Ground Rules of Existence

"There are those who are persuaded that some new price-enhancing circumstance is in control, and they expect the market to stay up and go up, perhaps indefinitely. Then there are those, superficially more astute and generally fewer in number, who perceive or believe themselves to perceive the speculative mood of the moment. They are in to ride the upward wave; their particular genius, they are convinced, will allow them to get out before the speculation runs its course. They will get the maximum reward from the increase as it continues; they will be out before the eventual fall. For built into this situation is the eventual and inevitable fall. Built in also is the circumstance that it cannot come gently or gradually. When it comes, it bears the grim face of disaster. That is because both of the groups of participants in the speculative situation are programmed for sudden efforts at escape."

– John Kenneth Galbraith
A Short History of Financial Euphoria, 1990

Over the years, I’ve often quoted Galbraith’s remark about the “extreme brevity of the financial memory.” During every speculative episode, investors come to believe that past experience is “the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present,” that investors and policy makers are more enlightened, and that some newly discovered innovation (even as crude as the sheer willingness to print money) can permanently avoid the disappointments of the past.

December’s steep selloff was a rather small reminder that when doubt emerges, it emerges quickly. One has to remember that the current market capitalization of U.S. corporate equities now stands at $40 trillion, twice the level of U.S. Gross Domestic Product – the highest multiple in history (the multiple peaked at 1.9 in 2000). Investors are vastly overestimating the effectiveness of monetary policy if they believe that the Federal Reserve buying a few trillion in Treasury bonds can reliably stop “sudden efforts at escape” among investors holding $40 trillion in securities that the Fed cannot buy, and that even the U.S. government could not buy without a vote by Congress to effectively nationalize U.S. corporations.

What the Fed did through its policy of quantitative easing was simply to encourage yield-seeking. It purchased interest-bearing government securities, and paid for them by creating $4 trillion in zero-interest bank reserves, which someone had to hold at every point in time. The effort by each successive holder to get rid of that zero-interest money created a game of “hot potato,” by which other securities were bid up until their long-term expected returns were also driven toward zero. And here we are.

In 2009, once the S&P 500 had collapsed by over -55% and investors shifted toward a speculative mindset, quantitative easing and zero interest rates became a highly effective tool to encourage speculation. The speculation continued well beyond the point that rich valuations were restored. Given an expanding economy and a sufficiently speculative mindset, extreme syndromes of “overvalued, overbought, overbullish” conditions did nothing to limit continued speculation, as they had in prior cycles across history. By necessity, we had to abandon the belief that reckless speculation had “limits,” and we became content to use market internals to identify the presence or absence of speculative pressures, using valuations to gauge prospects for long-term market returns and full-cycle risks.