For those paying attention to mainstream media outlets and the pundits of propaganda, we are now living through one of the greatest economic expansions of all time. Those not willing to blindly accept the narrative and look under the hood can see a very different picture. We hear the same sensationalized claims of prosperity that eerily echo the statements made in 1928 and 1929, just before reality hit the American people like a freight train. The mass acceptance of an overheated economy is analogous to people running toward the receding shoreline just before a tsunami strikes. Over the past number of years, people have seen their home values ratcheting higher and their retirement accounts returning double-digit rates of return. While it seems like the perfect scenario for the baby boomers to live out their golden years effortlessly, it is an illusion.
The Catalyst
During the great financial crisis and subsequent aftermath, nothing was done to correct the problem. Instead, the Federal Reserve and our politicians chose to bail out the weak banks, stimulate the economy through quantitative easing, and paper over the problems with more currency creation.
In a free-market economy, the weak are allowed to fail. Competitors that managed their businesses properly then take over the market share previously held by the failed institutions. This is a healthy process and akin to pruning vegetation. Bailouts and stimulus create moral hazard, which allows companies, such as banks, to reduce risk management in an attempt to maximize profits. If their risky bets pay off, it means higher bonuses. If they go south, the taxpayer will ultimately be required to subsidize the expenses of their mismanagement.
Whenever intervention is taken to avert a crisis, the root of the problem is never addressed. Instead, the problem is compressed like a spring and the crisis that later follows is amplified in magnitude. The excess currency printed to avoid said crises must go somewhere between the time the currency is created and the next leg of the crisis hits. The excess reserves often find their way into a single asset class, causing an overinflated speculative bubble, such as the housing market two decades ago, which followed the aversion of the dot-com collapse.
The financial crisis in 2008 and excessive responses to the COVID virus added so much liquidity that allocations went beyond the inflation of a single asset class bubble. Stocks, bonds and real estate have each made spectacular upward moves, fueled not by market forces, but by the necessity to absorb the excess capital.
Asset Bubbles
Asset classes, along with economies in general, tend to follow cyclical patterns. These patterns are naturally occurring and closely track previous cycles without outside interference. When excess liquidity enters an economic cycle, it exacerbates the underlying cycles and inflates them beyond what market conditions would otherwise allow/command.
Stocks have historically been an excellent choice for long-term appreciation. In the past decade alone, stocks have performed extraordinarily well. However, there are historical trends that are important to compare this period with. In the event of over-appreciation, there are generally a handful of years that follow, reverting the annualized rates of return back to the mean. The current metrics show that the price-to-earnings ratios of all major US indexes are far above sustainable levels. As a matter of fact, stocks in the US are extremely overvalued, vastly exceeding the overvaluation of 1929 comparatively.
Bonds are a staple for most portfolio managers and are used to preserve capital when stocks are underperforming. A common portfolio recommendation is 60/40 (60% stocks, 40% bonds). The ratio adjusts more heavily in bonds and less in stocks as one gets closer to retirement age. Bonds are favored in asset management as they generally perform at an inverse pattern of stocks. But - bonds were in a cyclical bull market for the past 40 years and have recently broken the cycle. The important thing to note here is that stocks and bonds have not been acting upon the inverse relationship; until very recently, they have been rising in tandem.
Real estate, for the average family, is the most valuable asset they own. Residential homes, along with stocks and bonds, have risen precipitously. Just like stocks and bonds, home values have far exceeded long-term annualized appreciation trends. Rising bond yields have an impact on interest rates for buyers. Those who locked in rates under 4% are in an exceptional position, but may not be sheltered completely if a major correction occurs to rebalance values. Rising rates make homes less affordable as high sticker prices with high interest rates make monthly payments unaffordable for most buyers. Because interest rates are determined by the global bond market, the only variable that can rebalance affordability is a reduction in price.
The Pin
The very thing that is likely to cause an upheaval of unprecedented scale is the very thing being touted as the savior of humanity - Artificial Intelligence (AI).
Back in the late 1990s there was a rather significant over-investment into everything related to technology and the internet. It’s not that investment was unwarranted, but the avalanche of capital flowing toward it could not be supported by the technology of the time. 25 years later, the internet has become an important part of our daily lives, but at that time, we had nowhere near the required infrastructure in place.
AI will likely play an important role in the next wave of technological evolution. The problem currently is that hundreds of billions, if not trillions of dollars have been invested in the advancement of a technology that is not mature enough to absorb and deploy the capital efficiently.
The scale of over-investment into AI is almost unimaginable and dwarfs the misallocated investment made during the dot-com bubble. When the internet bubble burst, it sent shockwaves globally, forced liquidation of many companies, and many jobs were lost. These are unfortunately the consequences of too much capital crowding into the inflated assets.
In case you are wondering why the over-investment in AI will likely be the villain in the story of our fairy tale economy, it is a matter of contagion. The "Magnificent Seven" tech companies are what is supporting every major index in the US markets. If those companies sneeze, the rest of the market catches a cold.
Aside from the AI-centric companies holding a majority stake in the stock market itself, margined securities are at the highest point in history (borrowed money invested into stocks). These leveraged positions, should they stumble, will trigger the trading algorithms to sell, which will cause further liquidation, which will cause the algorithms to sell even more, etc. On top of that, much of the margined funds came from shadow-banking institutions, which borrowed vast sums of their funds from large banking institutions. If the AI stocks falter, they will trigger a domino effect across everything from technology funds to retail and the banks themselves. The collapse of Lehman would look like a non-event or an average Monday morning.
Unintended Consequences
Whether or not the government and Federal Reserve are trying to protect the people or intentionally destroying our nation is debatable. For argument's sake, we'll exclude the latter and assume the best of intentions. One could argue that we couldn’t let the banking system fail in 2008 as it would be catastrophic for the people. Of course the other side of that argument is that after some short-term adjustment, the people would have been better off without the corrupt system in place. In either case, the inevitable law of unintended consequences comes into play.
By papering over the losses from the last financial crisis and preventing the liquidation of mismanaged banking institutions, the seeds of a much larger financial crisis were sown. The liquidity created has caused bubbles in real estate, stocks, and bonds simultaneously. Even with the absorption of capital by those markets, we are already experiencing debilitating price inflation. If the funds supporting those bubbles should exit and enter the real economy, the price inflation we are currently seeing shall look rather insignificant.
When the everything bubble bursts, there will be a cascade of bankruptcies, loan defaults, unemployment, and inflation. The market algorithms will liquidate anything they can to stave off margin calls on other assets. Those margin calls may still occur, causing even further liquidation. The fall in stocks will affect everyone with a 401(k) or IRA, with the greatest harm coming to those who are recently retired. The loans propping up the margined securities will default, putting enormous strain on the banking industry that should have been dealt with in 2008, and instead has only been magnified.
Bonds will suffer further, as global investors view the U.S. deficit, trade imbalance, and national debt as being unsustainable. They will demand higher yields to hold government paper, taking a bite out of the "safe" side of Americans' portfolios. The interest alone on our national debt will consume a vast majority of taxes collected, requiring further deficit spending, and even more interest to be paid on that debt.
Real estate is already in a predicament that will only get worse. During the crisis of 2008, subprime loan losses to banks equated to roughly $600 billion. Right now, in the absence of crises, the banks are sitting on over $2 trillion in unrealized mortgage losses, caused by rate increases over the past two years. The average mortgage outstanding has an interest rate of 4.2%, while current rates hover at roughly 7.5%. It is impossible to sell those loans issued at the lower rates unless the banks want to take a loss in the sale. Should interest rates rise to 8.5%, the losses to banks will exceed $3 trillion, or five times the losses incurred during 2008. If home values fall, this exacerbates those losses as the collateral value will have also declined.
Each of these highly likely scenarios were set in motion by interfering with the free market rebalances required during the dot-com burst, the 2008 crisis, and the COVID experiment. Thus, even if the motives of government were pure, the law of unintended consequences will prevail. In the event of the bursting bubble, the goal will not be to earn as much as you can, but to lose as little as possible.
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