Sowing the Seeds of a Downturn

(The following article was originally published on Real Money Pro on Dec. 1.)

"The popularity of inflation and credit expansion, the ultimate source of the repeated attempts to render people prosperous by credit expansion, and thus the cause of the cyclical fluctuations of business, manifests itself clearly in the customary terminology. The boom is called good business, prosperity, and upswing. Its unavoidable aftermath, the readjustment of conditions to the real data of the market, is called crisis, slump, bad business, depression. People rebel against the insight that the disturbing element is to be seen in the malinvestment and the overconsumption of the boom period and that such an artificially induced boom is doomed. They are looking for the philosophers' stone to make it last." -- Ludwig von Mises (1940)

"Panics do not destroy capital, they merely reveal the extent to which it has been destroyed by its betrayal into hopelessly unproductive works." -- John Mills (1867)

Free money (and zero interest rates) are the fathers of malinvestment.

Over history, the artificially low cost of credit and central bankers' unsustainable increase in the money supply trigger poorly-allocated business investments.

The dot-com bubble in the late 1990s, the U.S.housing bubble in 2002-07 and the proliferation of those "financial weapons of mass destruction" (derivatives) are past examples of what Austrian economist F.A. Hayek called a byproduct of errant monetary policy, which produced low interest rates and, eventually, misleading relative price signals. causing a boom followed by a painful bust. 

Today, the Federal Reserve and, for that matter, central bankers around the world, have made a mockery of fundamentals as a slowdown in the rate of global economic growth (see overnight data in China, Germany and the U.S. (retail sales)) have coincided with a near parabolic move in the U.S. stock market over the last six weeks. 

Nonetheless, investors' confidence in central bankers' ability to engineer escape velocity and a self-sustaining trajectory of global growth is at a bullish extreme, manifested in relatively high valuations (at over 17x earnings). This comes despite 25% of the world's GDP barely growing (with Brazil, Japan, Italy and Russia in recession) and Germany's and France's flatlining growth and with the U.S. growing at only 2% to 2.5%.

In light of recent events, we must comment on the price of energy products. The thesis that an oil price collapse of 40% in only a few months is market and economy constructive is a weak one and is indicative of the bubble, like optimism of the type that permeates through the U.S. stock market. Do observers really believe that all of a sudden the market has become oversupplied by so much oil?

Free money drives misallocation of capital and overinvestment. This time it washed up in fracking and energy (see below). But energy messes with geopolitics in ways that telecom and housing does not and this could prove to be much more destabilizing than other bouts of over investment. It is not like Russia or Iran are going to just go gently into that good night -- they could cause trouble. (Perhaps this even explains why Russia's Putin saw this coming a while ago and why he invaded Ukraine). 

Misleading price signals (manifested in a new all-time high in the S&P Index) are being communicated to market participants. But signs of malinvestment and misallocation of resources have cropped up and represent risk to investors. 

Here are the most visible examples of malinvestment that might have already developed:

• Sell Low, Buy High? (Too Aggressive Corporate Buybacks?) -- Animal spirits have substantially lifted corporations' share repurchases, while capital spending remains moribund. But perhaps, as history has shown us (at Cisco (CSCO), IBM (IBM) and at and many others), corporations are becoming too aggressive in their buyback strategies. As an example, a company that I follow and had previously invested in repurchased 10% of its outstanding shares at more than $100 a share this year. Their shares currently trade at around $50-$55 a share. The difference of $50x 2 million shares repurchased, or $100 million, has evaporated into thin air in 6-8 months. 
• Energy-Related Risks Abound -- The oil landscape (oil and shale exploration/capital spending and the proliferation of master limited partnerships and high-yield energy debt) owe their existence to ever-rising energy prices. (It feels like déjà vu all over again, as was the case with the mushrooming in real-estate based debt/derivatives a decade ago). Production/capital spending cuts and reduced employment, lower prices for MLPs and a sharp markdown in high-yield energy-related debt may loom ahead.
• Commercial Real Estate's Unrealistic Cap Rates -- The most knowledgeable people I know in commercial real estate all say prices are so high for prime commercial real estate that, to quote Crazy Eddie, "the prices are insane!" Frankly, high-end residential prices -- in urban areas -- are no less insane. Investors, it seems, haven't learned from history and are repeating previous mistakes made less than a decade ago. 
• European Sovereign Debt, U.S. Treasuries and High Yielding Junk -- The former represents potential systemic risk issues in the EU banking system. The 30-year bull market in Treasuries holds the risk of huge potential losses for all investors in the decade ahead. And high-yielding junk bonds (especially of an energy kind) could lead to an across-the-board selloff in credit markets, importantly impairing the corporate buyback apparatus. Should oil prices drop further or just stabilize (and not rise) from current levels, it will translate into lessened global liquidity and impairment of the economies of energy exporting countries.
• Social Media, High P/E Stocks and the Valuations Of Emerging Private Companies (Uber, etc.) -- Arguably, once again, investors have flocked to a new paradigm with gusto and perhaps overexuberance. As previously stated, I am not a believer in social media, new tech, sustainable profit margins of the cloud, the endless power of big data, the optimistic prospects for smart advertising and the like being profit machines for decades. I am not even a believer that a majority of these companies will be profit machines ever. Rather, the new social media paradigm is reminiscent of another new paradigm infamously featured in a column in Wired Magazine back in 1997, "The Long Boom: A History of the Future 1980-2020." Written by Peter Schwartz and Peter Leyden, the article started with the following: "We're facing 25 years of prosperity, freedom, and a better environment for the whole world. You got a problem with that?" This notion proved to turn out poorly, as two recessions (one was shallow, the other represented the deepest contraction in nearly 80 years) followed soon after during the next decade. And money spent on speculation in technology (at inflated prices) vanished into money heaven, in what can only be described as one of the greatest stock market misallocations of capital ever. 

Bottom Line

In the mid-2000s the malinvestment of capital nearly took down the world's economic system and stock markets.

Of course, that era was unprecedented in terms of the misallocation of resources.

To the extent that the global growth recovery is sub-par, fragile and vulnerable, the emergence of new and different signs of malinvestment might have a potent and adverse impact on economic growth (especially at the margin) in the years ahead and could be sowing the seeds for the next business downturn, sooner than many feel possible.

At the time of publication, Kass had no positions in any of the securities mentioned.