As the Credit Cycle Turns

A rising stock market has the illusory effect of masking the economy’s warts and blemishes.  Who cares if incomes are stagnant when everyone’s getting rich off stocks?  Certainly, winning wealth via the stock market beats working for it.

Without question, the pleasure that comes when opening an inflated quarterly brokerage statement is much more satisfying than a lackluster biweekly paycheck.  But not only does paper wealth grow when the stock market rises, implied intelligence grows too.  The quarterly statements, with growth lines moving up and to the right, prove it.

Why grumble over a labor participation rate that’s at a 40 year low when Netflix is up over 6,000 percent?  The abundance of cheap, frivolous, and on demand content, more than makes up for the lack of well-paying jobs.  Indeed, there’s never been a better time in the history of the world to be a couch potato – particularly when 75 inch flat screen televisions can be bought on credit.

On Wednesday, with much celebration, a generally meaningless milestone was notched.  U.S. stocks, as measured by the S&P 500, marked their longest bull market run in history.  They’ve gone 3,453 days without a 20 percent decline…though there have been several close calls (i.e. mini bear markets) along the way.

Those who profited most over the course of this bull market, were those who ignored the many potential disaster scenarios that presented themselves, and blindly bought an S&P 500 Index Fund or shares of Facebook and Amazon.  Buy and hold.  Dollar cost average.  Buy the dip.  These were the strategies that delivered big over this bull market.

What to make of it…

One of the higher callings to aspire to in life is that of finding meaning in the meaningless.  Hence, we’ll take the stock market’s historic, yet meaningless, achievement and use it as a source for meditation and reflection.  Where to begin…

“The bigger they come, the harder they fall one and all,” observed Jimmy Cliff during the bear market of the early 1970s.  Taking this simple insight, what follows is a scratch for perspective on one of the suspicious cornerstones of this bull market.

Promise of the Gospel

The zealous belief in the tea leaves of data have confidently driven trading decisions via the rear view mirror over the course of this bull market.  The ardent rationale seems to be that with a long enough time series of data, and a well-tested rules based algorithm, tomorrow’s trading decisions can be made today.  The answers to tomorrow’s trading questions, according to the data models, were already uttered in the past.

Young economists, with much more data and much less understanding than 19th century homesteaders holding a dog-eared copy of the Old Farmer’s Almanac, operate with remarkable confidence.  They believe they know the answers to tomorrow’s questions while their feet are firmly planted in today and their eyeballs are glued towards yesterday.  Massive data sets are plotted and projected out with the promise of the gospel.

These statistical prophets dial in their cutting-edge computing power, place their faith in automated decision making, and preprogram future trades that will, no doubt, make them rich.  With enough data, and enough regression analysis modeling, there’s not a fraction of a dip that cannot be exploited for high frequency trading profits.  What could possibly go wrong?

One of the potential hazards of being uber-smart is it puts one at greater risk of being uber-stoopid.  Just ask Nobel Prize economists Myron Scholes and Robert Merton.  In 1998, Scholes and Merton, and their investors, learned an expensive and humbling lesson about the limits of modeled data.

In just four months, their hedge fund, Long Term Capital Management, hemorrhaged $4.6 billion.  Before the bloodbath was over, financial intervention was required by the Federal Reserve to avoid a panic of mass liquidation.

Apparently, the Nobel Prize holding duo’s quantitative models failed to predict the 1997 Asian financial crisis and 1998 Russian financial crisis.  In short order, Long Term Capital Management’s highly leveraged arbitrage convergence trades did what was statistically impossible – they diverged.  At that precise moment, the reputations of Mr. Scholes and Mr. Merton also diverged.

As the Credit Cycle Turns

The experience over the last nine years – and also over the last 35 years – presented by the stock market, is one of near uninterrupted upward progress.  The experience over the last 35 years presented by the debt market is one of ever declining interest rates.

We suspect the succeeding 35 years will look quite different than the preceding 35 years.  Yesterday’s market data will no longer be a good predictor of tomorrow’s market movements.  Rather, it will be a source of trouble for quantitative analysis.

Presently, the risks of a financial crisis are also increasing.  After a decade of cheap money policies, which resulted in a flood of credit from American and European investment funds to emerging market borrowers, the credit cycle has turned.  The Federal Reserve, albeit slowly, is shrinking the Fed’s balance sheet and tightening the federal funds rate.

As the dollar’s value increases, emerging market borrowers are finding it more and more difficult to repay their debts with their depreciating national currencies.  Turkey’s been the latest emerging market to feel this pinch.  Tomorrow it will be South Africa or Brazil or Russia or Mexico.

The consequences of an emerging market debt and currency crisis show up in the most unexpected places. The 1997 Asian financial crisis and 1998 Russian financial crisis resulted in the blowup of Long Term Capital Management.  The 1994 Mexican peso crisis resulted in the bankruptcy filing of Orange County.

Given the length and breadth of credit that has been extended over the last decade, and the ever more risky search for yield, it’s likely the next blowup will find its way into unsuspecting American investment portfolios.

Lastly, if you liked this article, we invite you to subscribe to the Wealth Prism Letter for our latest market research, including The “Economic Collapse Investing” Strategy that Returned 200% as the Stock Market Crashed.

Sincerely,

MN Gordon
for Economic Prism

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1 Response to As the Credit Cycle Turns

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