January 2016: A Banquet of Consequences (Again)


“Mostly, things move gently in place, but occasionally move violently from place to place.” —Unknown

 Recap of 2015

The past year will be easy to forget—not because it was bad, but because it was unremarkable.  There was lots of activity, but not much changed.

●Greece (again) flirted with bankruptcy and the demise of the European Union, but promised to implement additional fiscal reforms to receive a third bail-out

●Bonds issued by several European countries took a trip to Crazy Town, sporting negative interest yields

●The stock market had a hair-raising bout of volatility when, on August 24, the Dow Jones Industrials plunged 1,084 points in the first six minutes of trading, yet finished the year virtually unchanged, and

●The Federal Reserve finally raised interest rates 0.25% for the first time in 9-1/2 years (of which the last seven years were at zero). 

The stock market started and ended the year with very high (expensive) valuations. Interest rates for U.S treasury bonds and high-quality corporate bonds started and ended the year at ultra-low levels.  Elsewhere, commodity prices tanked. Most noticeable were declines in precious metals prices (gold and silver) to levels last seen five years ago, and plunging crude oil prices (off 38% in 2015 and down 61% from mid-2014.)

Still, nothing changed noticeably for the stock and bond markets.  Returns for stocks and bonds were essentially flat in 2015: the Dow Jones Total Stock Market index and Barcap Bond Index both nudged higher by about 1/2%.  Zzzzzzz… (Note: Zzzzzzz… is a euphemism for “complacency.”)

Where Are We Today

“That men do not learn very much from the lessons of history is the most important of all the lessons that history has to teach.” Aldous Huxley

Calmness in markets, and the complacency that accompanies it, should not be mistaken for stability.  Economist Hyman Minsky (1919-1996) pointed out the paradox that stability leads to instability

Minsky’s thesis was that during periods of perceived stability, like now—i.e., a period of low interest rates and easy credit, low inflation, high stock prices, high bond prices, and high real estate prices—financial institutions, businesses and investors become complacent.  This leads to excesses of debt and speculation.  That which is abundant (money and credit) is treated carelessly, and that which is dear is utilized prudently.  The world is awash in zero or near-zero interest rate cash that is being employed with reckless abandon.

Care and vigilance are the cornerstones of prudence.  However, the longer the good times continue (or, restated, the longer we go without a blow-up), feelings of well-being, prosperity, complacency and the assumption that good times will keep going indefinitely are reinforced… and prudence goes by the wayside.

The dominant contributor to today’s excesses is central bank extreme intervention.  From 2010 to 2014, the U.S. Federal Reserve injected $4.5 trillion into the financial system, inflating the prices of stocks and bonds.  Each successive round of money-printing was initiated after modest declines in the stock market, leading many investors to assume the Federal Reserve has their backs and will make sure that nothing goes wrong. The longer this state of mind continues, lenders and investors will become even more reckless.  Then, after the fun and games subside, the ill-effects always appear.

Here are three examples of Minsky’s thesis at work:

Example 1: Technology stock bubble and bust (2000).  In the dot-com era of the late 1990’s, you could get funding for a tech company if you had an idea, a heartbeat, and could fog a mirror.  At the root of the debacle was access to seemingly endless pools of investor capital.  Ridiculous metrics (Remember “eyeballs” and “clicks”?) were invented to justify funding new companies based on profitless concepts. Traditionally, companies that took their stock public had at least three years of profitability.  In the frenzy of the tech bubble, companies that had never turned a nickel of profit were going public—with valuations in the hundreds of millions of dollars. Technology stock prices rose to absurd levels. The longer the party continued, the more complacent and reckless investors became. This bubble, the worst since 1929, popped in 2000.

Example 2. Mortgage bubble and bust (2008).  In response to the tech bubble bursting and the resultant economic slowdown, Federal Reserve Chairman Alan Greenspan reduced interest rates to even lower levels. 

I suppose it is tempting, if the only tool you have is a hammer, to treat everything as if it were a nail.” – Abraham Maslow

Mr. Greenspan’s solution to the problem was more easy credit—the ingredient that caused the tech bubble in the first place! Making credit easier to obtain was like trying to put out a fire by throwing gasoline on it. 

In 2001, after the 9/11 terrorist attack, Mr. Greenspan’s Federal Reserve reduced interest rates even further.  Income-hungry investors sought alternatives to enhance their investment income.  They desperately turned to mortgage loans as a source of higher income.  Wall Street, full of consummate opportunists, rallied to the cause, packaging and peddling pools of mortgage loans. When they began running out of quality loans to peddle, they threw caution to the wind became creative and slipped more and more sub-prime loans into their packages.  The rating agencies were also making a fortune, so they played along, awarding AAA credit ratings to pools of loans laden with crappy loans.  Everybody, except the investors saddled with the toxic loans, was lining their pockets every step of the way.  The deceptively packaged and peddled loans and the illusion of stability led to actions that were catastrophically destabilizing, culminating in the 2008 financial meltdown.

But wait, there’s more!

Example 3: Stock and bond bubble and bust (2016?).  In response to the tech mortgage bubble bursting and the resultant economic slowdown, Federal Reserve Chairman Alan Greenspan Ben Bernanke reduced interest rates to even lower levels, zero! 

Mr. Greenspan's Mr. Bernanke’s solution to the problem was more easy credit, the ingredient that caused the tech mortgage bubble in the first place! The Fed, oblivious to prior policy errors, provided the fuel for the third bubble in 15 years, injecting trillions of dollars of cash into the financial system. Mr. Bernanke, like his predecessor, was also trying to put out a fire by throwing gasoline on it.

With interest rates pushed to zero, or near-zero, money market funds and traditional bank deposits paid investors virtually nothing. Income-starved investors desperately sought alternatives to increase their income (sound familiar?).  This time, they turned to mortgage loans stocks and bonds.  With trillions of dollars of new cash chasing stocks and bonds, prices were bid higher and higher until the money-printing ended in October 2014. That’s the point at which the stock market reached equilibrium and leveled off—when the (un)attractiveness of overpriced stocks and bonds equaled the (un)attractiveness of zero interest cash.

Since the end of October, 2014, when the money-printing ended, through 2015, the stock market made virtually no progress. The Standard & Poor’s stock index stood at 2,018 on October 31, 2014.  Fourteen months later, on December 31, 2015, the index was 2,044, advancing just one percent.  

When speculators of all stripes—banks, pensions, insurance companies, hedge funds and individuals—realized they could borrow money for next-to-nothing, they went on a buying binge, driving stock and bond prices higher.  Wall Street, still full of consummate opportunists, started underwriting and peddling junk bonds at ridiculously low interest rates… and people lined up to buy them!  

Roughly $1.1 trillion in junk bonds were funded in the last four years.  According to Standard & Poor’s Rating Service, $180 billion of that debt is now “distressed” (meaning those bonds are at risk of default). This is especially so for oil exploration and production companies (50%) and mining companies (72%). 

December’s abrupt closure of the Third Avenue Focused Credit Fund, a mutual fund specializing in junk bonds, should have been enough to shatter widespread investor complacency.  But this warning has been ignored, just like the Bear Stearns mortgage fund failures were ignored in the spring of 2007.  Such failures serve as a harbinger of underlying instability and approaching misfortune.

This is the point where we find ourselves today.  Example 3 has not yet been played out, but you can probably see where it’s headed.  If not, remember the words of Sir John Templeton, “The four most dangerous words in investing are: this time it’s different.”

Strategy Moving Forward

Money is an essential nutrient to healthy financial markets. But, an excess of cheap money is like a dangerous drug to euphoria-craving investors.  It may feel good at first, but it always goes too far, they do crazy-stupid things, and it ends badly. 

The Federal Reserve’s easy-money policies created three bubbles in the last 15 years: (1) the technology stock bubble, (2) the mortgage/housing bubble, and (3) the bubble in stocks and bonds. 

“Sooner or later, we all sit down to a banquet of consequences.”  — Robert Louis Stevenson

In today’s environment of overpriced stocks and bonds, we believe prudence and caution are required more than ever. Knowing the sequence of events, and recognizing the inevitability of current financial excesses unwinding, we can only embrace a path of prudence. 

Our client portfolios are positioned conservatively, embracing an aversion to risk and shunning speculation. Our portfolio stock allocations have been scaled back, dedicating roughly 47% of the typical moderate allocation portfolio to stocks, instead of a normal 50% to 70% allocation.  The offset is greater allocations to cash (14%), preferred stocks and convertibles (4%) and short and intermediate-term bonds (35%). Our cautiously positioned portfolios are like insurance: it’s only helpful if you have it before you need it.

When valuations become more attractive—and we firmly believe this is not a matter of “if,” but “when”—our plan is to significantly increase the allocation of stocks in our clients’ accounts.  We anticipate today’s patience will be well justified when the time to buy arrives.

Thank you for entrusting us with your investment capital, and thank you for your loyalty and friendship.  We wish you and your loved ones a healthy, happy and prosperous New Year! 


            Greg Schultz & Bruce Grenke

© Asset Allocation Advisors, Inc. 2016