Wall Street’s Latest Bounce——Ostrich Economics At Work
by David Stockman, Contra Corner It is more evident than ever that the world economy is heading into a deflationary conflagration, but today’s generation of house trained bulls wouldn’t recognize a warning if it slapped them upside their horns. They refused once again last week to exit the casino because they got another signal from Hilsenramp that the Fed is on “hold” until at least next March. That means we are heading for 87 straight months of ZIRP. So you have to wonder if these fearless robo-machines and day-trading punters by now have come to believe that central banks have abolished time itself—-to say nothing of the law of supply and demand. As to the latter, any rational investor should have headed out of dodge long ago in the face of the mother of all bond bubbles——a monumental worldwide distortion of debt pricing and “cap rates” which will bring down the entire financial system when it inexorably bursts. After all, how is it possible that sovereign debt prices and yields have not been drastically repressed by $19 trillion of central bank bond-buying during the last two decades? The central banks have vast powers, of course, but repeal of the law of supply and demand is not among them. Their big fat bid, therefore, has dominated debt pricing on the margin for most of this century. Yet all that financial purchasing power was conjured from thin air by central banks. Stated differently, these massive central bank debt purchases did not arise from society’s legitimate pool of savings set aside from current income. Instead, they amounted to a gargantuan fraud of the state, meaning that the financial system is infected with a monetary rot in its very foundations. Accordingly, the idea that historical (pre-1995) interest rate patterns over the course of the business cycle are relevant to today’s outlook is complete Wall Street flim-flam. Absurdly low interest rates, such as last week’s 60 basis points for two-year treasury notes or 210 bps for 10-year money, do not represent a surfeit of private savings; nor do they reflect business and household “hoarding” of cash in the face of a weak economy or near-term uncertainty, as the talking heads insist day after day. No, they represent a giant surplus of finance—credit made from whole cloth by the central banks and collateral based Wall Street dealers and lenders. Unlike honest capitalist savings, these vast, meandering pools of liquidity slosh around in money markets, but never become permanently deployed in capital assets such as machinery or software. Instead, they provide funding for financial market gamblers and carry traders. That is, these central bank generated finance pools provide the transient wherewithal of leveraged speculation; they are not permanent capital itself nor are they invested in long-term claims upon it. Accordingly, the price of financial assets is now artificial and wildly inaccurate—– set by speculators front-running central banks, not price discovery among investors and savers. Mispriced debt is at the heart of the global financial bubble. That is what allowed the US business sector to raise $2 trillion of net debt since the 2008 financial crisis, yet to deploy all of it on a net basis to financial engineering, especially stock buybacks. The proof that it has not gone into real productive assets is unassailable. Real net business investment is still 17% below its turn of the century level. These central bank generated liquidity pools are is also what enabled the amount of junk loans and bonds outstanding to rise from $1.3 trillion at the 2007 peak to more than $2.5 trillion today. The central bank repression of interest rates literally herded yield-starved money managers and homegamers alike into a drastic extensions of credit risk. The manner in which mis-priced junk debt is fueling the equity market could not be more dramatically illustrated than in the recent announcement that Dell will buy EMC for $67 billion; and that the deal will be funded almost entirely with junk debt and a squirrely second cousin called at “tracking stock” on EMC’s major asset, which, in turn, is a public company that pays it no dividends or other regular cash returns. So let’s see. Dell is a debt-crippled, junk rated (BB+) LBO in the PC sector—-an industry which is self-evidently disappearing at a rapid rate. On top of its shrinking cash flow, it will now pile enough junk debt and tracking paper to fund the deal at 17X EMC’s EBITDA less CapEx for the 12 months ended in June 2015. That’s a right sporty multiple even in the fevered precincts of high tech growth stocks. But EMC is no cash generating tech race horse. Its LTM (June 2015) EBITDA of $5.5 billion is only 2% larger than the $5.4 billion LTM EBITDA it generated two years ago in the period ending in June 2013. Needless to say, no one in their right mind would pay 17X free cash flow for 1% annual growth. But that’s just the point. The LBO guys loading junk paper on Michael Dell’s once and former growth horse that has now become an old gray mare are not in their right minds; they are simply stumping up the endless mis-priced funding that Wall Street has on offer. In all, the massive speculation unleashed in the equity markets since the March 2009 bottom has caused more than $5 trillion of current cash flow and new debt to be allocated to corporate stock buybacks, M&A deals and LBOs. The stock market is thus a creature of financial engineering, not a mechanism for efficiently allocating capital and accurately pricing prospective risk and return. Yet recall what happens under a regime of persistent, massive financial engineering. To wit, all of that finance power enabled by the central banks goes into repricing existing financial assets on Wall Street, not the creation of new or improved productive capacity on main street. Worse still, massive and chronic financial engineering like that reflected in the insanity of the $67 billion Dell/EMC deal distort and corrupt the culture of financial markets every bit as much as it distorts the price of finance. Valuations are self-evidently inflated, but the sell-side research machine and its megaphones in the financial press have literally confected a phony world in which time has no end and ex-items EPS hockey sticks do actually grow to the sky. Take a cursory look at the prominent features of the present hothouse global economy and financial system. Can patterns like China’s insane accumulation of foreign exchange reserves owing to two decades of massive and blatant currency pegging continue indefinitely? Can the $300 trillion of global finance ($225 trillion of debt and $75 trillion of market equity at the May-June peak) that issued from these same central bank policies remain stable much longer—–to say nothing of permanently?
No they can’t. The Red Ponzi of China is already rolling over, as reflected in the $850 billion capital outflow of the last 4 or 5 quarters. That is, owing to its hugely excessive internal investments China is still dumping massive amounts of goods on the world market and earning $300 billion per year in current account surpluses. Yet it still has suffered a $500 billion drop in FX reserves since late 2014. The difference is flight capital outflows, and its happening with a vengeance. The Wall Street meme that this is all temporary and “contained” is about as spurious as Bernanke’s similar statement about sub-prime in the spring of 2007. In fact, it is even more preposterous. At the time of its 3% devaluation in August the Wall Street line was that Chinese authorities were trying to please the IMF with market oriented currency reform, but let the FX market temporarily slip away from them. Nothing to see there except a few wobbles from the early stages of pro-market reform! C’mon. The red suzerains of Beijing have a roaring financial tiger by the tail and have no clue on how to tame it. That’s because there is no way to manage a $28 trillion house of debt cards, which grew by 56X in less than two decades, to a soft landing. The whole red capitalism project was an enterprise in economic madness fueled by state supplied credit. China will thus have a massive economic and financial conflagration. That’s baked into the cake because the Red Ponzi is based on the gross violation of every law of sound finance and economic discipline known to history. And it will spillover into the rest of the world because the entire EM economy was drafting on China’s runaway economy and investment bubble. Does the collapsing lesser bubble in socialist Brazil have any other explanation? Nor do the faltering mining districts of Australia, the tottering real estate market of Vancouver and even the abandoned man-camps of the North Dakota Bakken. The central banks unleashed the furies of speculation, leverage and free lunch economics after 1994 when Greenspan surrendered to the bond vigilantes and bailed-out Wall Street during the peso crisis; and Mr. Deng discovered the printing presses in the basement of the PBOC and inaugurated the greatest debt and speculative bubble known to history. So with the whole grand monetary experiment cratering everywhere, why would you capitalize S&P earnings at 21X, and in more probability at 30X or more? That’s right. Honest GAAP earnings for Q3 2015 will be lucky to amount to $95 per share on an LTM basis. And that would represent a 10% decline from the peak $106/per share earned in Q3 2014. It might be asked, therefore, why would the fast money be buying the dips, as was evident last week, when earnings are already heading down; and when there are headwinds gathering from all directions in the world economy? Even the vaunted German export machine is faltering—-and not the least because China and its convoy of EM suppliers are being forced into quantitative tightening (QT). That is, they are liquidating dollar and euro credit, not buying luxury cars and engineering machinery on borrowed money. At about exactly this point in the bubble cycle back in mid-2007, GAAP earnings on an LTM basis came in at $85 per share at a time when Wall Street’s ex-items hockey stick was pointing to $120 per share for 2008. Needless to say, the latter never materialized, but GAAP earnings soon plunged through $50 per share and by the June 2009 bottom posted at negative $15. This time around the Wall Street equity research shills and so-called strategists are projecting $130 per share on an ex-items basis for next year. That will never happen, of course, but the fact that it is given wide credence in the casino is indicative of the sickness all around Wall Street. There will be carnage, and, again, they will not see it coming. Look no further than this doozy penned by two of bubblevisions go-to Keynesian shills, Alan Blinder and Mark Zandi:
“Yes, QE has possible negative side-effects, but for the most part they have yet to materialize.”
Call it Ostrich Economics. But do it quick. Those side-effects are coming to the casino some day real soon.