Just one little interest rate hike…and stock market bubble is bursting?

This blog is not investment advice.  Mainly because yours truly has no clue what to tell you to do, although some foolishly ask him, demanding SPECIFICS.  As if without a specific prediction you have nothing worthwhile to say.  It is absolutely true that I might have nothing worthwhile to say–but not because I fail to include specifics!  I should also say I’m not currently shorting the market–although I wish I was.  I personally ended most of my “long” or bullish positions last October when QE3 ended.  Given my hypothesis that the low interest regime was the primary driver in the stock market, withdrawal of funds would–at minimum–stop the rise in the market.  I really expected the market to go down, but that was ceteris paribus–all things the same.  In the real world, of course there is never ceteris paribus and the Bank of Japan and the ECB went on their own money printing binge.  Given liquidity is global, this offset the U.S. halt to QE3–nevertheless the market basically went sideways since the halt of QE3.

The threat of impending U.S. rate hikes consistent with weakening of other currencies drove the dollar significantly higher in 2015. This caused commodity prices to fall (in dollar terms) and capital that had flowed to emerging markets in support of higher yields after the financial crisis to begin coming back to the U.S. in search of expected higher yields.  Emerging markets around the world suffered and continue to suffer amazing stress:  Brazil, Russia, Turkey, China are all reeling from bubble-based financial flows that have reversed.  Junk bonds that had financed the fracking revolution have been hammered.  We had our own August mini-crash led by China, with China forced to aggressively intervene in stock markets, prosecuting short sellers, and implementing stricter capital controls to stop the bleeding.  Nevertheless China’s vaunted foreign reserves fell about half a trillion dollars in 2015, showing how fleeting liquidity can be in a crisis.  And while the stock market indices recovered somewhat after August, the real damage lay hidden underneath, as most stocks were down last year while a few high flyers–FANG (Facebook, Amazon, Netflix, Google {alphabet}) continued higher in bubble territory and masked the carnage below.

So “would the fed raise,” “when,” and “how much” were the questions of 2015, dominating financial market discussions.  The Fed backed itself into a corner, with no good options, and started its rate hiking cycle at seemingly the worst time in Dec.  The markets have been reeling ever since, albeit taking a few days off over Christmas.  And now we seem to have panic—its 2008 all over again says George Soros.  Jim Cramer tells us not to panic.  Gartman says expect 10-15% more decline.  I can confidently tell you what to expect–continued market craziness.  There has simply been too much monetary distortion that must be realigned with reality.  Nevertheless the stock market may not go down further (at least in the near term).  What if the Fed blinks again tomorrow (as it did in the “taper tantrum” of 2011) and initiates QE4?  What is the Fed going to do? In the words of John Maynard Keynes, “We simply do not know.”  Which is why it is still perilous to short the market, even though its overvalued by many historical measures.    My own guess–purely a guess–is that the Fed will not want to intervene so the market will have to go down a good bit before they panic and implement QE4.  But if we do have a waterfall financial selloff, I expect a reversal of the current itty bitty tightening move.   What will be the market’s reaction if that happens?  We’d have to move beyond even intelligent guessing to answer that, so why try?

So what should you do?  I can’t tell you anything more than the Bible’s general guidance:  avoid debt (and paying off debt should be your #1 investment objective–irrespective of potential tax advantages), diversify your holdings (Ecclesiastes 11:2), give generously to causes that honor God, and daily work as hard as you can to bless your employer (as unto the Lord).  Invest in yourself to make yourself your most valuable  asset; keep your skills up to date. These are always good things to do, so keep doing them.

And most importantly, no matter what happens in the market, your future is determined not by the Fed, or any politician, but by a sovereign God who loves you.  If we do go into a general meltdown, Bereans should be at the forefront of continuing in a joyful attitude (such as in Hebrews 10:34), such that those around you wonder what is about you that can give you peace in the midst of crisis.   And if there is no crisis, just enjoy another day of God’s common grace.

13 thoughts on “Just one little interest rate hike…and stock market bubble is bursting?”

  1. What bubble?

    You are begging the question. You have not explained with specificity the difference between mere asset appreciation and a bubble.

    Critics of QE–especially those of the Austrian persuasion–have been speaking of bubbles for years, especially in 2009. Since 2009, the stock market has more than tripled.

    I have been following AMZN since its IPO, and the stock has been regarded in “bubble” territory for most of its nearly 19 years as a publicly traded company. FB, too. I remember laughing out loud in a hotel room dureing “Smart” Money on CNBC, when someone suggested shorting NFLX when the stock was less than half the price it is now. That’s a good way to lose more than 100% on one’s investment!

    Be careful about listening to Dennis Gartman. He is about as bad as a forecaster as one can find (look back to his 2014 call for a serious market collapse, right before a nice rally). And Jim Cramer quit running money when the rules were changed. With a (more) level playing field, he himself knew that the game was up. And Soros has done much better speculating in currencies than speculating in the stock market. He was on the wrong side in 1987, and in 2014, predicting a major collapse back in 2014.

    Bottom line: opinions are a dime a dozen, mine included.

  2. Jeff–
    Let me ask you a few ??s, you answer, and then I’ll offer a distinction between asset appreciation and bubbles.
    1. Do you acknowledge the housing bubble of the mid-2000s? Or was that simply asset appreciation?
    2. If so, did you acknowledge it before it burst? I.e., did you have a specific way to recognize bubbles?
    3. If so, what is your distinguishing definition of bubbles?

    1. 1. Yes.
      2. Yes
      3. Parabolic rise in prices far outside standard deviation (not just rise, a PARABOLIC rise). Involvement of the public (“shoeshine boy giving out stock tips”; real estate “investors” who make money flipping houses on television even though they have no experience or even any real understanding in the discipline). Prices far exceeding traditional, long-standing ranges of valuation (PE, price-sales, ). Sharp increase of people deeply going into hock to buy (margin debt, “liars” real-estate ). Evidence of panic buying, as if people completely lack patience and have no concept of risk.

      I did not know how to go short the real estate market in 2005 (not really my area of expertise). Shorting REITS was not practical to me, considering the dividends. I knew about the “Big Short” long before the book and movie came out.

      Hope this helps.

      1. Jeff
        Thanks for clarifying. On bubbles, you probably are aware that Alan Greenspan said its impossible to know you are in a bubble until you see it burst. Obviously I disagree, and by your answer, so do you. The symptoms you look for in your #3 response are reasonable, but I hope you see that they are certainly subjective–as is my own rationale. There are of course many, many things that you could see that would be indicative of bubbles, and I do look at many of them for symptoms–PEs at the upper end of historical valuation, for example. But w/hints of bubbles–and you are right, they are only hints, so how do you know its a bubble–I start looking at the enabler of bubbles, increased monetary liquidity. (Actually, I don’t start, as a student of monetary economics I’m looking at money and financial markets most of the time).
        Why money? Because in my study of bubbles, and I’ve read many of the books on financial manias and panics, while money isn’t the root cause of bubbles (I somewhat agree w/Keynes on this, that people get more bullish at certain times), it does seem to be the historical enabler of bubbles. In other words, we flawed humans can certainly get bullish and get excited about some new technology or investment. And then others can irrationally crowd the trade to drive prices above any sort of “intrinsic” value. But without the monetary system providing additional new credit (often on the basis of those higher valuations!), the rise is simply not sustainable.

        Why do I think we’re in a bubble now? Yes, I am looking for a bubble under every rock, because given my understanding of monetary ease as the source, when I see the Fed running negative real interest rates for seven years, I know this won’t end well. There were only two other times of sustained negative real interest rates in history, and both didn’t end well. The 2002-2005 period enabled the mortgage bubble. The 70s period was a bit different in that the real interest rate was negative only because of inflation surprises. Ex ante–which is what matters for investment decisions–the real interest rate was higher than it turned out to be ex post.

        So where do I see bubbles today? Well, when Mr. Bernanke says he intends to drive asset prices higher, to get a wealth effect that will trickle down to consumer spending to boost aggregate demand, and then the stock market triples at a time when the real economy is barely moving–well, I’m highly suspicious of a bubble. When the low interest rate makes borrowing by the federal government basically free, leading to an almost doubling of the national debt during the Obama administration, I see a government finance bubble. Especially when you see some of the numbers of what will happen to our interest payments should rates normalize.

        And we can go on. But that is some of why I see a bubble under the Fed-induced monetary rock.

  3. Still awaiting your take on this statement ( a reply to one of yours): “If someone clearly rests his theological views on the foundation of Scripture, there would NEVER, EVER be a need for a truly Christian institution to change its doctrinal standards. Never, unless Scripture itself changes or unless God provides additional revelation.”

    1. OK, I’ll bite, even though this question came from another Berean’s post, and only addressed me because I commented on your reasonable argumentation. And even though in this post you poke at bubbles as if you were affiliated with Chicago economics, which I strongly doubt is where you are coming from. But I’ll take it back to the original post so readers can follow:
      http://bereansatthegate.com/wheaton-college-and-theological-integrity/

      And once you read my response, then answer mine about bubbles please.

  4. Professor Haymond,

    You mentioned how most stocks were down last year except for the few high flyers. Why were those stocks able to continue to do well, even though they were all propped up by the same bubble?

    1. Until the Fed starts to drain the monetary swamp, liquidity will go somewhere. And those high flyers are getting haircuts now that the Fed is doing its itty bitty tightening.

      1. That federal hike was not unexpected.

        The ongoing market carnage is not merely a knee-jerk response to Fed tightening. It is far more complicated than that (China’s slowing economy is not a non-factor).

        We are testing last’s years lows on the S&P (perhaps Monday, in the futures, we may hit it) and then challenge last year’s highs by the end of the semester.

  5. “The 2002-2005 period enabled the mortgage bubble.”

    I agree that Greenspan (an Ayn Rand proponent, to say the least) should not have kept interest rates as low as he did for as long as he did.

    I consider him the worst U.S. federal banker in history. I think history will one day agree with me. I am not really a historian, so maybe history already has. :-)

    But the only reason why that bubble could inflate in the first place was because of deregulation, in particular, the Commodities Futures Modernization Act of 2000. And, yes, I blame Bill Clinton in part for signing it. Phil Gramm deserves blame as well.

    Oh, the ending of Glass-Steagall, yes, was a contributing factor.

    Remember, the financial crisis of 2008-9 was caused not merely by a real estate decline. Investment banks had CHOSEN to overleverage themselves to capitalize on the real estate appreciation (they did not think they could lose); what took down Bear Stearns and others was the fact that the derivatives they sold were not backed by sufficient capital.

    I don’t want to get into the arcane stuff here, but here is an analogy, in layman’s terms:

    In a bear market, those who own stock outright (not on margin) can get hurt, but they cannot go belly-up unless they put all of the eggs in one basket–one stock.

    What these investment banks did was the equivalent of selling puts, plus more and more puts on the stock market as the market rose, and doing so without increasing the capital underlying the investment. Those who bought the “puts” are the ones who made big money and are featured in the movie and book “The Big Short.”

    Selling uncovered puts is like picking up nickels in front of a bulldozer. You make money, until you make one slip up, and then the market pancakes you.

    No one told Bear to overleverage themselves. I don’t plan Greenspan for their demise–and the demise of other big players. I blame hubris.

    Gotta go. Way too much to do before the Monday holiday.

    Being long stocks in a bear market hurts. But what the investment banks did was be long der

  6. You gave great practical application of how we as citizens should model our life after scripture and be wise with our funds. My question is, what do you believe the the Fed should do? You explain in some detail what you believe they will do, but what do you think ought to be done?

  7. Its really hard to answer the question, “what should I do now to fix my car since I got drunk, wrecked it and got a DUI. What should I do going forward?” The answer to that question is entirely different from the advice I would give prior to the problem.

    Step #1: Stop digging the hole.
    Step #2: Stop managing interest rates; manage total spending in the economy right now.
    Step #3: Let Wall Street go where it wants, but keep a steady eye on total spending. As it goes down–as it undoubtedly will if we have a recession (which is likely)–this will require monetary ease.
    Step #4: Any monetary ease must be general; stop buying toxic assets off the books of crony banks. Go back to just treasuries
    Step #5: Let your balance sheet roll off, and drop interest payments on reserves sufficiently to ensure there is no monetary tightening in the real economy.
    Step #6. Be prepared to not be well-liked. That’s your job.
    Step #7. (my ideal). Prepare a plan to eliminate the central bank and establish a system of free banking, with minimal regulation being by the Treasury. That minimal regulation should include going back to the significantly higher capital that was held prior to the Great Depression and FDIC–more like 30-40% equity works (Anat Admati has the best position on this–google for more).

  8. Professor Haymond,
    Thank you for your insight on this topic. I agree with what you said and especially like the verses you integrated. You say to expect “continued market craziness” do you think it would be wise for shareholders of smaller stock companies besides the FANG ones, that are high flying, to withdraw partially from their stock?

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