Life is too short, too precious, too painful
to waste on worldly bubbles.
– From a prayer by John Piper
In my last post I suggested that staffing the most important financial policymaking body on the planet with a bunch of professors might be, shall we say, suboptimal. In case anyone is wondering why the Fed has missed every bubble in financial history, including the current one, there you have Exhibit A.
Back in May the Fed was shocked – shocked! – to see bond yields surge and stock prices plummet when the subject of tapering was brought up. The reason they were shocked was that the professors’ models showed clearly that tapering should have little effect on markets since the Fed intended to keep rates at zero forever. But models belong back on the leafy campuses. Anyone who makes his living in the market knew perfectly well that the markets had only run up thanks to Quantitative Easing Infinity and that when QE∞ started going the other way, so would the markets.
Even before she was confirmed, Dr. Yellen announced that there was no bubble in asset prices. Well, that’s reassuring. Fed Chairs were also certain there was no stock market bubble in the late 1990s, no housing bubble in 2006, no credit bubble in 2007.
When professors say there is no bubble, what they mean is that there is no bubble in the professors’ models of asset pricing. How, says the Fed, can there be a bubble in the US stock market when P/E ratios are barely above their long-term norms?
Here’s how. One way to decide whether we’re looking at a bubble is not to look at absolute pricing, but to look at the total leverage we’re using to push prices to that level.
So here’s Scary Factoid #1: Margin debt, according to Bloomberg, is now higher than it was during the Internet Bubble of the late 1990s or during the Housing Bubble of 2006. The Fed hoped to force people out of safe assets and into risky ones to create a “wealth effect.” But once you get people excited about buying risky assets, how do you stop them without crashing the market?
And here’s Scary Factoid #2: Retail investors (according to Morningstar) have finally capitulated and are plunging into equity mutual funds, only four and a half years late. Sure sign of a bubble? Not according to the professors’ models.
And, finally, here’s Scary Factoid #3: On top of the margin debt incurred by individuals to fuel asset purchases, the Fed has bought $3.5 trillion of bonds to fuel asset purchases. No one – no one in the markets, no one in the government, and no one at the Fed – has any idea how that gets unwound. But we do know what usually happens: inflation or default.
Maybe the fate of the American economy shouldn’t be left entirely to professors and their models.
Next up: Professors, Free Markets & The Fed – Part Three
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