Get Out (Of The Market)

This is arithmetic, not politics or “market structure” or anything else of the sort.

The last 30+ years have driven the S&P 500 from approximately 100 in 1980 to 1900 today.  This is commonly reported as being due to increasing sales and earnings, that is, a “larger economy” and “better efficiency.”

But that is, for the most part, a lie.

Oh sure, there is a kernel of truth in it, and that truth is responsible for some of the growth.  Maybe a doubling, tripling or even quadrupling between all of if — after all, population has gone up in the United States by a cumulative 1% annually, for example, and there has been a very material expansion in overseas trade and economic improvement.

But the rest of the nineteen-fold expansion didn’t come from there.

It came from this:

If I borrowed $1 million dollars for 10 years in 1980, and was as good a credit risk as the US Government, I had to come up with about $150,000 a year to service that debt.  That is, I could keep that million dollars forever but to do so I had to generate $150,000 in free cash flow each and every year to do so — and that $150,000 could not be spent on anything else.

But by 1990, when the debt rolled over, I only had to come up with $75,000.  The other alternative was to keep coming up with the $150,000 a year but to borrow and spend another million dollars.  Guess what most firms — and the government — did?  The credit growth numbers tell the story.

This pattern continued; today, as I write this, the 10 year Treasury yields 1.865%, which means that I can borrow about eight times as much money and keep it out for the same $150,000 that I could have borrowed in 1980.

That’s what drove the stock market.

Now here’s the important part: The market prices in forward expectations — not today’s “value.”

Today the market believes this pattern will continue.  But it cannot; negative interest rates at central banks are in fact deflationary; they do not drive increased borrowing because the cash that is deposited by the borrower or held by lenders is effectively taxed by said negative rate; that is, instead of increasing the amount of “moneyness” in the economy it is confiscated instead.

Negative rates serve to attempt to coerce spending rather than investment and thus increase velocity.  However, that is immaterial to what drove the market’s price appreciation and that cannot be promoted further; for short-term money the effective rate is already zero and as such only time preference remains which will never completely disappear.

Even if rates do not normalize the increased borrowing is what drove appreciation.  That increase has now come to an end, and the bursting of the housing bubble occurred because when rate decreases stopped happening at a rate that was sufficient to maintain the “rollover” behavior banks and others substituted ignoring credit quality.  This is guaranteed way to lose money because an unqualified borrower obviously won’t pay, but if you can manage to avoid going to prison, and lots of political arm-twisting accomplished that, you can steal “the last meal” from the “peasants” (that’s you and I, by the way.)

Unfortunately that truly is the last meal.  The amount of time it will take for markets to recognize this will vary from place to place; China, for example, is still playing the “hide the rotting fish” game as is Europe and, to some degree, the United States, but again that’s a timing matter rather than an outcome issue.

The outcome is not in doubt because arithmetic just is.

The stress this time is showing up first in natural resources (e.g. oil and shipping) companies but at its core the problem is in the financial system because essentially all of these projects are (or rather “were”) financed at or near 100% “coverage” assuming the price of oil and/or shipping would not fall and thus the operating cash flow would be sufficient.

But the price didn’t just fall, it collapsed.

None of these debts are covered, and we’re now arguing over how long it takes before the cash flow insufficiency starts to create losses that cannot be hidden and bankrupt not only the borrowers but those holding the paper who have used it to lever up other bets by using it as collateral.

This isn’t 2007 — it is in fact much worse because it’s global rather than being concentrated in subprime housing in the United States.