"Would I say there will never, ever be another financial crisis? You know, probably that would be going too far, but I do think we're much safer, and I hope that it will not be in our lifetimes, and I don't believe it will be."
That was Federal Reserve chair Janet Yellen's response during a question and answer event last week when asked about the possibility of another financial crisis.
History is marked by famous prognostications at key points in history that turn out to be remarkably wrong. In 1929, Irving Fisher's comment about stocks reaching "a permanently high plateau" in the days before the crash ruined his reputation as a prominent economist of the day. In 1973, Alan Greenspan, former chairman of the Federal Open Market Committee said, "it is very rare that you can be unqualifiedly bullish as you can be now."
My favorite is from Abby Joseph Cohen, the perennially bullish head strategist of Goldman Sachs, in the Barron's Roundtable discussion of January 2008. She was extolling how 2008 would be a great year for earnings on the S&P 500. Her forecast for the year-end value of the index was wrong by about 50 per cent, the worst I have ever seen. Everyone remembers the devastating bear markets to follow these remarkable prognostications; the crash in 1929, the great bear market of 1973-74 and the great recession of 2008-09.
There is nothing funny about Janet Yellen being in complete denial of the systemic risk embedded in massive global debts and deficits, as well as the negative-rate policies of Europe and Japan. Remember, she's in charge of regulating the too-big-to-fail banks that just got a clean bill of capital health. The volatility the market experienced this week in the days – even minutes – following her comments is troubling. I've said before that when we look at earnings from a generally accepted accounting principle basis over a decade-plus of outsized share buybacks, we are more expensive today than at any time in history. When we look at the valuation of the U.S. equity market as a percentage of GDP, we are extremely overvalued.
The CBOE Volatility Index (VIX) measures the expected volatility of all 500 companies in the S&P 500 index. It recently hit a multi-decade low and then spiked 50 per cent on Thursday before settling back down. Yellen's level of complacency is off the charts, and that scares me. Her comments that we will not have another crisis in our life times is laughable at best and terrifying at worst. Global governments have added over $25-trillion of debt to stimulate economies in the years since the Great Recession and have pushed interest rates to zero and beyond. The recovery to date has been the worst on record, and somehow Yellen thinks the economy is healthy. Economic growth will not likely recover to the levels seen in past decades. The debt levels and demographic headwinds just won't allow it.
I wonder what the central banks of the world will do with policy during the next recession. They barely got any growth coming off the Great Recession, and today's debt levels are choking out future spending.
This chart shows how world GDP has been declining for decades, as the ratio of debt to GDP has increased in all major economies in the world. Population growth rates have declined substantially, and labour productivity is running at a fraction of what it was in past decades. These are unhealthy trends, meaning we have to question the theoretical models that central bankers use to manage our economy. The chorus of central bankers appear ready to take the punchbowl away in the coming months, and the volatility seen this week is probably only a minor tremor.
The fact that the Fed thinks a crisis will not happen suggests they will be far behind the curve when it does. Governments have to realize that they cannot keep spending as they have been with monetary and fiscal policy losing efficacy. You simply do not pay the multiple this market is priced at given the growth headwinds we face. It's not a house of cards, but the footing under the economy is way softer than the Fed believes, and it's clear that Washington has no political will to cut entitlements. That's the real debt problem for the U.S. economy .
At the end of the day, we need to adjust policy for a lower-growth trajectory, and that's just fine. But we need to start moving on this today so that when the next recession hits, we won't do the same stuff that's already not working – cutting interest rates and ramping up deficits to deal with it. Playing defence in portfolios is simply prudent at this point in the cycle.
This week I put out a webinar on ETFs and some ideas on how I'm playing the more difficult environment ahead. The webinar replay can been seen here.
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