The way I see it, this is the current state of play:
The Dow is within a whisker of its record high.
The Cape Shiller P/E index (which measures the average earnings of the S&P 500 over 10 years in real terms) is registering a multiple that’s almost on par with the exuberance of 1929 (just before the Great Depression) and is only bettered by the manic period leading up to the dotcom boom going bust.
Sydney and Melbourne property markets are among the world’s most expensive (when measured as a multiple of average income).
Interest rates are at record lows.
Global debt levels — in both US-dollar terms and as a percentage of global GDP — are the highest in recorded history.
Trust me; I’m not making this up.
These are all established facts…readily available with a search engine and the click of a mouse.
If you accept these facts, you have to acknowledge that we are at extreme levels in asset pricing, debt loads, and the return on money.
Neither man nor machine can function at extreme levels indefinitely.
At some point, stresses inevitably take their toll.
History also tells us that financial systems also suffer from stress.
Without labouring the historical aspect too much, I’d like to give you a few examples of the stress fractures suffered by the financial system.
The Roaring Twenties gave way to the Great Depression; Japan’s 1980s miracle economy surrendered to 25-years of rolling recessions; the irrational exuberance of the 1990s was followed by a fairly spectacular NASDAQ nosedive; and, more recently, US property markets proved they can fall on a nationwide basis.
Can we agree that extremes create stresses?
Do we also have agreement on the law of physics — for every action, there’s an equal and opposite reaction?
These are both rhetorical questions, so please do not bother answering them.
That’s my logic.
If we take the logic to the next step, a financial system that’s at the most extreme level in recorded history must, at some point, suffer an equal and opposite stress fracture.
Is this not a reasoned and rational conclusion?
By the way, that’s not a rhetorical question.
Because your words and actions do not support my admittedly simple process of deduction.
Let me cite a couple of recent examples that have compelled me to send you this memo.
Yesterday, on CNBC, I read this:
‘[The] Fed released its meeting minutes from March which read: “Broad U.S. equity price indexes increased over the intermeeting period, and some measures of valuations, such as price-to-earnings ratios, rose further above historical norms… Some participants viewed equity prices as quite high relative to standard valuation measures.”’
At face value, it looks like the lights may have finally gone on at the Fed.
You then read the statement more closely and you see this: ‘some participants…’
The Federal Open Market Committee has 12 members. And only some view the market as quite high relative to standard valuation measures?
How many is some?
Three, four or five members?
Perhaps the other FOMC members who do not view the market as being overvalued on historic norms would benefit from Advisor Perspectives’ latest (April 2017) valuation update.
Source: Advisor Perspectives
Based on the average of four long-term valuation indicators (not just one or two), the US market is more than two standard deviations from the 117-year mean. That’s the statistical equivalent of ‘getting a selfie with a Yeti’.
Unless you have failing eyesight, it’s pretty evident that the US share market is in rarefied-valuation territory…even higher than the extreme of 1929.
Here’s some advice for those FOMC members who are at odds with some who can see equity prices as quite high, relative to standard valuation measures.
Somewhere, sometime, something is going to make this market revert to the mean (another mathematical law that has not been repealed or signed away by Presidential Executive Order). When that day comes, I can assure you that it will be quite some meeting at the FOMC.
Moving a little closer to home now, earlier this week, The Australian warned: ‘Economy at risk as debt bomb grows’.
This paragraph from the article caught my attention:
‘Dr Lowe [RBA Governor] rejected the idea easy credit was the primary cause of the boom, noting prices were subdued in other cities, and falling in Perth, where financial conditions were the same.’
I read this, then shook my head and read it again, at which point I shook my head again.
My immediate thought was: Surely Dr Lowe did not make this statement. It must have been a misprint.
Apparently not. Dr Lowe did make this statement.
In another life (in the late 70s and early 80s), I was a loans officer with a major bank.
If my memory serves me correctly, the basic formula for lending was:
Loan servicing capacity X interest rate = loan amount.
Just to make sure that’s still how the lending process works, I went online to ASIC’s (Australian Securities and Investment Commission) website and used the mortgage calculator.
Same repayment, same term, different interest rate = different loan amount.
I knew it!
Apologies for that outburst.
It’s just that my powers of reasoning are a little fragile these days, so it was reassuring to find out the maths behind the lending process still works the old-fashioned way.
Just so we are clear on this…if interest rates go lower, people can borrow more.
Do banks receive more fee revenue from a $388,000 loan or a $568,000 loan?
To avoid confusion, this is a rhetorical question.
The lower rates go, the more banks can lend, and the greater the amount available to bid up prices. Does that sound like a reasonable sequence of commercial logic?
In May 2016, the former RBA Governor Glenn Stevens announced the cash rate would be lowered to 1.75%.
This is an extract from the May 2016 RBA statement (emphasis is mine):
‘Sentiment in financial markets has improved recently after a period of heightened volatility. However, uncertainty about the global economic outlook and policy settings among the major jurisdictions continues. Funding costs for high-quality borrowers remain very low and, globally, monetary policy remains remarkably accommodative.
‘Given these conditions, it is appropriate for monetary policy to be accommodative. Low interest rates are supporting demand, while supervisory measures are working to emphasise prudent lending standards and so to contain risks in the housing market. Credit growth to households continues at a moderate pace, albeit with a changed composition between investors and owner-occupiers.’
If I’m not mistaken, ‘accommodative’ in central banker speak translates to ‘encouraging, enticing, come in spinner’.
The reason I selected the May 2016 statement is because this is the last one that includes the ‘accommodative’ terminology.
Yet only three months later, in August 2016, the cash rate was made even more ‘accommodative’, with another 0.25% cut. But the ‘A’ word was not mentioned.
The May 2016 statement claimed ‘credit growth to households continues at a moderate pace.’ What is the RBA’s definition of ‘moderate’?
According to the official Bank of International Settlements (BIS) data, Australian household debt rose from $1.3 trillion in January 2009 to $2 trillion in June 2016…a 54% increase in less than eight years.
How did our moderate pace in household credit growth compare to the rest of the world?
Deloitte Access Economics, on 29 September 2016, notes (emphasis is mine):
‘The more significant issue of Australia’s level of household debt hasn’t received nearly as much scrutiny.
‘Of the 44 countries reported on by the Bank for International Settlements, Australia is unfortunately a world leader. We have the highest ratio of household debt to GDP of all, and we’re one of just four countries where household debt exceeds 100% of GDP.
‘…back in 2000, our [Australia’s] household debt was roughly on par with that of other developed economies, at just below 70%. But since then, growth in household debt relative to GDP has strongly outpaced that in other countries.’
Australia strongly outpaced other countries. That sounds to me like it was a little bit faster than ‘moderate’.
Is this why the RBA ceased using the word ‘accommodative’ in the same sentence as interest rates?
The BIS data indicates that the lure of ‘cheap’ money had well and truly accommodated the ‘buy now, pay later whims’ of Australian households.
Dr Lowe mentioned that Perth property prices had not surged along with Sydney and Melbourne, even though financial conditions remained the same.
That’s not quite correct.
The following chart on capital-city property prices shows that, from 2007 to 2009, Perth and Sydney property values were on par with each other.
Source: Business Insider
The employment and income generated from the mining boom propelled Perth property prices to Sydney levels.
While the boom lasted, property values held up.
But as mentioned earlier, extreme levels tend to create stress fractures. The Perth property market is under stress.
According to real-estate site Domain on 5 April 2017:
‘Higher unemployment, a significant decline in population growth and an exodus of workers because of the slowdown in the resources sector saw Perth prices fall 7.3 per cent since December 2014, according to Domain Group data.’
Not all financial conditions were the same.
When people are concerned about their employment, and they’re unsure about the amount of income coming into their household, they will not borrow, no matter how cheap the money is.
The above chart shows the decisive move up in Sydney and Melbourne property markets came when the RBA cut rates to 3%.
Here’s another rhetorical question for the RBA: Was this just sheer coincidence?
What happens if unemployment rises and wages stagnate or fall on the east coast?
Do these markets suffer the same fate as Perth?
Which takes me back to the very beginning. If we accept the world’s financial system is operating at extreme levels, and if we accept that this is not a sustainable situation, the subsequent (equal and opposite) financial stress must pose a serious threat to Australian jobs and incomes. This will be the knitting needle our property bubble has been in search of.
Thank you for taking the time to read my memo.
I accept that my logic is probably flawed, and that you obviously know something I don’t. For everyone’s sake, I hope that is true…because, if my logic is correct, a Greater Depression is in our destiny.
Editor, The Gowdie Letter
Editor’s note: The above article was originally published in Markets & Money.
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