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Out on a Lim

John Lim

THIS WILL SOUND like heresy to buy-and-hold investors. But I believe risks are building within the financial system—and we ignore these risks at our peril.

If you’re a diehard buy-and-hold investor who, come hell or high water, plans to dollar-cost average into the stock market, feel free to skip this article. It is not for you. On the other hand, if you believe—as I do—that there are more and less advantageous times to invest one’s capital, please read on.

Like death and taxes, economic and market cycles are indisputable facts of life. It has been a long time since the U.S. has had a recession. The last one—the Great Recession—ended in June 2009. That means the current economic expansion is now a decade old. If we get through June without a recession, this will be the longest economic expansion on record.

There is no law that limits the length of an economic expansion to one decade. By the looks of it, this economic expansion is headed for the record books. But here’s my concern: Many risks and warning signs are seemingly being ignored by investors, perhaps due to the unprecedented length of the current economic cycle and bull market. Here are nine huge risks—which, I believe, investors are blithely ignoring:

1. The yield curve is inverted. Based on the difference between 10-year and three-month Treasury yields, the yield curve inverted in March of this year and again in May. As I’ve discussed previously, this has been a reliable harbinger of recessions.

In fact, I suspect the yield curve would have inverted earlier and, indeed, is currently more inverted than it appears, due to the Fed’s quantitative tightening (QT) program, which began in October 2017. As the Fed has attempted to shrink its balance sheet, QT has the effect of increasing the supply of long-term Treasurys, which raises their yields. In other words, just as quantitative easing (QE) lowered long-term interest rates, reversing QE raises them. The bottom line: Without QT, 10-year Treasury yields would likely be even lower and the yield curve even more inverted.

2. Stock market valuations—particularly in the U.S.—are very high by historical standards. By some measures, the market is as expensive as it has ever been. One of Warren Buffett’s favorite metrics for overall stock market valuation—the market value of all publicly traded stocks divided by GNP—currently stands at about 190% in the U.S. In Buffett’s own words during a 2001 speech, “If the ratio approaches 200%—as it did in 1999 and a part of 2000—you are playing with fire.”

3. Interest rates have been lower, and lower for longer, in this cycle than ever before. The enormous importance of interest rates cannot be understated. Nothing has a greater influence on the economy and markets. Interest rates determine the price of all financial assets by discounting future cash flows. Interest rates also control the availability of credit, which is the lifeblood of the economy.

In December 2008, the Federal Reserve lowered short-term interest rates—as reflected in the federal funds rate—to essentially zero, where they remained for the next seven years, until the first rate hike in December 2015. This extraordinary policy was known as ZIRP, or zero interest rate policy. The fed funds rate remained below 2% until September 2018, or nearly a decade of extraordinarily low interest rates. To put this in perspective, from July 1954 to December 2008, the fed funds rate was below 2% for a combined total of just 66 months, or 5½ years.

I don’t pretend to know the ramifications of keeping interest rates extraordinary low for so long—but then again, neither does the Federal Reserve. One thing is certain: Easy money induces risky behavior, and money has never been easier.

4. The jury is still out on the Federal Reserve’s quantitative easing experiment. QE simply refers to the policy by the Federal Reserve to lower long-term interest rates by buying up Treasury bonds. Since the Fed can “print” money, this also has the effect of injecting liquidity into the economy. When the Fed embarked on this policy, it described it as a temporary measure.

But as with many things in life, the Fed may be discovering that QE was easier to get into than out of. The Fed’s balance sheet is down just 15% from its peak of $4.5 trillion. Moreover, it’s important to remember that QE is a global experiment. The European Central Bank just ended its version of QE six months ago. Japan’s QE is still going strong, buying not only bonds, but also stocks.

Where has this massive global QE experiment left us? Negative interest rates, for one thing. Both the German and Japanese 10-year bonds are slightly negative. Imagine lending your money to the government for 10 years and having to pay for the privilege. If extraordinary times require extraordinary measures—the rationale for QE in the first place—might extraordinary measures not lead to extraordinary times?

5. Corporate debt is at record levels. Right now, companies are able to pay the interest on their debt with relative ease. But what happens during the next recession? Or when interest rates eventually rise?

6. Trade wars and tariffs threaten to squelch global trade. This topic receives more than enough attention in today’s press, so I have only two words to say about it: Smoot-Hawley.

7. This year has seen a huge jump in initial public stock offerings, including tech unicorns going public. It’s expected that the money raised in IPOs this year will exceed that in 1999, the height of the dot-com boom. That fact alone is not necessarily worrisome, as our economy is obviously much larger than two decades ago. What is worrisome is the valuation and lack of profitability of this year’s crop of IPOs. Stock prices reflect investor pessimism or optimism. Too much of the latter often leads to disappointment.

8. Federal government debt is exploding even during the peak of this economic cycle. Economists Carmen Reinhart and Kenneth Rogoff wrote a paper in 2010, exploring the relationship of government debt and GDP. The one-sentence summary: When the ratio of government debt to GDP exceeds 90%, growth in GDP falls significantly.

The current economic expansion has been one of the slowest on record. One possible explanation: U.S. government debt as a percent of GDP has climbed sharply since the Great Recession, exceeding 90% in 2010 and never looking back. Today, it stands at 105%. The last time this ratio breached 90% was 1944 to 1949, due to the cost of the Second World War. Here’s something uncomfortable to ponder: What will happen to our debt during the next recession, when tax revenue will likely shrink?

9. Student debt is at record levels. To be sure, of all the forms of debt, student loans are probably the most benign, as they’re an investment in future earnings potential. Still, there are limits to even this. Today, there’s more than $1.5 trillion in student loans outstanding, which is almost 8% of GDP.

John Lim is a physician who is working on a finance book geared toward children. His previous articles include My SentenceYielding Clarity and Grab the Roadmap. Follow John on Twitter @JohnTLim.

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David Powell
David Powell
2 years ago

The next 12-18 months will be interesting. US mfg PMI for May hit its lowest level since Sep 2009.

I like this site for its US debt-to-GDP analysis/visualization:
https://www.nwcapitalsolutions.com/project/us-deleveraging-analysis-total-debt-to-gdp/

parkslope
parkslope
2 years ago

Excellent article, although it is ironic that it appeared on a day when the market gained more than 2%.

Langston Holland
Langston Holland
2 years ago

For a buy and hold guy like me, the dumbest thing I could do is skip your article and others like it. To disallow challenges to one’s decisions is asking for trouble. Both the wise and the foolish have access to the same information, it’s just that one learns from it and the other doesn’t.

Your points are spot-on as always, though I do have a few thoughts. Bottom line is that the investor should consider what he believes to be the worst*/best/probable cases over the time horizon of interest and allocate resources accordingly, i.e. portfolio allocation. The Guide on this web site provides the best perspective I know of.

Thoughts:

1. The yield curve seems to be one of the best predictors of recession we have. Then again, on-coming recessions haven’t reliably hammered the stock market, while actual recessions seem to have been a pretty good buy signal.

2. PE is definitely high by historical standards. I made a log plot using data from 1871 showing CAPE vs. the S&P500 demonstrating what we all know – low PE’s are usually good times to buy. So are high PE’s if you hang in there long enough. Maybe today’s PE isn’t that high given increased profitability as well as increasing numbers of investors compared to the past. Are these two increases temporary, thus pricing the market at unsustainable levels or are they long-term shifts? Allocate your portfolio accordingly, but as for me I’m in with MPT math and a dash of emotional salt.

BTW, I recommend selecting log vertical axes when possible with this kind of stuff as it shows more intuitive percentage-like movements than absolute scales. Thus a change from 100 to 110 will show the same vertical movement as 1000 to 1100.

6. Smoot-Hawley happened after the crash of course. Hindsight makes it look like a pretty good buy signal, though what we’re up to now with tariffs seems more in line with the corrective Reciprocal Trade Act of 1934.

* Worst case planning is a fascinating exercise to do with your spouse. It could involve more than just poor returns on paper. Consider food, clothing, shelter, hygiene, medicine and other things for those you are responsible for. FEMA recommends 3 days of supplies. I’d recommend 3 months. I’d also read what it was like for the poorest (and richest) during the depression. One of the best books was published in 1937 and is a stunning look at the southern sharecroppers in my family’s background.

Phil Dawson
Phil Dawson
2 years ago

It’s hard to argue with any of these observations, and the lot of them are likely to produce some scary outcomes. The question is, what are you doing to mitigate these risks for yourself?

YalieNE
YalieNE
2 years ago

Stocks have gone straight up since this came out

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