Thank You America

January 25, 2021

Thank you for voting in a president. While it may be difficult to agree with some of the things on the Democratic agenda, it is far more difficult to find room for a tyrannical, self-centred and dangerous president like Donald Trump. Thank you, from the rest of the civilized and democratic world.

Now, fix things. Please. Your house is not in order, you have left much to fester for far too long and that damage has allowed a treasonous mouthpiece like Trump to come in and move pieces around, seemingly to start a ‘return to greatness’. Alas, what has happened is the marginal participants in society have found a voice and somehow believed they are the majority; somehow believe that their causes (numerous as they are) and conspiracies (why rely on facts when you can just create whorls of angst and fury from make believe) are of sufficient importance that the majority should be shouted down, pushed down and even ignored.

The sad news is that the primary focus of economic advancement is now at serious risk and the full weight of the COVID pandemic will continue to complicate the country’s extraction from the difficulties. They are not going to recede soon, or easily and are likely to amplify in the coming months.

So why, why, why are markets at all time highs?

Over the past year, nothing has changed. It’s because governments around the world have thrown trillions of dollars at the economy to remain liquid. Here is an updated chart of the M1 money supply. A couple of important items about this chart. First is that at the beginning of the year (and the beginning of the COVID crash), M1 was just under $4 trillion. Today it is at $6.8 trillion. A gain of nearly $3 trillion or about 75% from the start of the year. Second is that there was a massive infusion just before the election, likely to ‘reduce uncertainty’ as election fears gained steam, but that money has not been removed from the system yet.

A broader measure, M2 is also surging. From about $15.3 trillion at the start of the year to about $19.2 trillion at year end (a 25% jump), it has jumped up by another $300 billion (1.5%) in the first three weeks of 2021. These numbers are astounding and they will be very, very difficult to reverse. Here is a chart for M2:

All of this is happening under the backdrop of very troublesome unemployment numbers, business failures and personal devastation that hasn’t been seen for decades. But the market is going up.

Of course there is hope that new stimulus will continue to prop up prices, but that is a very risky bet. In fact I can’t think of a time in modern history where financial markets have been so closely tied to a single, necessary outcome. The risk is enormous.

Currently, of course it all appears to be working out. The powers that be must have stable prices to prevent a collapse in asset prices, and all of that borrowing is providing sufficient liquidity to prevent a collapse. The goal must be inflation however. (If not now, very soon in the future). Without it all of this debt, this liquidity will require massive taxation, massive calls on productivity and significant selling of assets to cover these debts.

One small measure of that risk is in margin debt, that is money that is borrowed to buy securities. Using margin when things are going up provides extra leverage and can amplify returns magnificently. During the financial crisis of 2008/2009 margin debt peaked around $668 billion. At the end of November, margin debt was just over $722 billion, eclipsing that peak and it has likely gone higher by year end. The unwind can be treacherous, but for many the debts remaining will still be outstanding.

That includes government debt.

One interesting tidbit is that many are comparing debt to GDP numbers following the second world war and the boom that followed. That boom unleashed a massive wave of spending on innovative products. Unfortunately that is not likely to alter the landscape this time.

Much of that innovation was in mechanization (resulting in massive gains in productivity), distribution (people had very little and bought a lot of things of any variety) and finance (debt and credit revolutions began in earnest as earnings power increased). Chemistry, physics, and biology went through such an astounding change that areas such as health care, transportation and many other things changed the world forever. There is little happening to usher in such great change at this time.

Most innovation is ‘replacement’ innovation such as:

  • electric and hydrogen powered vehicles (to replace internal combustion engine vehicles) which will dramatically reduce demand for one of the biggest job creators, oil & gas while creating demand for metals specifically, and green energy solutions generally. There is little if any increase in financial gain from this transition and taxation will be drastically reduced (oil and gas is a major source of tax revenues)
  • artificial intelligence is a major contributor to innovation. The improvements in this areas will continue to reduce or eliminate necessary labour while providing acceptable or excellent results for many tasks now performed by humans. This will result in lower aggregate wages.
  • health care continues to improve in many areas, and while human life expectancy may be reaching a maximum (it declined in 2020, with COVID appearing to be a major factor), it is not clear that health care will continue to make economic improvements at anywhere near the rate it did in the last century.
  • finance isn’t often thought of as an innovative area, but the last 50 years has brought about wonderous new products for creating businesses, for creating demand, for moving money and for managing complex financial relationships. New products don’t appear to offer much additional scope beyond that already created.

So while there may be improvements in productivity they are not likely to unleash a massive wave of financial benefit. This will then require inflation to make repayment of debts possible, or alternatively a significant decline in asset prices to make things affordable.

I don’t know which way things will go, but the long run view suggests that a decline in prices is the most likely outcome. Investing for that outcome is wise, particularly as we age.

Here is a reminder of just how expensive stocks are currently. This is a look at the market capitalization for the Wilshire 5000 (essentially all US stocks) versus the US GDP. The long term average is 0.8 times GDP. It is currently a little over 2 times GDP or about 150% higher than the long term average.

To finish with a little math, for the valuation to drop down to 1 times GDP, GDP would need to either double or equity prices would have to drop by 50%.

It took GDP 18 years to double from $10 trillion (in 2000) to $20 trillion (in 2018). The last time that equity prices dropped by 50% (2007-2009) it did so in 13 months. It went further dropping by over 60% over 18 months. But then took five years (and $4 trillion of government support) to return to the prior high from 2007.

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