A Star Wars warning for markets

Balance-wise the Force is not with us

On the Contrary

Over the holidays I ventured out and watched Star Wars: The Last Jedi. It was an enjoyable film with plenty of action, but what caught my attention was the theme of the universe being in balance.

Balance is certainly lacking in today’s market environment and I wonder if 2018 will finally be the year that rationality returns or if markets will continue to test the limits of euphoria. So far it looks to be the latter with companies changing their names to include “blockchain” in order to boost their share prices, Millennials becoming overnight cryptocurrency millionaires and a record amount of leverage being deployed to buy up any dip in U.S. equities.

This is nothing new by the way. In the nearly two decades of my direct experience in the market I have personally witnessed this euphoria in many forms. There was the dot-com mania in the late 1990s.

There was “peak oil” theory in the early 2000s, which held that a plateau in supply was going to send oil prices perpetually higher. And immediately after that, the flip-this-house-and-become-an-instant-millionaire bubble emerged, as prices skyrocketed thanks to teaser subprime mortgages.

In my opinion, a lot of this irrational activity can be attributed to central banks trying to control a rapidly evolving economy via an archaic inflation model that no longer works in the same way it did in the past.

For a group so smart we wonder why they don’t understand that when you deploy a near-zero discount rate to one’s modelling the underlying asset valuation explodes higher.

Or to put another way, as famed investor Stanley Druckenmiller recently did on CNBC, the central banks are the financial world’s Darth Vader, creating asset bubbles that will eventually explode and cause the very deflation they are trying to avoid.

The problem is that the so-called wealth effect from these asset bubbles is not trickling down into the hands of the already debtheavy middle and lower income classes.

Instead of expanding capital programs, companies are borrowing a record amount of debt and buying back stock at an astounding pace.

One can’t blame them as this is a very effective way of financially engineering growth. According to a report by Artemis Capital Management, they calculate that buybacks have accounted for more than 40 per cent of total earning-pershare growth since the market lows in 2009 and over 72 per cent of earnings growth since 2012.

Then there are the tech companies that are utilizing cheap debt to deploy a model whereby they provide a product or service for below cost all in hopes of rapidly building out a client base — essentially giving away $100 bills for $90 and seeing how fast they can grow their revenue base. Meanwhile, investors are piling into these stocks at a multiple of more than 10 times revenue.

Here in Canada, our equity market is significantly lagging the U.S. thanks to our exposure to the bursting of the commodities bubble in July 2014. However, low interest rates and a shadow banking market that has grown to more than half the size of our traditional banking sector have created a new level of euphoric wealth in Canadian housing. As a result, households in Canada are undertaking exactly what our southern neighbours did leading up to the financial crisis.

The problem is that we never seem to learn from our mistakes, giving in to the fear of missing out and skewing our perception of risk, though to be honest, one can’t blame people for capitulating when central banks have fixed the market in favour of the speculator.

That said, time is both a speculator’s and central bank’s worst enemy as markets will eventually rebalance themselves. Essentially, risk is like energy as it cannot be destroyed but simply transformed from one form to another.

If you are wondering where the risk has gone simply follow the debt. The balance sheets of the world’s largest central banks have expanded by nearly 10 times since 2000, rising from just over 10 per cent of GDP to nearly 40 per cent. Over this same period total global government debt has more than doubled.

According to Epoch Investment Partners, since 2009, there has been a 95 per cent correlation between the level of the S&P 500 and the combined balance sheet of the G4 central banks. Therefore, despite all of the recent talk of easing, central banks are in a precarious situation as they do not want to transfer the risk they have taken out of the market back to the investor.

But how much longer can these banks control the force?