We Are All Contrarians Now

Let’s agree to buy tulips. If many of us do, the price of tulips will go up and all of us will feel richer. We’ll then start spending more money, which in turn will create an economic boom. This is called the wealth effect. Now, replace tulips with 401 Ks and it will also look like a sophisticated economic plan.

Another smart way to promote consumption is to have the government borrow money and inject it in the economy. The money spent creates more economic activity and this results in job creation.

It seems simple, doesn’t it? Unfortunately, history tells us that asset bubbles end in tears and Keynesian stimulus programs never work.

The main problem with the latter is the lack of a multiplier effect. Give someone a fish for a day and he will survive another day. It will also give a fisherman some work for a day. But what happens if you do not give him another fish? The fisherman is unlikely to increase his capacity based on such short term, unsustainable demand. Nor will he hire any help.

History Tells Us Keynesian Stimulus Does Not Work.

Markets have now anticipated 5 of the last zero recoveries. After throwing trillions of dollars at the economy, all we have to show for it is feeble GDP growth. At least it is positive growth, optimists argue, but isn’t it time to wonder why the world economy is not responding the way the Fed expected? Remember the over-optimistic projections of 4% growth that led to last year’s January rally?

Einstein famously defined insanity as doing the same thing over and over again and expecting a different result.
So, why are we still in a world of Keynesian deficits monetized by central banks? Why are people still expecting results from Keynesian fiscal stimulus? We know from history that unless one’s definition of success is “things could have been worse”, Keynesian economics never works. It also always leaves a very large bill at the end.

Three of the most obvious examples of Keynesian failures are well documented. Popular misconception notwithstanding, the New Deal did not reduce unemployment. Nor did it get the economy growing. European experimentation with fiscal profligacy in the 1970‘s lead to stagflation and Eurosclerosis. Japan’s repeated stimulus programs over the last 25 years only helped prolong the lost decades, or should one say lost generations. Can anybody in Princeton give one example in real life where Keynesianism has worked? Furthermore, if reducing government spending – now labeled “austerity” – automatically leads to recessions, why did the US economy do so well in the 50‘s after the massive cuts which followed WW II?

Let’s be clear. This is not an attempt to get involved in today’s ideological debate. The problem is not ideology. Rather, one has to ask: why would it work this time? Do we really believe–pace Paul Krugman–that the economy is not bouncing back because we are not spending enough? Are trillions of dollars just not enough?

Capitalism Up-Side-Down

By monetizing the debt and by manipulating the price of long bonds, the Federal Reserve Bank is making bond vigilantes irrelevant. With the wealth effect, he makes a mockery of capitalism. In fact, the Bernanke put is one-upping the Greenspan put. It not only sets a floor on asset prices to avoid big losses; it also raises the strike price above today’s levels to guarantee profits!

The goal is clearly stated. Chairman Bernanke wants asset prices to go up in order to create a growing wealth effect. Bond prices, house prices and stock prices are all “encouraged” to go up. As far as we know, tulip prices are not yet part of this scheme!

Our modern Federal Reserve Bank has turned the free market upside down. Whereas market prices were once a reflection of economic activity, in this brave new world, the economy is supposed to be a reflection of the markets. Stock prices are used to send signals that the economy is supposed to follow. Maybe this is Soros’ reflexivity theory pushed to its full logic. Prices no longer reflect wealth created and markets no longer function as a price discovery mechanism. Instead, the monetary powers decide where prices need to be in order for people to feel wealthy. This, then, is supposed to generate spending and economic activity. Only a college professor could come up with such a scheme.

The Exit Strategy.

Combined fiscal and monetary stimulus is supposed to be temporary. It was meant to ease the transition to a healthier economy. Five years and trillions of dollars later, one might thus reasonably expect the exit is near. The Fed has at least begun to debate timing.

This is the tricky part. Spending fiat money does alleviate pain for a while, but the time will come to slow down and then to unwind the stimulus program. How can it be done without creating havoc? At what point will the economy accustomed to massive cash injections be able to stand on its own feet? For now, the majority of directors at the Fed thinks it is too early. But they know the time will inevitably come. Open ended money printing cannot go on for ever.

The longer this goes on, the more difficult it will be to undue. Habits die hard. An economy used to living off government handouts enabled by the central bank does not revert to free markets easily. Ask the Europeans. A man used to receive a fish every day, tends to forget the urgency of becoming independent. He could learn how to fish, but why bother?

However, Keynesians do not see it that way. They do not seem to be concerned about new habits creating a very different economy. Instead, they believe time allows for a smooth transition and an abrupt end to stimulus would create another crisis like the crash of 1937.

Keynesians believe FDR was wrong to try to get public finances under control at the start of his second term. Eight years after the start of the Great Depression, the economy had not yet fully recovered. According to the narrative more deficits were needed. Hence today’s question for investors is simple: how many years do the Keynesians believe we need this time to get out of the Great Recession?

Decades after the New Deal, in the 1970s, Europeans tried a different exit strategy. They attempted to inflate their way out of what seemed at the time like unthinkable levels of debt. That did not end well either. A full generation later, it is particularly sobering to see that the public debt as a percentage of GDP in most European countries is still where it was then. In spite of numerous austerity programs, tax hikes and a very favorable global economic environment, Italy’s debt-to-GDP has not changed at all.

In Japan, no exit strategy has yet been seriously considered. There have been a few attempts to reduce the deficit through higher taxes as well as to normalize monetary policies. All were quickly abandoned after sell-offs in the markets. Now, the newly elected Prime Minister is doubling down. In spite of a debt-to-GDP ratio of more than 230% and a double-digit yearly deficit, Abe-san is launching another fiscal stimulus plan equal to 4.4% of GDP. To top it all, he is also forcing the once-independent central bank to start another ambitious quantitative easing policy. Japan too can print money! Japan too will join the currency war.

Maybe we are smarter this time. Maybe the economy will finally recover. Maybe we have found a way to manage the exit without causing another crisis. Maybe. But, history is not on our side.

Implications for Investors.

Central bankers have succeeded. Investors have gotten the message: be complacent, do not worry. Buy on any dip, regardless of the fundamentals. Because of the Bernanke put, markets never go down very much and always bounce back to new highs. Any correction is an opportunity to buy. Take more risk. Actually, Uncle Ben has taken the risk factor out of the stock market. Just look at the VIX. It is at an all-time low.

What’s wrong with this picture? We have a central bank that enables 13-digit public deficits every year and pushes soon-to-retire baby boomers to speculate in the markets. Not to be outdone, their European, British and Japanese counterparts are making sure too that no one can retire on income alone.

The End of Risk On/ Risk Off?

Stock prices’ correlation with the S&P 500 index has reached 85% recently, up from a historically more normal rate of about 50%. Investors no longer differentiate between good and bad companies. Instead of trying to identify winners and losers, investors focus on ETFs. The Fed is announcing more fiat money? Risk on. Buy cyclical ETFs. Buy commodity ETFs. Buy emerging market ETFs, etc. Economic figures disappoint? Risk off. Buy defensive ETFs like those that focus on high yielding stocks, pharmaceuticals or utilities. At least for now, fundamental analysis is over.

However, thanks to the Bernanke put, we know risk on never takes too long to follow risk off. When stocks sell off, buying always pays off. That’s why we have all become contrarians when markets turn sour.

“Earnings aren’t growing very much overall, but expectations are so low that I don’t think earnings are going to hurt the market much” according to one investment strategist. Flat earnings are the new normal. It could be worse.

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