Friday, 12 February 2016

Stocks and The Money Supply Bear Market

The great bull market is over. Following at least two years during which the stock market disconnected greatly from any sensible long term estimates of earnings and economic fundamentals, speculators are in the process of landing on earth once again. Greater fools are increasingly in short supply as around the world stock markets have plunged since peaking during spring and summer time last year. Many major stock markets have since “officially” entered a bear market. [1] The S&P 500 is down 14.2%, Nikkei is down 28.3%, Shanghai has plunged 46.5%, stocks in Europe are down 26.6% while the oil dependent major stock market index in Norway has shred 20.8%.

Even more noteworthy, the stocks of major banks have crashed. Since their (intermediary) peaks in Q2 last year, Goldman Sachs has dropped 35.6%, JP Morgan 24.3%, Bank of America 39.6% and last but not least, Deutsche Bank has plummeted a full 57.0%.

What to blame this time around? Well, China of course. And sharply lower oil prices which today are even lower than in the midst of the previous banking crisis (December 2008).

That oil prices consistently remained near $100 per barrel for almost four years (2011-2014) no doubt helped fuel booms across all sectors benefiting from high oil prices. These sectors faced great challenges during the whole of 2015 and do so even more today as oil prices have continued to drop and are now eating away at balance sheets and expected earnings. Of grave concern is the exposure banks have to the oil sector as default- and delinquency rates will increase as a result of lower oil prices. Furthermore, market values of collateral will also decline due to the lower cash flows these assets now generate (e.g. oil rigs). To protect their balance sheets, a natural response by the banking sector is not only to not extend further loans to the sector, but also to tighten lending to other parts of the economy. One therefore should not be surprised to see a sharp contraction in bank lending growth going forward. This could trigger an economic collapse in the U.S. and world-wide for one primary reason: ever since the Federal Reserve started tapering in 2014 and ending QE3 the same year, it has been the U.S. commercial banks that have supplied the economy with ever more money. When bank lending growth stops the money supply growth rate will stall as well, bringing with it a plethora of necessary economic adjustments. The truth is however that, though it has remained high, the lending growth rate in the U.S. has already stalled...

…resulting in a money supply growth rate that has remained flat for the better part of the last year, but which during the last week has collapsed to a level last seen toward the end of 2008. 

And do keep in mind: though the money supply growth rate has been uncommonly stable for quite some time, it is considerably lower today than at any time since the 2008 banking crisis. The money supply growth rate has in effect been in a bear market for some time.

Some of these economic adjustments caused by a slowing money supply growth rate are already well under way, the most apparent ones perhaps being the sharp fall in stock market prices and the dramatic increase in junk bond yields. [2]

A feed-back loop is now in progress: the significant growth in money supply following the 2008 banking crisis created an asset price boom that has now come to an end and is rapidly deflating. The financial turmoil this creates will further deter bank lending growth which will result in stock prices and other assets and commodity prices deflating further. Margin calls will surge while margin lending will contract pushing stocks down still further. The previously money supply-inflated company earnings decline rapidly and stock prices fall substantially quicker as expectations move quicker than earnings reports. Write-downs and big bath accounting soon follow suit adding to the woes. When such events unfold, stock prices easily shred 50% of their peak values and, if history is any guide, fall back to pre-boom levels. Interest rates will rise and the expectations of such an increase combined with a flight to safety will mirror a decline in P/E ratios. Employment previously benefiting from ever new injections of money will now to some extent be lost. Capital will also be partly lost. Consumption spending will decline and savings rates will increase. Investment spending will also drop and remain low until new savings have accumulated sufficiently and the economy has adjusted to the new economic reality. 

Way before the economy has fully adjusted, but after the stock market has lost much of its value, the Federal Reserve will intervene. QE4 is implemented and the whole merry-go-round starts once again. But central bank interventions will become less and less effective with every bust as savings and capital are becoming increasingly scarce. 

Such is the case not only in the U.S., but in most (developed) countries around the world as only too evident in surging debt levels. This is one reason “currency wars” might soon be replaced with “capital wars”, i.e. a state where countries once again compete to attract savings and investments from abroad. And such a war is not won by implementing negative interest rates and destroying the local currency. Quite the opposite. 

[1] A drop of 20% or more from the peak say some financial pundits.
[2] Do keep in mind that the damage was actually done during the period the money supply was inflating.

Disclaimer: I am short U.S. mid-caps and the Norwegian Benchmark Index. Read the full disclaimer here.


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