The further on we get from the crisis while still operating in a regime characterized by crisis-era policies, the more difficult it becomes for investors to remember a time when markets were not receiving continual support from policymakers.
The presence of a communication loop between markets and central banks allows traders and investors to effectively “vote with their feet” whenever they see or hear something they don’t like from the Fed, the ECB, or any other DM monetary authority. The very fact that it can be described as an open channel of communication means the relationship is reflexive.
The more reflexive the relationship between policymakers and markets, the more at risk we are of reaching the point of no return. Beyond that point, the existing state of affairs (defined as it is by “bad behavior” in the form of vol. selling, yield chasing, etc.) becomes so entrenched, the feedback loops become so efficient, that it is for all intents and purposes impossible for central banks to reassert their independence from markets. At that point, “extraordinary” policy becomes “ordinary” policy. What was supposed to be temporary becomes permanent.
In the meantime, legions of retail investors have come to believe they suddenly became geniuses in early 2009. Everyone who felt utterly betrayed just six months prior (everyone whose pretensions to “understanding” markets vanished with Lehman and with their 401ks) not only regained their confidence, but in fact, by some divine intervention, was bestowed with investing acumen the likes of which no active manager on the planet could match.
Of course that’s not true.
But the longer we persist in accommodation, the more retail investors forget to what they owe their good fortune – the more everyone rewrites history in their own minds in order to pretend as though these charts are a coincidence:
And do you know what doesn’t help? Commercials like this one, from E*Trade:
Maybe this can go on forever. But that seems a dubious proposition. And when it finally comes to an end, it will be the same people who thought they had it all figured out headed into 2008 only to be completely disillusioned when they discovered that behind the scenes, things were going on that they didn’t understand, who will find themselves right back in that same situation: crushed thanks to an unceremonious unwind in something they didn’t truly grasp.
Ok, so that intro turned out to be longer than the passages it was meant to introduce, but regular readers know that’s par for the Heisenberg course.
To be sure: nothing you’ll read below is new. Indeed, anyone who actually understands what’s going on and what’s been going on for the better part of a decade, can just go ahead and skip it. That’s how obvious this all is to anyone with any semblance of sense.
But the reason I wanted to publish it is to give anyone who is still in doubt an opportunity to peruse a quick and very concise summary of how we got to where we are.
Via Goldman’s Peter Oppenheimer
For several years after the start of the financial crisis of 2007, deflationary fears accompanied a persistently weak recovery in the global economy. Central banks responded, aggressively cutting interest rates and commencing Quantitative Easing (contributing to further yield compression). While global growth finally started to recover about a year ago, and has since broadened out, inflation has remained steadfastly low and in most cases below central bank target rates.
Structural factors, including the impact of technology, demographics and globalisation, are often put forward as explanations for the ongoing disinflationary pressures in the face of stronger growth. Whatever the reason, the lack of inflation has enabled central banks to keep interest rates at record lows. In the UK the official bank interest rate remains at 0.25% (the lowest rate since records began in 1694). The rate at which governments can borrow money is close to recent record lows and demand for ever longer dated debt continues to be strong. Austria recently issued a 100-year bond with a yield of a little above 2%.
In search of income, investors have been forced to buy riskier assets which, in turn, pushed their yields down and prices up. High yield European corporate bonds are now yielding on average less than the dividend yield on equities for the first time. But equities, too, have enjoyed the benefits of lower interest rates. The US S&P Composite index has increased a staggering 340% in total returns since its low in 2009 shortly after the start of QE. As with other asset classes, higher valuations have played an important role. The price/earnings ratio for the US equity market has driven nearly 40% of the return since the 2009 low. In Europe, where profits have been even weaker, valuation expansion has explained roughly 75% of the return in the benchmark (Stoxx600) index over the same period.
Should investors take cover and reduce risk now for fear of an imminent bear market?
Goldman’s answer to that last question is “no.” Or at least probably not right now.
But that’s not the point of this post. The point, rather, is that you should file that brief history lesson from Peter Oppenheimer away for posterity because one of these days, you’re going to reread it and realize why this was destined to fail.
