Unlocking Your Financial Potential: Strategies for Wealth Building and Financial Security
Sewing The Seeds of Crisis
It took years for the financial crisis of 2007–2008 to develop. By the summer of 2007, financial markets all across the world were indicating that a protracted binge on cheap borrowing was finally coming to an end. BNP Paribas was alerting investors that they might not be able to withdraw money from three of its funds, two Bear Stearns hedge funds had collapsed, and the British bank Northern Rock was about to request emergency liquidity from the Bank of England.
Nevertheless, despite the warning indications, few investors were aware that the world financial system was going to be hit by the biggest crisis in nearly eight decades, which would knock Wall Street's titans to their knees and cause the Great Recession. (Is history repeating itself?)
What Caused The 2008 Financial Crisis?
The 2008 financial crisis began with cheap credit and lax lending standards that fueled a housing bubble. When the bubble burst, the banks were left holding trillions of dollars of worthless investments in subprime mortgages. The Great Recession that followed cost many their jobs, their savings, and their homes.
Years Of Cheap Money, What Could Go Wrong?
The seeds of the financial crisis were planted during years of rock-bottom interest rates and loose lending standards that fueled a housing price bubble in the U.S. and elsewhere.
The Federal Reserve reduced the federal funds rate from 6.5% in May 2000 to 1% in June 2003 in response to the September 11 terrorist attacks, the dot-com bubble crash, and a slew of corporate accounting scandals.
By making money inexpensively available to consumers and businesses, the economy was intended to be boosted.
As a result of borrowers taking advantage of the cheap mortgage rates, housing values began to rise rapidly. (Does this sound similar to what has been happening for years?)
The Wall Street banks bought the loans from the banks after which they packaged them into what were marketed as low-risk financial vehicles, such as mortgage-backed securities and collateralized debt obligations.
What Could Go Wrong, Did Go Wrong
Interest rates started to rise and homeownership reached a saturation point. The Fed started raising rates in June 2004, and two years later the Federal funds rate had reached 5.25%, where it remained until August 2007. By 2004, U.S. homeownership had peaked at 69.2%.8 Then, in early 2006, home prices started to fall.
For many Americans, this was quite difficult. The value of their properties was lower than what they paid for them. They owed money to their lenders, therefore they were unable to sell their homes. If they had adjustable-rate mortgages, their expenses increased as the value of their properties decreased. The most vulnerable subprime borrowers were forced to stay in mortgages that they couldn't actually afford.
One subprime lender after another declared bankruptcy as 2007 got under way. More than 25 subprime lenders failed in February and March. Sub-prime loan specialist New Century Financial filed for bankruptcy and fired half of its staff in April.
By August 2007, it was clear that the subprime crisis could not be resolved by the financial markets and that its effects extended far beyond the boundaries of the United States.
The global credit markets, which were collapsing due to falling asset values, would receive billions of dollars in loans from the Federal Reserve and other central banks in the upcoming months. Financial institutions were having trouble determining the value of the hazardous mortgage-backed assets worth trillions of dollars that were still listed on their books. - Investopedia
Jeremy Grantham Knows a Thing or Two About Bubbles in our Economy.
All 2-sigma equity bubbles in developed countries have broken back to trend. But before they did, a handful went on to become superbubbles of 3-sigma or greater: in the U.S. in 1929 and 2000 and in Japan in 1989. There were also superbubbles in housing in the U.S. in 2006 and Japan in 1989. All five of these superbubbles corrected all the way back to trend with much greater and longer pain than average.
Today in the U.S. we are in the fourth Superbubble of the last hundred years. (January 2022).
Previous equity superbubbles had a series of distinct features that individually are rare and collectively are unique to these events. In each case, these shared characteristics have already occurred in this cycle. The checklist for a superbubble running through its phases is now complete and the wild rumpus can begin at any time.
We've all heard of market bubbles and many of us know someone who's been caught in one. Although there are plenty of lessons to be learned from past bubbles, market participants still get sucked in each time a new one comes around. A bubble is only one of several market phases, and to avoid being caught off-guard, it is essential to know what these phases are.
Markets move in four phases; understanding how each phase works and how to benefit is the difference between floundering and flourishing.
In the accumulation phase, the market has bottomed, and early adopters and contrarians see an opportunity to jump in and scoop up discounts.
In the mark-up phase, the market seems to have leveled out, and the early majority are jumping back in, while the smart money is cashing out.
In the distribution phase, sentiment turns mixed to slightly bearish, prices are choppy, sellers prevail, and the end of the rally is near.
In the mark-down phase, laggards try to sell and salvage what they can, while early adopters look for signs of a bottom so they can get back in. - Viewpoints
Then in August of 2022, Mr. Grantham Warned that we are entering the SuperBubbles final act.
Only a few market events in an investor’s career really matter, and among the most important of all are superbubbles. These superbubbles are events unlike any others: while there are only a few in history for investors to study, they have clear features in common.
One of those features is the bear market rally after the initial derating stage of the decline but before the economy has clearly begun to deteriorate, as it always has when superbubbles burst. This in all three previous cases recovered over half the market’s initial losses, luring unwary investors back just in time for the market to turn down again, only more viciously, and the economy to weaken. The summer rally of 2022 has perfectly fit the pattern.
The U.S. stock market remains very expensive and an increase in inflation like the one this year has always hurt multiples, although more slowly than normal this time. But now the fundamentals have also started to deteriorate enormously and surprisingly: between COVID in China, war in Europe, food and energy crises, record fiscal tightening, and more, the outlook is far grimmer than could have been foreseen in January. Longer term, a broad and permanent food and resource shortage is threatening, all made worse by accelerating climate damage.
The current superbubble features an unprecedentedly dangerous mix of cross-asset overvaluation (with bonds, housing, and stocks all critically overpriced and now rapidly losing momentum), commodity shock, and Fed hawkishness. Each cycle is different and unique – but every historical parallel suggests that the worst is yet to come.
Most of the time (85% or thereabouts) markets behave quite normally. In these periods, investors (managers, clients, and individuals) are happy enough, but alas these periods do not truly matter. It is only the other 15% of the time that matters, when investors get carried away and become irrational. Mostly (about 12% of the time), this irrationality is excessive optimism, when you see meme stock squeezes and IPO frenzies, such as in the last 2 years; and just now and then (about 3% of the time), investors panic and sell regardless of value, as they did at 666 on the S&P in 2009 and with many stocks trading at a 2.5 P/E in 1974.
These times of euphoria and panic are the most important for portfolios.
We’ve been in such a period, a true superbubble, for a little while now. And the first thing to remember here is that these superbubbles, as well as ordinary 2 sigma bubbles, have always – in developed equity markets – broken back to trend.
The higher they go, therefore, the further they have to fall.
The stages of a SuperBubble
My theory is that the breaking of these superbubbles takes multiple stages. First, the bubble forms; second, a setback occurs, as it just did in the first half of this year, when some wrinkle in the economic or political environment causes investors to realize that perfection will, after all, not last forever, and valuations take a half-step back. Then there is what we have just seen – the bear market rally. Fourth and finally, fundamentals deteriorate and the market declines to a low.
Let’s return to where we are in this process today. Bear market rallies in superbubbles are easier and faster than any other rallies. Investors surmise, this stock sold for $100 6 months ago, so now at $50, or $60, or $70, it must be cheap. Outside of the late stage of a superbubble, new highs are slow and nervous as investors realize that no one has ever bought this stock at this price before: so it is four steps forward, three steps back, gingerly exploring terra incognita. Bear market rallies are the opposite: it sold at $100 before, maybe it could sell at $100 again.
Fundamentals Threaten to Fall Apart
Economic data inevitably lags major turning points in the economy. To make matters worse, at the turn of events like 2000 and 2007, data series like corporate profits and employment can subsequently be massively revised downwards. It is during this lag that the bear market rally typically occurs.
Why are the historic superbubbles always followed by major economic setbacks? Perhaps because they occurred after a very extended build-up of market and economic forces – with a major surge of optimism thrown in at the end. At the peak, the economy always looks near perfect: full employment, strong GDP, no inflation, record margins. This was the case in 1929, 1972, 1999, and in Japan (the most important non-U.S. superbubble). The ageing cycle and temporary near perfection of fundamentals leave economic and financial data with only one way to go.
My papers, “Waiting for the Last Dance” and “Let The Wild Rumpus Begin,” made a simple point: in the U.S., the three near perfect markets with crazy investor behavior and 2.5+ sigma overvaluation have always been followed by big market declines of 50%. The papers said nothing about fundamentals except to expect some deterioration. Now here we are, having experienced the first leg down of the bubble bursting and a substantial bear market rally, and we find the fundamentals are far worse than expected.
The whole world is now fixated on the growth-reducing implications of inflation, rates, and wartime issues such as the energy squeeze. In addition, there are several less obvious short-term problems. Meanwhile, the long-term problems of demographics, resources, and climate are only getting worse and now are beginning to bite even in the short run.
Short-Term Problems
The food/energy/fertilizer problems, exacerbated by the war in Ukraine, are even worse in the emerging world (especially Africa) than the European energy problems we have heard about. Russia and Belarus account for 40% of global exports of potash, a key fertilizer, driving wheat/corn/soybean prices to records earlier this year. Increased food and energy prices are causing acute trade imbalances and civil disorder in the most vulnerable countries, as seen for example in the extremely rapid virtual collapse of the Sri Lankan economy. The energy shock is now all but guaranteed to tip Europe into recession; while the U.S. market has a long history of ignoring foreign problems and interactions, global growth is assuredly coming down.
In China, which has carried by far the biggest load of global growth for the last 30 years, too many things are going wrong at the same time. The COVID pandemic continues, massively affecting its economy. Simultaneously, the Chinese property complex – key to Chinese economic growth – is now under dire stress. This real estate weakness is mirrored around the world, with U.S. homebuilding for example now declining rapidly to well below average levels, as perhaps it should given the record unaffordability of new mortgages. The situation looks even worse in those countries where mortgages are typically floating rate. Historically, real estate has been the most important asset class for economic stability.
We are coming off one of the greatest fiscal tightenings in history as governments withdraw COVID stimulus, both in the U.S. and globally. Historically, there has been a strong relationship between fiscal tightening and subsequent decline in margins (see Appendix). At the same time, the new U.S. excise tax on stock buybacks looks like a harbinger that the U.S. government is beginning to shift its attitude toward the eternal battle between labor and capital (which capital has been winning for many decades now). This may even flow through in time to renewed antitrust action, which would be fantastic for consumers but less fantastic for stock investors.
Prepare for an Epic Finale
Previous superbubbles saw a much worse subsequent economic outlook if they combined multiple asset classes: housing and stocks, as in Japan in 1989 or globally in 2006; or if they combined an inflation surge and rate shock with a stock bubble, as in 1973 in the U.S. and elsewhere.
The current superbubble features the most dangerous mix of these factors in modern times: all three major asset classes – housing, stocks, and bonds – were critically historically overvalued at the end of last year.
Now we are seeing an inflation surge and rate shock as in the early 1970s as well. And to make matters worse, we have a commodity and energy surge (as painfully seen in 1972 and in 2007) and these commodity shocks have always cast a long growth-suppressing shadow.
Given all these negative factors, it is unsurprising that consumer and business confidence measures are testing historic lows. And in the tech sector, the leading edge of the U.S. (and global) economy, hiring is slowing, layoffs are rising, and CEOs are increasingly bracing for recession. Recently, we have seen a bear market rally. It has so far played out exactly in line with its three historical precedents, the bear market rallies that marked the middle phase of deflating superbubbles. If the bear market has already ended, the parallels with the three other U.S. superbubbles – so far so strangely in line – would be completely broken. This is always possible. Each cycle is different, and each government response is unpredictable. But these few epic events seem to act according to their very own rules, in their own play, which has apparently just paused between the third and final act. If history repeats, the play will once again be a Tragedy. We must hope this time for a minor one. - ViewPoints
A Black Swan Event?
A black swan is an unpredictable event that is beyond what is normally expected of a situation and has potentially severe consequences. Black swan events are characterized by their extreme rarity, severe impact, and the widespread insistence they were obvious in hindsight.
The term was popularized by Nassim Nicholas Taleb, a finance professor, writer, and former Wall Street trader. Taleb wrote about the idea of a black swan event in a book just prior to the events of the 2007-2008 financial crisis.
Taleb argued that because black swan events are impossible to predict due to their extreme rarity, yet have catastrophic consequences, it is important for people to always assume a black swan event is a possibility, whatever it may be, and to try to plan accordingly. Some believe that diversification may offer some protection when a black swan event does occur. Investopedia
The massive leveraging of US non financial businesses over the last several decades is utterly incompatible with the stock market cap rising from 62% to 204% of GDP.
The US business economy is now carrying 13X more leverage than it did 50 years ago.
What Has Actually Happened to Business Balance Sheets?
Back in 1972, total business debt outstanding of $634 billion amounted to just 46% of the gross value of US industrial production, which was $1.38 trillion.
By 2007, business debt had soared to $10.1 trillion and stood at 321% of the gross industrial production of $3.15 trillion.
By 2020, the debt figure had risen to $17.7 trillion even as the value of industrial production had remained pinned to the flat line. That is to say, at the end of last year’s Fed-fueled borrowing spree in the US business economy, the leverage ratio clocked in at an off-the-charts 592%.
With this high leverage, growth and profits-generation will become steadily weaker over time. This means that the stock market capitalization rate of the national income should be falling, not heading skyward as described above.
