The central banks of the world are massively and insouciantly
pursuing financial instability. That's the inherent result of the
68 straight months of zero money market rates that have been forced
into the global financial system by the Fed and its confederates at
the BOJ, ECB and BOE. ZIRP fuels endless carry trades and the
harvesting of every manner of profit spread between negligible
"funding" costs and positive yields and returns on a wide spectrum
of risk assets.
Moreover, this central bank sponsored regime of ZIRP and money
market pegging contains a built-in accelerator. As carry trade
speculators drive asset prices steadily higher and fixed income
spreads steadily thinner-- fear and short interest is driven out of
the casino, making buying on the dips ever more profitable and less
risky. Indeed, the explicit promise by central banks that the money
market rate will remain frozen for the duration and that ample
warning of any change in rate policy will be "transparently"
announced is the single worst policy imaginable from the point of
view of financial stability. It means that the speculator's worst
nightmare--suddenly going "upside down" due to a sharp spike in
funding costs--is eliminated by central bank writ.
Stated differently, ZIRP systematically dismantles the
market's natural stability mechanisms.
One natural deterrent to excessive financial gambling, for example,
is the cost of hedging a speculator's portfolio of "risk assets"
against a broad market plunge. In an honest market environment,
hedging costs consume a high share of profits, thereby sharply
limiting risk appetites and the amount of capital attracted to
By contrast, an extended regime of ZIRP, coupled with the
central banks' perceived "put" under risk assets, drives the cost
of "downside insurance" to negligible levels because S&P 500
put writers are emboldened and subsidized to pick up nickels (i.e.
options premium) in front of a benign central bank steamroller.
This ultra-cheap downside insurance, in turn, attracts ever larger
inflows of speculative capital to the casino.
This corrosive game has been underway ever since the Greenspan
Fed panicked on Black Monday in October 1987 and flooded the stock
market with liquidity. It is now such an endemic feature of Wall
Street that it is falsely assumed to be the normal order of things.
But, then, would anyone have been picking up nickels in front of
the Volcker steamroller?
This dynamic is evident in the chart of the S&P 500 since
the March 2009 bottom. The dips have gotten shallower and shallower
as ZIRP and other pro-risk central bank policies have eroded the
market's natural defenses against excessive speculation. As of
mid-2014, therefore, it can be fairly said that fear and short
interest have been extinguished almost entirely. The Wall Street
casino has thus become a one-way market that coils dangerously
upward, divorced completely from the fundamentals of earnings and
cash flow and real world economic conditions and prospects.
The inverse side of this coin is disappearance of volatility in
the equity markets. As shown below, the current readings are at
all-time lows, even below bottoms reached on the eve of the 2008
financial crisis. Needless to say, this dangerous condition does
not appear by happenstance: its is the inexorable and systematic
result of ZIRP and the associated tools of monetary central
But all of this is ignored by the central banks because their
Keynesian economic plumbing models contain a fatal flaw. These
models purport to capture capitalism at work, but they contain no
balance sheets and hardly any proxy for the financial markets which
are at the heart of modern capitalist economies. As a result,
central banks pursue ZIRP in order to inflate the plumbing system
of the macro-economy with more "demand"-and hence more jobs,
income, investment and GDP--while ignoring the systematic
destruction of financial stability that results from these very
As a consequence, Keynesian central bankers are bubble-blind.
Whereas they monitor immense amounts of "in-coming" high-frequency
macro-economic data that is trivial and "noisy" in the extreme,
they ignore entirely "in-coming" financial market data that points
to monumental troubles just ahead.
At the present time, for example, 40% of all syndicated loans
are being taken down by sub-investment grade issuers. This is
materially higher than the 2007 peak, and is accompanied by an even
more virulent outbreak of "cov-lite" credit terms. Indeed, upwards
of 60% of these junk loans have no protection against debt layering
and cash stripping by equity holders--notwithstanding their nominal
"senior" status in the credit structure. The obvious implication,
of course, is that the Fed "easy money" is being massively diverted
into leveraged gambling and rent stripping by the LBO houses. Three
times since 1988 this kind of financial deformation has led to a
thundering bust in the junk credit market. Why would monetary
central planners, who allegedly watch their so-called "dashboards"
like a flock of hawks, think the outcome would be any different
The monetary politburo remains unperturbed, of course, because
they are not monitoring the composition and quality of credit.
Their models simply stipulate that aggregate business loan growth
will lead to more spending on capital assets and operational
expansion including hiring. That assumption is manifestly wrong,
however, because it is plainly evident that most of the massive
expansion of business credit since the last peak has gone into
financial engineering--stock buybacks, LBO's and cash M&A
deals--not expansion of productive business assets. Indeed, total
non-financial business credit outstanding has risen from $11
trillion in December 2007 to $13.8 trillion at present, or by 25%,
yet real business investment in plants and equipment is still $70
billion or 5% below its pre-crisis peak.
And that is "gross" spending for plant and equipment as recorded
in the "I" term of the GDP accounts. The far more relevant measure
with respect to economic health and future growth capacity is "net
business investment" after accounting for depreciation and
amortization allowances. That is, after accounting for the
consumption of capital that occurred in the production of current
period GDP. As shown below, that figure in real terms is 20% below
the peak achieved two cycles back in the late 1990s.
In short, the combination of faltering investment in real plant
and equipment juxtaposed to peak levels of leveraged loan finance
should be a warning sign of growing financial instability. Instead,
the central bankers bray that valuation multiples are not out of
line and financial institution leverage is reasonably
The "valuations are normal" line proffered by Yellen and her
band of money printers, however, is simply an adaptation of the
Wall Street hockey sticks based on projected earnings ex-items.
That is to say, the kind of "earnings" estimates that omitted on
average 23% of actual P&L charges over the course the 2007-2010
boom and bust cycle owing to non-recurring write-downs of goodwill,
plants, leases and restructuring costs, among countless other real
expenses-all of which ultimately consume corporate cash and
capital. As I demonstrated in "The Great Deformation", cumulative
S&P 500 "earnings less items" over that four-year period
amounted to $2.42 trillion compared to GAAP reported earnings--that
is, the kind that you don't go to jail for reporting to the SEC-of
only $1.87 trillion.
Consequently, the Fed fails to see the in-coming data on
financial instability because it isn't looking for it, and is
simply tossing out Wall Street sell-side propaganda as a sop. The
disappearance of volatility in the S&P 500 chart shown at the
beginning, for example, is nearly an identical replica of the
run-up to the 2007 stock market peak. Yet the appearance of a
proven warning sign of a bubble top has been resolutely
The fact is, PE multiples are far above "normal" based on GAAP
earnings in historical context. During the LTM period ending in Q1
2014, S&P 500 earnings amounted to $100 per share after
adjustment for a recent change in pension accounting that is not
reflected in the historical data. Accordingly, even the big cap
"broad" market is trading at 19.6X reported earnings-a level
achieved historically only at points when the stock market was on
the verge an implosion.
Moreover, today's $100 per share of earnings are highly
artificial owing to massive share buybacks funded by cheap debt and
by deep repression of interest carry costs. The S&P 500
companies carry upwards of $3 trillion in debt, but were interest
rates to normalize- earnings per share would drop by upwards of
$10. Likewise, profit margins are at an all-time high, indicating
that the inevitable "mean-regression" will chop significant
additional amounts out of currently reported profits.
In other words, at a point which is month #61 of the current
business cycle, and thereby already beyond than the average cycle
since 1950, why would any one in their right mind say a market is
not bubbly when it's trading at nearly 20X reported earnings.
Indeed, in a world where interest rate and profit rate
normalization must inevitably come, the capitalization rate for
current earnings should be well below normal--not extended into
the nosebleed section of historical results.
And this applies to almost any other measure of valuation in
risk asset markets. The Russell 2000, for example, still stands at
the absurd height of 85X reported earnings. The cyclically adjusted
S&P stands at 24X, or six turns higher than its half century
average. The Tobin's Q measure is also far more stretched than in
Likewise, emerging markets have piled on $2 trillion in foreign
currency debt since 2008. This makes them far more significant in
the global financial scheme than they were in 2008 or even at the
time of the East Asia crisis of the late 1990s. And that is not
even considering the massive house of cards in China, where credit
market debt has soared from $1 trillion at the turn of the century
to $25 trillion today.
At the end of the day, the Fed and its fellow traveling central
banks have systematically dismantled the natural stability
mechanisms of financial markets. Accordingly, financial markets
have now become dangerous casinos in which speculative bubbles are
guaranteed to build to dangerous extremes as the central bank
driven financial inflation gathers force. That's where we are now.
) CEO Daniel Coleman on Q2 2014 Results - Earnings Call