Edge of the Edge

Don’t hassle me about the crumbs, man. I’m on the edge of the edge.

– Christopher Walken, Envy

The simplest thing that can be said about current financial market and banking conditions is this: the unwinding of this Fed-induced, yield-seeking speculative bubble is proceeding as one would expect, and it’s not over by a longshot.

I expect that FDIC-insured, and even most uninsured bank deposits will be fine. I also expect that hedged investments will be fine. In contrast, a great deal of market capitalization that passive investors count as “wealth” will likely evaporate, possibly including steep losses to bank shareholders and unsecured bondholders. Investors and policy-makers have confused speculation and extreme valuations with “wealth creation,” but it never was. A parade of seemingly independent “crises” will emerge as this bubble unwinds, including bank failures, pension strains, and market collapses, but they all have the same origin.

The chart below shows our estimate of likely 12-year total returns for a conventional passive investment mix invested 60% in the S&P 500, 30% in Treasury bonds, and 10% in Treasury bills, along with actual subsequent total returns. At present, this estimate stands at just 1.03%, matching the level of August 1929. By contrast, the average return for this conventional portfolio mix across history is just over 7% annually, which is where current pension return assumptions stand. That’s another way of saying that investors are setting their return assumptions based on average historical returns, ignoring the valuations that actually drive those returns. As explained in more detail at the end of this comment, I continue to expect a loss on the order of -58% in the S&P 500, from current levels, over the completion of this cycle. Nothing in our investment discipline relies on that outcome, but having correctly anticipated the extent of the 2000-2002 and 2007-2009 collapses, it’s best not to rule it out.

Notice that by late-2021, a decade of speculation by yield-starved investors had driven prospective investment returns to negative levels. That’s something that didn’t even occur at the 1929 and 2000 extremes. The sudden crises and financial strains emerging today are just the consequences of the extreme valuations and inadequate risk-premiums engineered by reckless zero-interest rate policies.

Estimated 12-year total return for a conventional passive investment mix, 60% S&P 500, 30% Treasury bonds, 10% Treasury bills (Hussman)

Origins of a bank crisis