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There’s something deeply anomalous about a stock market crash at the peak of United States corporate profitability. Nothing like this ever has happened before. Nonetheless, judging from overnight moves in Asian markets, last week’s plunge in world stock markets will be repeated in Europe and America on Monday morning – although recent intraday moves have been so extreme that one is loath to guess.
Standard and Poor’s downgrade of American sovereign debt from the highest, triple-A rating may be the silliest pretext for a stock market crash in world history. America is the only big industrial country in the world that will have more taxpayers rather than fewer when a newly-issued 30-year bond matures.
In Asian trading, the US 10-year note lost about a point and a half, a modest response to S&P’s action. But the 3% to 4% declines in regional stock markets and a parallel fall in US stock futures, is harder to explain. Stock markets never have undergone this sort of crash when corporate earnings outpaced the alternatives by such an extreme margin. The earnings yield on stocks is a full 5 percentage points higher than the yield on 10-year US Treasuries, something we have not seen for a generation.
The so-called Equity Risk Premium (ERP) – the earnings yield on stocks minus the 10-Year Treasury yield – stands at a generational high. The corporate bond market assigns a low risk to corporate earnings. In a world short of earnings to fund history’s largest retirement wave, why is the market selling an S&P earnings yield of 8% to buy 10-year Treasuries at 2.5%?
Systemic strains exist, first among them the likely restructuring of Italy’s enormous government debt, but there is no reason for this to become a global liquidity event. Central banks stand ready to provide unlimited liquidity. There are good reasons to sell European banks. The American economy is weaker than the consensus forecast, and the US consumer may have dug in for the duration. But the link between US GDP and corporate earnings is the weakest in history, and 46% of S&P sales are outside the US.
If equity earnings are strong – and careful analysis reinforces the impression that they are – then we have observed a liquidity event like 1987 rather than a systemic crisis like 2008. The banking system, whatever its difficulties, is not the source of the liquidity problem, for banks have been reducing their holdings of risk assets for two years. Governments are not the source of the liquidity problem, for government stimulus in the West has been irrelevant to the economy since 2008.
There is, however, a bubble in the world economy. Anecdotal evidence points to hedge funds as the bubble that has popped. With equity hedge funds down 10.72% year-to-date on the Hedge Fund Research Index as of August 3, investors are demanding their money back. The debt-ceiling cliffhanger in Washington may have provoked the redemption calls, and the S&P downgrade might provoke more.
But the reason for the downgrades is that hedge funds have crippled out. Hedge funds can’t earn the 15%-20% returns they promise investors in a world of 3% bond yields and 2% gross domestic product (GDP) growth. Investors desperate for higher returns, including pension funds, returned to the hedges during 2010 and 2011, and are now suffering spasms of buyers’ remorse. That prompted an across-the-board liquidation of all assets, including commodities and emerging market equities most favored by the hedges. The nearly $2.6 trillion of hedge fund assets constitute the system’s only real bubble: too much money chasing too few returns, with a lot of fingers on the recall button. As of May, equity hedge funds with $1.25 trillion in assets had strongly net bullish positions.
They are stampeding to get out. Their overwhelmingly bullish bias left them vulnerable to a wave of redemptions, what has happened to the real-money investors who require the income that only the equity market can provide? No-one can fund a retirement on Treasuries yielding 2.4%, or a corporate bond index yielding less than 3.5%.
There are other investors, to be sure, who need income to fund current and prospective retirements cannot act as quickly as the hedge funds. Pension funds and insurers require months of committee meetings to change their allocations. They shifted massively to bonds after 2008, moreover, and their book yields cannot be replaced in the present market. Tactical asset allocation is out of the question; they can filter funds into the equity market slowly.
If them that has ’em can’t hold ’em, them that wants ’em can’t buy ’em. That leaves individual investors to ponder the cheaper valuations on the equity market. The trouble is that the vast majority of American households are deeply in the hole: according to the Federal Reserve’s most recent survey of personal wealth, American households’ real estate is worth about a third less than it was in 2006, that is, $16.1 trillion compared to $22.7 trillion.
The problem is that most Americans approaching retirement age in 2007 had most of their net worth in non-financial assets.
Apart from real estate, the next-largest component of middle class wealth was in the form of equity in small businesses. Small business has had no share in the recovery. A rough gauge of small business income is non-farm proprietors’ income as reported in the GDP tables. As the table below indicates, corporate profits have soared to a record, but proprietors’ income remains below the pre-recession peak.
Judging from the surveys published by the National Federation of Independent Business and other organizations, small business remains in a slump. That is not surprising, for reasons spelled out in a recent study by New York Federal Reserve economists. Most small business growth during the past decade followed the housing bubble.
Stock crashes in the past have followed bouts of what former US Federal Reserve Chairman Alan Greenspan called “irrational exuberance,” or external circumstances that made equity unattractive. The chart below sums up a generation of valuation and equity returns.
The last three big drops in the S&P are circled on the chart. All of them occurred when the Equity Risk Premium was negative – that is, when Treasuries offered more yield than stocks. When a safe asset yields more than stocks, investors have to clap their hands and say “I believe in earnings” in order to hold stocks. But we have never had stock market crash when stocks earned nearly three times the Treasury bond yield on a current basis.
The US government won’t go bankrupt. China won’t sell its Treasuries (who would buy them?). The world’s Asian epicenter of economic growth won’t roll over and die. Italy’s $1.4 trillion debt might be restructured, Europe’s banks might go under the auction hammer, and today’s Europeans might postpone their retirement for 10 or 15 years – but that won’t change the grand scheme of the world economy. If Italy were the problem, we wouldn’t see the sharp rise in the euro that occurred in early Asian trading.
The bubble that has popped here is not American government debt, but the overstretched and overpromised hedge fund industry. It’s impossible to tell how long the liquidation will continue. But the stock market today does not run off fumes as in the dot-com days of the 1990s, nor off the phony profits of ultra-levered financial companies as in the 2000s. Corporate America is flush with cash, financially sound, and making better money than ever before.
For that reason, I consider this a liquidity event like 1987 rather than a true crisis like 2008 (with a $6 trillion shock to household balance sheets and the evaporation of bank equity). It’s not the end of the world. It’s just the end of the hedge fund industry.