gross market value is somewhere around $21 trillion. A figure that is itself based upon the larger value of outstanding contracts which is about $630 Trillion. All of this would be dust, in a collapse that was not bailed out.

Is this actually happening?

Well price inflation certainly is. According to an article from AP a few days ago,

…professional investors are warning that companies are presenting misleading versions of their results….What’s worse, the financial analysts who are supposed to fight corporate spin are often playing along. ”Companies are tilting the results,” says fund manager Tom Brown of Second Curve Capital, “and the analysts are buying it.”

How bad is it?

At one of every five companies, these “adjusted” profits were higher than net income by 50 percent or more….Quarter after quarter, the differences between the adjusted and bottom-line figures are adding up. From 2010 through 2014, adjusted profits for the S&P 500 came in $583 billion higher than net income.

At the same time leverage is again creeping up to unwise levels. Not in the banks this time (not officially at least) but in Hedge funds where it is up to 2004 levels. It is a truism that risk never goes away it just migrates to where the regulators can’t see it or have no power to do anything about it.

Even the slowest guys in the room, the regulators, are beginning to be worried. In March of this year,

The Office of Financial Research, the agency tasked with promoting financial stability and keeping an eye on markets, released a paper last week stating that the stock market is dangerously overpriced, and that excessive leverage will exacerbate the next market correction.

You can read the whole report here. The author presents good data showing inflated prices but then does his best to say it could all still be fine. Like I said, the slowest guys in the room.

The point, however, is that there is an air of conspiracy about it. The companies (which includes financial ones) are playing around on the border between creative accountancy and fraudulent misrepresentation and the analysts and auditors are not correcting them. Much as we saw in the figures for all the banks in the run up to the crash. All of the big 4 accountancy firms were signing off on the robust financial health of  banks sometimes mere weeks before said bank then collapsed. All of the big 4 auditors subsequently found themselves in court. So to suggest that companies, analysts and auditors might be not just allowing and enabling dangerous misrepresentations but even endorsing them is not really conspiracy theory, more painful experience.

Why is it happening?

Obviously my argument is that its happening because the wealth and power of the Global Over Class are stuck, as they have been for a decade and more,  in a bubble of inflated prices with not easy way out. I think the longer the Bull market of the last 6 years, goes on and the more decoupled it looks from the non-recovery in the rest of the economy(the employment economy) which the rest of us live in, the more it looks to me like something that is being engineered. And of course the longer it goes on and the more decoupled the bubble gets, the more those invested in it have to lose and the more stuck they feel.  I have suggested the mechanism for maintaining the bubble this long has become the wealthy buying the financial products they all own from each other over and over. Facilitated by banks providing the necessary money supply and complicit experts covering over the yawning gap between share prices and likely profits.

I am not suggesting an organized conspiracy so much as a system finding a new way to keep going. This might seem a herculean task of coordination till you remember that 147 companies own 40% of the wealth nominally owned by tens of thousands of companies. And 737 companies own 80%, And these are the companies that are owned and or run by the wealthiest 10 percent.

The result is a ponzi kept alive without new entrants. The new money being supplied by the banks back-stopped by us via endless QE and back door subsidises like ultra-low interest rates.

If this idea has any merit then our politics will now be bent to preserving this.

One last point for those who have not yet lost the will to live.

Price discovery

The basis of investing used to be Price discovery. And ‘Price discovery’ used to mean discovering how profitable a company was likely to be over the next year or so. That determined what you would pay for a share in that company.  Share price and the market in shares was a reflection of the underlying reality of companies and what they did.

But as speculation has gradually come to overshadow investing, what price discovery means has shifted.  Today, in the age of companies being worth billions one month and very little the next, share price has less and less to do with what profit the company expects to make and more to do with investing strategies (such as ‘buy the dip’), market momentum and above all the political decisions concerning how much easy money will or will not be injected in to the banks..sorry economy.  Value comes to be less about the company itself and the profit it might make and more to do with the collective beliefs and the herd behaviour of traders reacting to each other.

 As long as speculators keep looking at each other and forgetting any notion of profit based value then the  market ceases to be about any lasting physical basis of profitability and can be pulled so far from its old course of tracking ‘profit that price discovery ceases to be anything ‘real’. It becomes a fairly empty measure of …well of what?  Of market confidence? Of feeding frenzy?

What happens in a market dominated by speculation is that the ‘game’ aspect where shares are just a convention of chips in a game has come to dominate any notion of shares representing anything real outside the game.  This is what I think is increasingly what our stock markets are. No wonder they can be so massively manipulated.

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