Inadequate Historical Valuation Measures and What Comes Next in This Monetary Bubble Investing Frontier

  • Market analysts far and wide continue to pound their fists on the table daily about overstretched equity valuations (and many other assets for that matter) putting risk markets in dangerous territory ripe for an imminent sizable correction, or worse.
  • Indeed, global risk markets are tremendously overvalued by almost any historical measure. It takes a heroic effort of wishful thinking to believe otherwise.
  • If we take a look at the S&P500 as one prime example, 18 out of 20 of the most widely followed valuation measures are flashing “overbought” with red blinking lights. Four of the measures indicate an S&P500 at least 50% overvalued, historically speaking.

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  • Therein lies the problems with historical valuation analysis: first, it is based on backward looking data only. Additionally, valuation alone has proven to be an inadequate timing mechanism.
  • Assist FX does not see the historically overstretched valuations currently witnessed in global equities, real estate, and bonds imminently leading to a near term risk-off crash as the base case, although that is always a possibility. Valuations will likely become even more stretched first. Additionally, the current bubble investing environment might lead to a different ultimate resolution than the traditional risk-off market correction/crash many are accustomed to witnessing. We see a different range of scenarios playing out involving capital eventually being less attracted to paper/fiat based financial assets and more attracted to physical-based assets and decentralized stores of value. Imbalances may very well be resolved via asset depreciation in real terms rather than in nominal terms. An occurrence of this nature is not likely to materialize for some time, but risks are building daily as global debt pressures become less and less reversible.
  • Key question: Is this time really different? Answer: yes and no. There has never been another time in history where global central banks have been this supportive of asset prices all at once. During a time marked by real estate bidding wars and new all time highs in global stock indexes, central banks still feel the need to create more than $200 billion dollars per month from thin air to buy mortgage bonds, stock ETFs, and government bonds. Markets are rigged, but they are actually rigged to rise in order to supposedly create a self fulfilling “wealth effect” of unrealized asset gains fueling greater economic activity and confidence.
  • You can’t skirt the basic laws of market supply and demand forever. Reference Venezuela as one of hundreds/thousands of unfortunate examples involving central planners throwing a grand party on borrowed time that ends in widespread misery as soon as the bill comes due. Today’s advanced economies are not being operated with the same extreme mismanagement as in Venezuela, but less severe policy errors are impossible to ignore when cumulatively compounded over time.
  • Current state of global monetary policy: The Fed, ECB, BOJ, PBOC, BOC, SNB, RBA, RBNZ, and other central banks have enabled massive asset price inflation to grow unchecked across several asset classes, particularly in real estate and equities. They do this in the name of fighting a phantom crisis of consumer price deflation which only seems to exist in heavily adjusted inflation index data conjured up by statisticians who know the entire political and industrial complex desires the lowest official readings possible. The appearance of low inflation makes GDP look higher, wages look stronger, and government transfer payments linked to inflation indexes lower. Understated inflation indexes are to politicians and executives what Photoshop editing is to swimsuit models.
  • What many well-meaning analysts have been getting wrong is just how long this type of central planning charade can go on before supply and demand imbalances are aggressively shocked back to reality in a reversion to the mean event. That is because this is not only a function of economic mathematics but also of mass psychology. Dispassionate valuation modeling alone is not enough for a prudent money manager. One must also have their finger on the pulse of market psychology to know when the music has stopped and isn’t coming back on for a very long time during the metaphorical musical chairs game also known as investing in a bubble environment. Assist FX research indicates the music isn’t quite ready to stop–we aren’t there yet. But don’t pile into expensive asset classes with huge leverage either. Stay vigilant and nimble.

Bottom Line: Assist FX has believed for some time, and continues to believe, that central banks have “doubled down” on a quasi commitment to keep asset prices elevated by doing “whatever it takes” as their primary strategy to minimize the onset and severity of cyclical recessions. This improves the appearance of macro economic activity in the near term while adding to dangerous systemic risks longer term. It is difficult for financial markets continually pumped with newly created money and ultra low interest rates to simultaneously crash and stay down. It tends to materialize with earnings multiple expansions in stocks, cap rate contractions in real estate, and overall suppressed volatility, making nearly all asset classes appear “overvalued” for a much longer period of time than many market observers believe can occur.

Make no mistake. We are in yet another central bank inspired asset bubble that was engineered to “fix” the aftermath of the last two central bank inspired asset bubbles. The imbalances grow more pronounced with each reflated bubble because instead of having moderate, occasional recessions where the most unproductive debt is reset via bankruptcies, you have massive unproductive debt imbalances augmented much further by artificially cheap credit and financial engineering. This dramatically increases systemic risk associated with major financial crises, economic meltdowns, and complete monetary system resets. Yet, bubble environments can exist for very protracted periods of time.

Nearly everyone who thinks about these types of economic topics knows at some level, whether more conscious or subconscious, that the current central bank driven free-lunch asset holders are enjoying today are creating the types of systemic risks that endanger the global monetary system tomorrow. This will push private citizens worldwide to increasingly seek alternative stores of value for their savings. That is why demand for decentralized, alternative stores of value such as block-chain technology-based digital currencies is set to accelerate. The block-chain trend is just getting started. As for traditional financial markets, we see a continuation of the type of slow grind, nearly dead volatility asset price levitation to continue for the time being.

USD Soft Patch to Set the Stage for Another Grind Higher in Asset Prices and Interest Rates

  • Bullish USD sentiment clearly became overly reliant on the Trump Administration’s desired agenda of tax cuts, deregulation, and infrastructure.
  • Due to the host of potential political scandals plaguing the Administration, as well as general political dysfunction in the US Congress, expectations of a pro-growth agenda being enacted this year have been significantly muted, though not completely discounted by Assist FX.
  • Assist FX still sees passage of a lighter version of market-friendly reforms in 4Q2017/1Q2018 limping past the finish line in what is becoming a non-consensus call. Sparring blocs within the Republican party will increase cooperation as political viability becomes increasingly threatened for the 2018 midterm elections.
  • In the near term, USD will struggle to stage sustainable rallies as political uncertainty takes its toll.
  • As financial asset prices in equities, real estate, and alternatives continue to inflate further into historically stretched valuation territory, it will place pressure on the Fed to remain on track for gradual rate hikes approximately once per quarter.
  • Long duration USTs will be pressured by lower real yields, lifting rates at the long end of the curve. This will contribute to moderate firming in USD in the medium term 3-6 month outlook.
  • Top risks to this view include a pronounced spillover effect from China’s debt deleveraging efforts resulting in global financial market instability, as well as any number of potential Trump Administration scandals escalating to such severity that the blow-back shifts the political landscape in favor of left leaning populists for 2018 and beyond. While these risks are currently underappreciated by markets, they are not our base case.

China’s Controlled Deleveraging

  • China has decided it is time to pull away the punch bowl for a little while.
  • There is a coordinated series of moves by China’s leadership to slow down the risk buildup posed by excess leverage.
  • The correction in both Chinese bonds and equities has thus far been met primarily with utter disinterest by advanced economy risk markets. Volatility levels are still crawling near historic lows across major asset classes and new all time highs are regularly being surpassed.
  • Still, if there is anything posing an out-sized share of global systemic risk it is China’s massive debt load.
  • Keep an eye on raw commodity prices in China as a leading proxy for  inflationary/deflationary asset price impulses. Iron ore specifically has had difficulties stabilizing as the Q4 2016 run up is moving closer to being fully erased on the way back down.
  • My base case is that China is not yet ready to unravel and this is a healthy process of mild deleveraging. However, it won’t take many more risk off days in China before it begins to spill over into developed markets elsewhere. If this situation does not materialize with increased stabilization by the middle of next week, there will be a tradable risk off wave. Stay tuned.

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