Core of the Core
Saturday, August 8, 2015
I’ve enjoyed Barry Eichengreen’s “Hall of Mirrors – The Great Depression, The Great Recession and the Uses – And Misuses – of History.” Curious title. I’m envious of Eichengreen’s talents as a writer. And his book is replete with entertaining insight from critical periods in history. Eichengreen as well perpetuates a distorted view of the “Roaring Twenties” period.
Similar to today, there was a critical debate in the late-twenties. Was the stock market an indicator of newfound prosperity - or was it instead an out of control speculative Bubble? Was the Credit system sound or unsound? How about the underlying economic structure? Was the Federal Reserve adroitly managing the economic boom or was it instead unwittingly feeding a catastrophic Bubble? Could the bustling U.S. economy and markets just ignore negative global developments?
Despite being right on key issues, history has been especially unkind to those from the late-twenties that argued that Credit was unsound, the stock market was a Bubble and the economy was an accident in the making at the hand of Federal Reserve money and Credit mismanagement - that it all in the end would come crashing down. Curiously, accuracy doesn’t seem to be a priority for most that recount this period. History has unfairly clumped the “naysayers” in a basket and dubbed them “liquidationists.” Ben Bernanke lambasts that period’s misguided “Bubble poppers.” And historical revisionism has painted the twenties as the “golden age of capitalism.” If only the Fed had printed sufficient money and saved the system from the Great Depression…
Strangely, Eichengreen simplifies the revisionist view to about one sentence where he claims that responsibility for the crash and Depression rests with adherents to an ill-advised “real bills doctrine.” Why an economic historian would chose to so readily dismiss such rich and pertinent debate regarding Credit dynamics and repercussions; financial flows, market speculation and Bubbles; and monetary management, is beyond me.
Eichengreen then annoys: “[Roger] Babson believed that Newton’s third law of physics applied to financial markets: to every action there is a reaction, and therefore what goes up must come down. Babson had been predicting a decline in stock valuations since the market took off in 1927. He was the first to acknowledge that his pessimism was hardly news. As he put it on September 5  in introducing his remarks, ‘I am about to repeat what I said at this time last year and the year before.’ Even a stopped clock is right twice a day…”
The “even the stopped clock…” nonsense became too popular with the arrival of financial crisis in 2008. I remember it as well from the bursting of the tech Bubble in 2000. Bullish proponents were quick to point out that the “bears” had been “saying the same thing for years.” Even as the “naysayers” are proved correct, the determination to discredit remains as intense as ever.
And all the misinformation and revisionism really deters from the learning process.
Not surprisingly, we keep making even more atrocious policy mistakes. The issue is not some bull versus bear shoving match. And it should not be about competing ideologies. Instead, the issue of whether a boom is sound or an inflating Bubble is of profound consequence. Whether policymakers are fostering sustainable recovery or merely fueling an unsustainable boom is absolutely critical. The Bubble Issue should be front and center for analysis and debate. And, in the end, the Bubble prognosis should be recognized as right or wrong – not at a point in time but with regard to the overall cycle.
There are Bubble analyst facts of life. First of all, you and your analysis will be discredited, and the bigger the Bubble the more complete and utter disparagement. You see, Bubble periods tend to evolve over years. Major Bubble episodes – as we’ve witnessed – can endure for as long as six or seven years. And, importantly, post-bust policymaker measures can reflate Bubble Dynamics, leading to serial Bubbles (i.e. “tech” to mortgage finance to global government finance). So if you have a series of Bubbles with six or seven year lives, you’re discussing an overall Bubble span of a couple decades (or more). What analyst can survive 20 years of what the vast majority sees as irrefutable prosperity only occasionally interrupted by central bank resolvable issues?
I have posited my case for the “Granddaddy of All Bubbles.” I believe the current “global government finance Bubble” is the finale of a historic multi-decade Bubble period. And each week I see important confirmation to the thesis that this global Bubble has been pierced. Ominous storm clouds are building in global Credit, throughout global markets, in economies, within societies and all about geopolitics. Things are turning serious, and any talk of a stock market correction completely misses the point. The entire bull thesis is coming under fire.
Even in the harshly depleted “bear camp,” I sense Bubble fatigue. In general, backdrops conducive to crisis can linger for so long that fears naturally fade as optimism and complacency take full control. In this regard, this period has been extraordinary. Our odd world of Trillions of central bank liquidity thrown at global markets sees crises dynamics move at a crawl. Over the past year, things at times seem to be playing out in super slow-mo in HD.
This was a key week from the perspective of my analytical framework. The crisis broke through to the “Core of the Core.” I would expect crisis dynamics to now speed up. I’ll try to explain.
In general, “Periphery to Core” analysis holds that financial crises originate at the “Periphery,” home to the riskiest and most vulnerable borrowers. Risk aversion, de-risking/de-leveraging and financial outflows then see the tightening of financial conditions at the “Periphery” begin to gravitate toward the “Core.” This framework was especially valuable in the early-2000s, as the incipient “tech Bubble” saw problems in telecom debt erupt into a full-fledged corporate debt crisis (by 2002). “Periphery to Core” dynamics were much more apparent as the 2007 subprime dislocation evolved into the so-called “greatest financial crisis since the Great Depression.”
“Periphery to Core” analysis turned much more complex and nuanced throughout this prolonged global government finance Bubble period. Typically, stress at the “Periphery” begins a process that begins to weigh on the “Core.” But in this phase of unprecedented central bank monetary inflation (“money printing”), trouble at the Periphery has elicited aggressive policy responses that have tended only to stoke Bubble excess at the Core.
I found it helpful to further delineate sector dynamics - to incorporate “Periphery of the Periphery” and the “Core of the Periphery.” Similarly, there is the “Periphery of the Core” and the “Core of the Core.” Over recent months, heightened stress had made it to the “Periphery of the Core” (Greece, commodity-related stocks and high-yield debt, in particular). Yet the “Core of the Core” had remained immune to global forces - that is until this week.
First of all, the “Periphery of the Periphery” is an unfolding unmitigated disaster: With EM generally encompassing the global “Periphery,” the likes of Venezuela, Ukraine, and Argentina demonstrate accelerated deterioration. More importantly, conditions at the “Core of the Periphery” – the likes of Brazil, Mexico, Russia, Malaysia, etc. – now suffer rapid “vicious cycle” deterioration. Markets have turned illiquid and the “hot money” wants out. Confidence has waned that central banks can keep currency and securities markets orderly. So it appears “Core of the Periphery” dynamics have reached the point where crisis dynamics shift from “slow-mo” to high-speed. This week saw the Russian ruble sink 3.8%, the Brazilian real 2.5%, the Colombia peso 2.0% and the Malaysian ringgit 2.7%. Brazil stocks were hit for 4.5%.
Analytically, China occupies an integral spot in both the “Core of the Periphery” and the “Periphery of the Core.” China’s unfolding financial and economic crisis will either directly or indirectly impact virtually all global markets and economies. I see the ongoing energy and commodities collapse supporting the view of the end of the historic Chinese Bubble period.
The bursting of China’s equities Bubble marks a momentous global Bubble inflection point. China’s reflationary measures over the past year (in particular) worked primarily to spur precarious speculative excess in Chinese stocks, in the process stoking optimism that Chinese reflationary measures would work to reflate commodities and “Periphery” economies. China’s “Terminal Phase” was extended, while EM adjustment was postponed. In the end, China’s misguided policies only worsened Bubble Fragilities, in China, throughout the “Periphery” and elsewhere. After a hiatus, Bursting Bubble Dynamics have reemerged with a vengeance. The risks that arise with China’s extraordinary response to collapsing stock prices only compounds mounting global uncertainties.
Here at home, the S&P 500 Media Index traded at 640 on Wednesday, sank to a low of 565 on Thursday before ending the week down 7.4% at 587.26. Core stock holdings such as Disney, Viacom, Time Warner and CBS were taken out to the woodshed.
Thursday from Bloomberg (Oliver Renick Callie Bost) under the headline “Another Pillar of the Bull Market is Collapsing”: “Until Tuesday, media shares were the best-performing shares of the bull market, rising 531% to eclipse automakers, retail stores and banks. The industry’s market capitalization was about $650 billion, compared with $135 billion in March 2009. That value is evaporating. In just five stocks -- Disney, Time Warner Inc., Fox, CBS and Comcast Corp. -- almost $50 billion of value was erased in two days. Viacom slid 14% on Thursday alone, its biggest drop since October 2008. The selloff is a blow to investors who have seen breadth dry up and the number of advancing industries narrow. More than 100% of this year’s increase in the S&P 500 is attributable to two sectors, health-care and retail, the tightest clustering for an advancing year since at least 2000…”
Media stocks reside importantly at the “Core of the Core.” Though not generally recognized, today’s media industry is extraordinarily Credit sensitive. As financial conditions loosen, the media industry is among the first to benefit. When corporate managements are incentivized to borrow freely, advertising and marketing budgets are immediate beneficiaries. And I would argue the current Bubble creates an extreme case of an already powerful dynamic.
When the Fed slashed rates and began aggressively printing “money” after the mortgage finance Bubble collapse, corporate Credit conditions loosened profoundly. And with managements hesitant to move forward with long-term capital investment, the much easier course was to borrow and boost advertising (and, of course, repurchase shares). This helped spur impressive revenue growth throughout the media industry, which in combination with ultra-easy corporate Credit conditions incited a major industry M&A “arm race.” Throw in the proliferation of new technologies and Internet “media” and one had the makings for a full-fledged - and systemically important - media Bubble.
With ad dollars slushing all about the system, the value of media franchises inflated tremendously – cable, wireless, satellite, professional sports, college athletics, Internet, “Hollywood,” etc. It’s the age of the billion-dollar sports franchise, the $100 million professional athlete and movie star, multi-million dollar annual pay packages for professional as well as college coaches. The fortunate few have enjoyed incredible pay inflation, boosting national income and GDP along the way.
Between inflated franchise values, inflated stock prices and inflated compensation, it’s just an incredible amount of perceived value propped up with endless advertising dollars. Indeed, a strong case can be made that “media” has been one of the most inflated and distorted sectors throughout this Bubble period. For me, “media” and all the related technologies evolved into the poster-child for the U.S. Bubble – for “Core” Bubble distortions and imbalances – for the maladjusted U.S. “services” Bubble economy structure. And it all absolutely requires ongoing monetary inflation.
For a while now I’ve viewed the “media” Bubble as vulnerable to an inevitable tightening of financial conditions. But the Fed and global central bankers for almost seven years have stuck with ultra-loose monetary policy. This ensured the “media” Bubble inflated to self-destructive extremes. In short, there’s today extreme overcapacity for what is an unsustainable Bubble in advertising expenditures (more ad spending, more perceived wealth to spend on more ads). Now advertising spending has begun to slow, an early consequence of a deteriorating backdrop. And as Credit conditions begin to tighten more generally, advertising and marketing budgets will suffer. Perceived wealth will evaporate, M&A appeal will disappear and this bastion of Credit growth and spending will succumb to new realities.
Let’s expand on the “Core of the Core” theme. This week also provided additional support for the view that risk aversion is now moving decidedly toward the Core. Commodities losses – notably energy and precious metals – are leading to a major exodus from commodity hedge funds. More importantly, commodity losses have hit some of the large fund complexes. A more generalized flight out of the hedge fund industry would be a major Bubble development.
The hedge funds are major players in media industry stocks and bonds. Especially after losses in EM, energy and commodities, a stampede out of media securities would have major ramifications. And, rather suddenly, markets now suffer from Crowded Trade Dynamics and dislocations. Some of the “Core” Wall Street Darlings – from Apple to Tesla to Biogen – have suffered major declines. The biotech Bubble is now deflating. The vulnerable tech Bubble is oscillating. And as losses mount, there will be impetus to sell first and ask questions later. Fund outflows could become a major issue. This week also saw the small caps hit for 2.6%. When de-risking/de-leveraging dynamics begin to attain momentum and liquidity becomes a worry, the beloved small cap universe abruptly turns unappealing.
The “Core of the Core” prognosis goes beyond equities. With energy and commodities-related bonds taking another leg lower, junk bond funds saw their second straight week of meaningful outflows. The riskiest universe of junk borrowers – those most vulnerable to a tightening of Credit conditions – is under intense pressure. More attention is also being paid to mounting losses in the popular master limited partnership area. And with Puerto Rico defaulting, flows turned negative this week in muni funds as well. Even investment-grade corporate bond funds this week saw outflows (from the “Core of the Core”). Credit concerns are spreading.
August 7 – Bloomberg (Michelle Davis Carolina Millan): “Pressure from sliding commodities prices is spreading from the junk-bond market to a broader gauge of U.S. corporate-credit risk. The cost to insure against default on high-grade bonds as measured by the Markit CDX North American Investment Grade Index rose to 75.1 basis points, the most since December. The Bloomberg Commodity Index fell for the third straight day, touching its lowest level since 2002.”