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Playing high tide in the bath tub

March 20, 2013

Have you heard of “groupthink?”  It’s something we should all strive to avoid.

I was recently at a meeting where investment professionals were discussing where markets might be in the future. Instead of rolling my eyes and closing my ears, I decided I would really try to listen to why they were such believers in this present rally. After all, aren’t the financial markets proving the bulls right and the bears wrong? (By the way, I don’t categorize myself as a bear per se. I would call myself more of a contrarian. Being a bear sounds so pessimistic and much less intellectual than a contrarian.☺)

So back to the presentation I was listening to. This individual seemed very bright and stated his pro-market position with impressive authority. Believe it or not, I actually kept my mouth shut in an attempt to keep my ears open. My pro-market friend made a case for not only why the markets were justified in their record highs, but why they would obviously go higher. Certainly it is difficult to argue that the markets aren’t supporting the bulls these days. Here is the list of improving economic conditions that support his bullish position: Topping his list is the improving housing market; after that, energy and, more specifically, the discoveries of large quantities of shale oil fields that provide relief for limited resources; the improving employment picture, even if very slowly; emerging markets that will add to demand; auto sales that are up; and (this next one is one of my favorites) the “manufacturing renaissance.” I was enamored with the term renaissance. At any rate, it was his claim that manufacturing was making a comeback. And then there was his “money sitting on the sidelines” proclamation. I have heard this one many times before and it infers there is pent-up savings not being put to work that will find its way into the markets.

This is quite a list and my colleagues on the investment committee seemed duly impressed. Obviously, this is a sound recovery and none of need to be concerned! But what often happens after a presentation like this is the natural chasing after the gold rush. By this I mean that when we hear a presentation such as this one, we look at what markets are performing best on the way up and we join the crowd. With interest rates at all-time lows and equity markets at all-time highs, we would be a fool not to “diversify” more into stocks. And this is where I make my colleagues sorry that they put me on the investment committee. I had only one question.  (Note that I did not say I kept my mouth shut forever.) My question was, “How many of the good news items on that list are the result of a massive infusion of liquidity by the Federal Reserve? And what would be happening if we did not have a flood of new money driving financial markets? And finally, what will happen if the valve of this liquidity is turned off?” Ok, that’s three questions!

bathtubWhat is the saying? “A high tide raises all boats.” Well, when it comes to our central bankers, they are playing in the Wall Street bath tub and they have the faucet turned up full blast. They have raised all the toy boats in the bath tub they play in. But if the economy were self-sustaining, they would not have to continue their ever-increasing amounts of liquidity/monetary easing.

I wish I could be a believer in this “recovery,” since it would make my life so much less complicated. Reasonable, stable and secure returns on investments are absolutely critical for the business we are in.  But from where I sit, I can only see that we have chased bad monetary policy with worse monetary policy. We have dug a deeper hole, a hole so deep that we cannot even see daylight. Everyone is chasing yield, reducing the premium for risk. In other words, risk is not being appropriately compensated exactly when everyone is taking on more risk to improve yield. For example, if you bought a 10-year BBB corporate bond (which are referred to as junk bonds) versus a 10 year U.S. backed treasury, you could have historically expected to receive as much as a 2 percent higher interest rate because of the risk of the junk bond possibly not paying off. But now investors are attempting to improve returns/yield, and might buy a junk bond that gets less than 1 percent for taking on the additional risk. And I think this is during a period when systemic risk is actually higher than any time in history. With systemic risk higher than any time in history and compensation for taking that risk lower than any time in history, why are investors taking on more risk? To bleed out maybe a half percent in yield? It just isn’t worth the risk.

I have discussed the distortions this investment strategy is creating in nearly every financial asset. The market pundits enjoy crowing about the recovery in real estate. Bloomberg has a report that explains why this might not be the case in certain real estate markets. My personal observations/experiences reinforce the distortion that is addressed in this Bloomberg article.

I’m not sure why anyone would ever ask me to be on an investment committee — I sure know how to ruin a good party!!!

I was thinking about the Defying Gravity blog post and how many different ways we have added “liquidity” to our economy in the past by means other than printing money and zeroing interest rates. I think one of the most amazing moves in recent history was when President George W. Bush pushed an agenda to offer prescription drugs to Medicare patients (Medicare Part D), all while significantly reducing the tax rate. Both of those moves stimulated the economy at the time, while pushing off the costs and liabilities to the future. That was one of those times we should have been asking, “How does this math work?”

It is easy to promise what you do not have to pay for.  And our leaders have learned that this is an accepted practice. They will long be retired before future generations get stuck with their shortsighted give-aways. Why wouldn’t someone do this if it gets them elected and no one asks the question, “How can this math add up?” The solution is to let those who are not yet born vote! After all, they are the ones who will someday have to figure out how to make our illegitimate math work. And that will undoubtedly be very difficult, if not impossible.

  1. March 21, 2013 3:15 pm

    Sometimes I turn on Bloomberg radio, or click to, or turn my head to cnbc on the television and am left thinking that I am an economic idiot. If everyone knows that the equity markets will climb forever, how can I doubt that. I appreciate your sentiments about the Fed. Often, the only thing I have left to say is “the Fed cannot raise interest rates without destroying equity markets, there is no way…” thanks for read.

  2. T. Tracy permalink
    March 29, 2013 8:55 am


    I’d be interested to read what you think of Mr. Steil’s memorandum? Would you consider addressing it in your blog? Thanks.

  3. Wayne Heine permalink
    April 2, 2013 1:36 pm


    Jon can probably address this article better than me but, let me quickly share my point of view.

    First, the mortgage-backed-securities discussed in the article were all purchased from the banks at what accountants refer to as “mark-to-market”. This means that the Fed purchased MBS that in effect were not worth the face value of the mortgage.

    First, after the 2008 crash the banks were allowed to adjust the value of the mortgages they held on their books at the face value of home when it was purchased. This means that if they lent $500,000 to a borrower to purchase a $550,000 home they carried the mortgage value on the books at $550,000 even though the home had dropped in value as much as 50 percent or more. Consequently, the loans that the Fed bought from the banks were not worth what the Fed paid, but substantially less. This means when it comes time for the Fed to sell these loans to the Treasury, or whomever, the difference between the mark-to-market purchase and the actual value of the MBS will most likely be significantly less. Thus, it looks like the tax payer gets stuck making-up the difference. Not to sure how well that will go down with John Q. Public? As he states in the article, “The effect of these transactions was to transfer riskier securities from the private sector the the public sector”. He further states “In the case of the proposed Fed-Treasury securities swap, however, there is no such transfer of risk from private to public–one arm of government is merely swapping securities with another. The overall financial risk to the government as a whole remain unchanged. In other words, he is just rearranging the deck chairs on the Titanic.

    Second, each time I read one of these convoluted economic articles that lays out a plan I am reminded of Nassim Taleb recent book The Black Swan wherein he warns it is not the the anticipated known that derails a plan, it is the unanticipated unknown impact of the “highly improbable” that has caused and created every memorable catastrophe though out history. Consequently, the predictable is easy to predict, but it is the unpredictable that causes havoc. I am reminded of this each day I peruse the news and it is fill with articles where Economists state ” Employment rose unexpectedly”; “the GDP dropped unexpectedly”; manufacturing is up unexpectedly. We live in a time of the unexpected, so when an Economist lays out a plan filled with expectations, my only thought is to prepare for the unexpected.

    And third, given the unknown and unanticipated probable and improbable impacts facing the world today……The “Problem” as stated in this article is both narrowly defined and narrowly focused. The author is only looking at one asset class namely housing. With all the potential asset classes at risk the Fed will have to be much more circumspect to avoid an economic disruption as the try to unwind the unprecedented monetary policies they have imposed. I am very unimpressed with the Feds track record so far given their ability to predict significant economic events such as the Savings and Loan collapse, DotCom bust, Housing bubble and consequent market crash etc, etc, etc.

    Therefore, I believe we are headed down dangerous economic path that will eventually not end well. The longer we stay on this path the more difficult it will be to undo the mistakes that came before.

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