Ben, You Blew It
by Adam English, Outsider Club This Monday gave us another installment of the financial wonk world’s version of geeks lining up outside of Apple stores, then immediately hopping online to give first impressions. In keeping with exactly how exciting the crowd of financial wonks is, the big event was the release of Ben Bernanke’s latest blog post. I’ve tried to avoid jumping into this scene, and this is the second time I’ve failed. This is partly due to a slowly crumbling delusion that I have more exciting things to get worked up about and dwell on for hours at a time, and partly because there are plenty of others falling over each other to pick it apart. However, what got my mental gears turning was not what Bernanke critics have largely addressed — signs that the Fed did indeed boost income inequality — and I haven’t seen any mention of two glaring issues with the post. Yet, at its core, it represents a fundamental flaw with the Fed’s views and an error that constantly plagues investors, from newbies to seasoned pros to ex-central bankers.
Undermining Its Own Mandate
Here is a quote from Bernanke’s post (emphasis added):
Stock prices have risen rapidly over the past six years or so, but they were also severely depressed during and just after the financial crisis. Arguably, the Fed’s actions have not led to permanent increases in stock prices, but instead have returned them to trend. To illustrate: From the end of the 2001 recession (2001:q4) through the pre-crisis business cycle peak (2007:q4), the S&P500 stock price index grew by about 1.2 percent a quarter. If the index had grown at that same rate from the fourth quarter of 2007 on, it would have averaged about 2123 in the first quarter of this year; its actual value was 2063, a little below that. There are of course many ways to calculate the “normal” level of stock prices, but most would lead to a similar conclusion.
First off, this is basically an admission that the Fed’s goal was to boost the market, something it has no business doing.
Plus it comes with the unintended consequences of low-cost debt, namely the ability to skew earnings per share metrics through buybacks.
This comes at the cost of reduced capital expenditures, which are needed with non-zero interest rates because expanded revenue is needed to overcome the cost of debt and produce meaningful growth.
Wealth naturally gravitates upwards, it does not trickle down. Poor people spend everything they can get, then some more if lines of credit are available.
As you move up the wealth spectrum, less and less spending of a person’s total income is needed to maintain survival and comfort.
Eventually, you get to the super rich, who can have everything in the world while still accumulating excess money. They can either let it sit there and do nothing but steadily lose value, or invest it in businesses and the stock market.
In a healthy economy, this money would go from the very top to the very bottom to generate the best available return. It would go to construction workers, expanded mining payrolls for basic materials, and unskilled labor.
In short, the cycle begins anew, and the injected wealth of the super rich would start trickling back up the chain.
With interest rates pegged a hair from zero and capital expenditures depressed, less of this money gets recycled.
More of it is ultimately used to go into stock buybacks, which disproportionately benefit the extremely rich, who have much higher percentages of their net worth invested.
The Fed’s actions have weakened this cycle, encouraged income inequality by incentivizing wealth injections much further up the chain, and thus exacerbated income inequality.
Past Performance Does Not Indicate…
The next troublesome aspect of what he had to say has to do with mean reversion.
Mean reversion, or the tendency of something to move back towards a long-term trend, is a very real thing and it works quite well.
Until a new trend comes along. Then, it absolutely fails.
Traders have made this mistake countless times. Just because a stock or index moves away from a trend does not mean it is guaranteed to come back one day.
Better, legitimate data is needed to assess if a trend is in the process of ending, and even then it is never a sure thing until you can review what is happening today, many years later.
Here is a chart showing the trend Bernanke cites in red:
Within his limited time span, it certainly appears that the S&P 500 is reverting to the mean.
However, look at the black line I added over a much larger time frame.
It uses more data and makes it appear that the the nadir of the dot com crash and corrections following the Great Recession were the mean reversions.
So which one is better? No one can possibly present a strong argument in either case, and Bernanke doesn’t even attempt it.
What we do absolutely know is that massively overpriced stock valuations led to the dot com bubble bursting, and that unsustainable practices across several sectors led to the Great Recession.
With just this information to work with, I’d choose the black line over his red line because, when the S&P 500 deviates from it, it has reverted to the mean when unsustainable market activity halts.
Yet without omniscience about market forces, it is impossible to say who is right, or at least closer to the mark, and no reasonable person would make a claim.
Bernanke seems comfortable making his assumption, but it is a foolish, data-poor one that is easily seen for what it is.
Plus, he makes the blind assumption that most other metrics actually driven by data will lead us to the same conclusion.
One of the most recognized is Nobel Prize-winner Robert Shiller’s CAPE ratio. The cyclically-adjusted price-to-earnings ratio is sitting at 27.22.
Essentially, what this means is that stock buyers of S&P 500 companies are paying prices equal to 27 years of the average inflation-adjusted earnings over the last 10 years.
That is a lot of time for earnings to catch up, and nearly a decade longer than the historical mean.
That is 64% higher than the 16.61 mean, and right on par with the peak before the Great Recession.
This doesn’t necessarily mean that the market will crash, but it strongly suggests that:
- When it does it will probably have a long way to go, and that odds that the trend Bernanke cited is correct are very low.
- It also pokes a big hole in Bernanke’s assumption about most other ways to determine “normal” stock prices, considering CAPE is one of the most recognized metrics today.
It Is Terrifying
I truly believe that Bernanke is a smart man, and I certainly don’t think I could come close to filling his shoes, but as the old saying goes, pride cometh before the fall.
These blog posts show baseless assumptions and flawed arguments that highlight a quote I put in my last article about Bernanke, written when he posted his first article.
David Blanchflower, who was at the Bank of England during the financial crisis, sat down for an interview with Jacob Goldstein from Planet Money back in mid-March:
He was at least willing to admit that central banks were making it up as they went:
Blanchflower: “They don’t have a nice chapter in a textbook to tell them what they should do. They’ve never done it before. They’re struggling.”
Goldstein: “So the Fed doesn’t know what’s going to happen when they finally wind down QE?”
Blanchflower: “Absolutely not. Sorry. They absolutely don’t know.”
Goldstein: “That sounds terrifying.”
Blanchflower: “It is – it is terrifying.”