As you’re reading this, some of the world’s best and brightest are in Stockholm, Sweden to accept their Nobel prizes in recognition of their brilliance and ground-breaking work.
Two of them are bringing very deep concerns about a coming crash with them.
Robert J. Shiller, Eugene F. Fama, and Lars Peter Hansen will take the stage to receive their awards for analyzing asset prices in finance and the markets.
Both Shiller and Fama — two men with profoundly different views — have recently been peppered with questions about the economy and markets.
Neither like what they see, and what they discussed touches on the short-sighted manipulation of assets from real estate to stocks and bonds.
Speculative Bubble
Robert Shiller won his prize by compiling and analyzing long-term housing sale information in the U.S., probably for the first time ever. From the data, he drew some strong conclusions. Here is a short list:
- There is no continuous uptrend in home prices in the U.S.
- Home prices show a strong tendency to return to their 1890 level in real terms
- Changes in home prices bear no relation to changes in construction costs, interest rates, or population
Yet people consistently make the error of getting into real estate because prices rise in nominal figures that are not adjusted for inflation or other factors.
The U.S. Census has proof of this going back for over fifty years. Since 1940, it has asked homeowners to estimate the value of their homes. The estimates average out to a 2% appreciation per year in real terms. The actual increase is 0.7%.
Housing sales have been strong. Existing homes are scarce, houses stay on the market for less time and prices are way up in the hardest-hit markets. It looks healthy on the surface, but it is a mirage.
Cash-only transactions have dominated the market, peaking at 60% back in May of this year and drifting down to 30% in recent months. 15-20% is average and reasonable.
Families do not pay cash. Wealthy private and large institutional investors use cash to speculate on rising values while pocketing rental income.
On CNBC two weeks ago, in response to hedge funds and institutional investors claiming they are long-term investors, Shiller had this to say:
…[Housing investors] are not. I think what they’ve learned… there is short-run momentum in the housing market, and so they know how to play momentum, but as soon as it looks like it’s weakening, they’ll exit…. we can’t trust momentum…
How can these guys not notice how fast home prices have been going up and the fact that historically momentum is a much better play in housing than it has been in the stock market? So I’m pretty sure this is on their minds. They are not going to say this, I guess. They’re not going to say they’re going to dump them.
I wholeheartedly agree. Wealthy private and institutional investors are funneling unprecedented asset price gains and unfettered access to easy credit with bargain bin interest rates into home purchases.
They’ll keep hyping the market until a bitter end is in sight, capture short-term gains, and leave a new batch of families indebted for life.
“Bubbles Look Like This”
Shiller was back in the press earlier this month talking about stocks as well. Talking with German news service Der Spiegel, he stated that he believes sharp rises in equity and property prices could lead to a dangerous financial bubble and may end badly.
As he told the magazine, “…in many countries stock exchanges are at a high level and prices have risen sharply in some property markets.”
“I am most worried about the boom in the U.S. stock market. Also because our economy is still weak and vulnerable,” he said. “Bubbles look like this. And the world is still very vulnerable to a bubble.”
Of course, the Fed doesn’t see a bubble forming and is not weighing the concerns of Shiller and many other prestigious economists in their deliberations over quantitative easing.
If you’re like the Fed and just look at price to earnings multiples, everything looks just fine.
However, earnings are looking good on the surface because profit margins are roughly 70% above their historic norms. If you take a look at the stock market over the past century, you’ll see that profit margins inevitably return to the norm and negatively impact future earnings growth for years afterwards.
The median price to revenue ratio in the S&P 500 is now higher than it was in 2000. When profits return to normal, an abnormally large proportion of revenue will disappear and expose extremely high valuations.
Robbing Peter to Pay Paul
In real estate and the stock market, we can trace this growing asset bubble back to the Fed, along with government debt and policies.
It even applies to the bond market. Government debt is ballooning due to unfunded spending and entitlement programs. Manipulation of interest rates and a steady flow of easy money is driving massive inflows into risky corporate and junk bonds.
Some of the worst — payment in kind bonds that allow borrowers to repay interest with more debt — have jumped from $6.5 billion in 2012 to $16.5 billion this year.
This has Eugene Fama, who normally voices skepticism about the existence of asset bubbles at all, concerned about a debt-fueled crash.
Saturday he told Reuters: “There may come a point where the financial markets say none of their debt is credible anymore and they can’t finance themselves. If there is another recession, it is going to be worldwide.”
As for the exuberance over the last job report he said, “I am not reassured at all. The jobs recovery has been awful. The only reason the unemployment rate is 7%, which is high by historical standards in the U.S., is that people gave up looking for jobs. I just don’t think we have come out of [recession] very well.”
The simple fact of the matter is you can’t rob Peter to pay Paul. Adding easy credit and cash into bloated asset markets, along with corporate and government debt, is not worth creating confidence in the market and out-sized gains for a select few.
The only silver lining is that so much value was stripped from real estate and the stock market five years ago — mostly from the lower and middle classes — that we won’t see the same 60% losses. However, the longer the situation persists, the worse it becomes.
Of course, many won’t see a loss at all. They aren’t working. The number of employable Americans rose 2.4 million over the last year while the official labor force shows a 25,000-person drop.
Yet the Fed, other central banks and governments continue to manipulate the free market and strip future growth and earnings. Entrenched financial institutions and politicians continue to enrich themselves to maintain their wealth and power at our expense.
Hopefully, the research Nick Hodge has been doing is true and a Fourth Turning is right around the corner...
