Part I of this series set the backdrop of how years of accumulated debt and easy money leads to market bubbles and subsequent crashes which politicians and Fed Chairmen try to repair (along with their reputations) by repeating the cycle again with more easy money and debt… As poster boys of this dangerous pattern, Part I showcased FDR, and Part II pointed a finger at Nixon.
Despite such bad examples, we also saw how fiscally sound leadership—the kind that focused on productivity, sovereign balance sheets and a willingness to be unpopular market chaperones—existed “once upon a time.” I listed Truman and Eisenhower as the most recent (and last) examples of economically courageous leaders.
Finally, we saw how (mis) “guidance” at the Federal Reserve adds to the pattern of bubble creation and subsequent disaster. Greenspan, Bernanke and Yellen emerged as the easiest guilty parties… Only William Martin and Paul Volker made the Fed’s “good guy” list, as they were uniquely able and willing to bring harsh sobriety to drunk markets.
We then began to look at what happens when markets are drunk, citing the Black Monday of ’87 as an example. But as we plunge forward, we see there are many, many more examples that prove the pattern established in Part I.
So let’s take a look…
The Exchange Pits and the Birth of Derivatives
Policy makers who create environments where the dollar is unrestrained, credit is easy and regulation is lax (or favors “creativity”) set a stage where clever market players are free to scheme their ways into ever-increasing bubbles.
This is true in every asset class, including within the once humble mercantile exchange. It was in this former cob-web-modest Chicago-based exchange where the wrongly acclaimed Leo Melamed applied the notion of using futures contracts (originally and modestly created to help farmers and suppliers adjust for price volatility) to global currencies, a greedy idea which could only have been spawned in the unfettered currency environment created by Nixon’s folly in 71.
Shortly thereafter, Melamed, having conferred with Greenspan and other easy-money minds (including Milton Friedman), got the green light to open currencies to an entirely new level of speculative alchemy. Four decades later, the volume of currency (and risk) traded in 1 hour on the commodities exchange exceeds the annual volume of funds traded on the original MERC.
Now, like all post-71 markets, the exchange pits have morphed into a casino with an astonishing 50,000X growth based on derivatives, leverage and hi-tech software trades that set up 100:1 ratios of hedging volume to the underlying activity rate. These “modern derivatives” are nothing more than levered hot potatoes whose degree of risk and tranched confusion are so far from the plow of any actual value that when a liquidity crisis comes again, this very tall house of cards will fall like the others. This is not our grandfather’s MERC…
By introducing derivatives, the exchanges were no longer trading cash bonds at thin (i.e. farmer common sense based spreads). Instead, traders (aided later by other falsely acclaimed “geniuses” like Larry Summers) learned to use 20:1 leverage on T-Bill Futures, which soon went to wheat futures. Again: this was not your grandfather’s ordinary “spread trade” of simultaneous longs in month A and shorts in month B or the “basis arbitrage” which trades spreads on the futures price at the exchange and the current cash market price.
Instead, the trades metastasized by the late 80’s into a game of simple, same-duration T-Bill shorts in cash markets paired with long T-Bill futures on the exchange with margin requirements of only 5%!
As time passed, the “casino” invented other clever new slot machines/trading vehicles, like the Merc’s launch (with CFTC complicity) of the cash-settled S&P futures contract (a tool for shorting long positions in the cash market).
Because the Fed’s open market desk was transparently taking the volatility out of the Treasury trade, this was easy money at easy leverage for exchange traders. Yet like all easy money schemes, the party stops at some point, as it did in 87.
In a single day, free market forces stepped in and reminded speculators/gamblers that pair trades don’t always act as planned, and levered longs can tank in massive, unexpected sell-offs at the very same time the equally levered (and “protective”) shorts are unexpectedly squeezed, a rare but not impossible occurrence in frothy, margin-addicted markets moving on momentum rather than fundamentals.
As for the Fed reaction to 87, rather than assume responsibility or learn lessons from “derivatives” speculation and the leveraged time bombs it unleashed upon the Chicago Merc and the S&P futures between 71 and 87, they simply blamed “animal spirits.”
In doing so, the central bank conveniently overlooked the fact that “animal spirits” are not a cause of market DUI’s, but a result of the FED moonshine supplied by deliberate and transparent policies of easy money.
Yet another symptom of easy money leverage leading to bad behavior and even worse Fed policy was the 1998 collapse of LTCM—aka Long Term Capital Management—a hedge fund leveraging over $125B (yes, $125B) at the height of its drunken splendor.
This Greenwich, CT-based child of John Meriwether with a staff of the best and brightest Wall Street algorithm writers and Nobel Laureate advisors stands out as telling reminder of three additional observations regarding Wall Street: 1) the smart guys really aren’t that smart, 2) wherever there is exaggerated leverage, a day of reckoning awaits, and 3) the Fed once again comes to the aid of Wall Street when its misbehavior leads to yet another DUI—that is trading under the influence of easy credit and hence easy leverage.
In 1998, when the Russian default sent the S&P down 12%, this was an acceptable pullback rather than grounds for a “Fed-to-the-rescue” panic. LTCM, whose risk models had no formula for the complexity of black-swans (i.e. “$#!T Happens”), got caught with its hands in the leverage cookie jar and deservedly lost all its fingers.
Nevertheless, the Fed, fearing that the loss of one bad mega-hedge fund was too much for natural markets to handle, intervened and did what its spoiled nephews on Wall Street had grown to expect: they cut the Fed Funds rate three times in fifty days to artificially re-ignite lending and restore the muscle power to an over-levered bull market rather than allow the free market (and its bull and bear struggle) do its own thing.
Of course, the pattern (and lesson) after LTCM was not headed, it simply continued…
Enter the Dot.Com Mania
Just as the smoke was rising from the Connecticut rubble of LTCM, another classic asset bubble misconstrued as free-market prosperity was playing itself out in the form of a dot.com hysteria. I remember it well, as I started my first fund during this crazy period of excess and over-valuation. Even at age 28, my common sense knew the dot.com NASDAQ was a bubble not a market…
The Fed, however, saw these rising tech prices as proof of a rising economy, when in fact, dot.com mania was just a protracted spring break of traders gone wild that ended with a memorable hangover and market nosedive.
The easy money had begun in 1971, continued well past 1987 and rolled deep into the 1990’s; by 1999, this credit tailwind had inflated the balloon of the S&P to over 4 times its decade-earlier size while trading at an unprecedented (and unbelievable) 28.5X earnings. In that same year, actual earnings growth clocked in at only 8%; this meant 1999-2000 saw a S&P valued at 4 times its earnings growth rate.
The Index itself climbed from 110 in 1982 to 1485 by August 2000, a 13.5X gain, the likes of which had never been seen in modern finance.
Now that’s a bubble, and anyone who believed such climbs and PEG rates (Price to Earnings Growth) were sustainable knew little about facing uncomfortable facts. But if the S&P figures weren’t enough to sober up a market on a binge, a NASDAQ trading at 100X earnings at its March, 2000 peak was warning enough that the party was nearing an end.
And it was. By April of 2000, a tech bubble inflated by the easy money which flows from public policies to private credit expansion did what bubbles do best: it popped.
In retrospect, the dot.com implosion seems obvious. But even at the time it was happening, that market (precisely like today’s) felt, well: unreal. Consider Dell Inc. It started at $0.05 per share and grew to $54.00/share (a 1,100X multiple) only to slide back to 10.00/share.
Does that smack of efficient market pricing? (There are numerous examples of other roller-coaster mis-pricings of that era, from Cisco, Juniper, Nortel, Yahoo and Lucent to Global Crossing and Commerce One.) I’ve written elsewhere how those days and stocks remind me a helluva lot about today’s TESLA, AMZN and Netflix comedies…
In the late 90’s, even “blue chip” names like AIG (trading at 40X multiples), GE (at 30X), and of course Microsoft, (trading at 64X net income), were collective evidence of the private-credit intoxication that flows in the wake of easy-money public policy and the MSM illusion of “economic progress.”
And the result is always the same. Easy leverage (credit) and peak valuations are harbingers of bubble creation and bubble implosion. Dell and others in the late 90’s were like RCA in the pre-Depression era 1920’s, which went from $5.00/share to $400.00, trading at 200X earnings before sliding back to $10.00/share after the crash of 29.
The dot.com champagne party of the 1990’s, like its predecessor in the dapper 1920’s, ended in ruins, with the S&P down 45% and the wild-child NASDAQ off 80% by 2003.
Today’s tech bubble, by the way, will be no different in its eventual fall from grace…
As for the FED: did it learn any lessons in the wake of yet another massive implosion, such as the possibility that perhaps it might be time to finally rethink the theory of easy money/low-rate spigots? Perhaps they considered reigning in the banks and traders who, due to their own policies, lost humility and discipline?
Instead, in the rubble of the dot.com bubble, the market-enamored policy makers at the Fed began an even more aggressive rate-reduction and bubble creation campaign. In an act of almost unthinkable hubris (and with the wreckage of the NASDAQ still smoldering in its rear-view mirror), the Greenspan Fed instigated a 75% reduction in policy rates to less than 1% by 2003.
This was the greatest rate reduction in such a brief time ever seen, resulting in a wide-open spigot for more easy credit, leverage and hence debt-induced market deformations.
Does any of this look familiar? Yep…
Wall Street “Stimulated,” Main Street Screwed
And why all these emergency measures from the Fed? Was America’s Main Street (i.e. the real economy) in danger?
The straight answer is no.
As in 1987, 1998, and 2000, Main Street was not in “crisis” nor begging the Fed to help America right itself. In fact, by Q4 2001, personal consumption expenditures were actually up by 2.8%.
The sadder truth is the Fed’s furious rate cuts just after the 2000 bubble-burst were aimed at boosting Wall Street stock averages, not the national productivity levels. Thus, the Fed’s take-away from the dot.com bubble was a policy to create another one. As a result, Greenspan merely set the drumroll for the next easy-credit-then-bust sequence, namely the real estate and sub-prime bubbles of 2008.
But we’ll save that and other un-headed lessons for Part IV…
August 18 2017