A Dangerous Boom In Unsound Corporate Debt

John Hussman’s Latest Comments on the Bubble

In his newest weekly column, John Hussman talks about a feature of the current echo bubble era that we believe will turn out to be an extremely important one. Readers of this site know of course that we have frequently sung from the same hymn sheet, but it is a topic the significance of which cannot be stressed enough.  After briefly recapping the history of the housing bubble and the ensuing credit crisis, Hussman writes:

 

“Now, as we observed in periods like 1973-74, 1987, and 2000-2002, severe equity market losses do not necessarily produce credit crises in themselves. The holder of the security takes the loss, and that’s about it. There may be some economic effects from reduced spending and investment, but there is no need for systemic consequences. In contrast, the 2007-2009 episode turned into a profound credit crisis because the owners of the vulnerable securities – banks and Wall Street institutions – had highly leveraged exposure to them, so losing even a moderate percentage of their total assets was enough to wipe out their capital and make those institutions insolvent or nearly-so.

At present, the major risk to economic stability is not that the stock market is strenuously overvalued, but that so much low-quality debt has been issued, and so many of the assets that support that debt are based on either equities, or corporate profits that rely on record profit margins to be sustained permanently. In short, equity losses are just losses, even if prices fall in half. But credit strains can produce a chain of bankruptcies when the holders are each highly leveraged. That risk has not been removed from the economy by recent Fed policies. If anything, it is being amplified by the day as the volume of low quality credit issuance has again spun out of control.

Leaving aside for a moment that securities prices are currently (and almost always) distorted by monetary policy, we can state the following: Insofar as the stock market is a mirror of the economy, it reflects only profits and losses that have already arisen in the course of activities in the real economy.

Even in an economy hampered by monetary pumping, the relative prices of different stocks essentially tell us which economic activities have found favor in the marketplace. What the stock market then does is to distribute the resultant profits and losses among investors according to the foresight they have displayed in picking stocks.

There is of course also a discount/expectations component embedded in the prices of stocks – but this forward looking premium also reflects an appraisal of past decisions and the effect they are held to have on future returns. To illustrate this with an example: if a company announces that it has begun to manufacture a new product (say, the iPad, for instance), then this decision is already in the past, but market participants now may place a premium on the company’s stock because they estimate the decision to have a positive effect on the company’s future profitability.

In any case, the point we are driving at is only this: insofar as stock prices reflect the investment decisions taken in the real economy, the profits and losses of investors in the stock market do not affect the world at large. Just as John Hussman writes above, they only affect investors in the market.  Mr. Hussman also had a few choice comments on the thinking that informs today’s stock market investors that strike us as quite pertinent with respect to the current situation:

“My sense is that investors have indeed abandoned basic arithmetic here, and are instead engaging in a sort of loose thinking called “hyperbolic discounting” – the willingness to impatiently accept very small payoffs today in preference to larger rewards that could otherwise be obtained by being patient. While a number of studies have demonstrated that hyperbolic discounting is often a good description of how human beings behave in many situations, it invariably results in terrible investment decisions, particularly for long-term investors. As one economist put it, “they make choices today that their future self would prefer not to have made.” In effect, zero interest rates have made investors willing to accept any risk, no matter how extreme, in order to avoid the discomfort of getting nothing in the moment.

[…] many investors realize that the most reliable valuation measures have never been higher except in the advance to the 2000 peak (and for some measures the 1929 and 2007 peaks), but they have started to treat these prior pre-crash peaks as objectives to be attained.

While recent years have diminished our belief that severely overvalued, overbought, overbullish syndromes are sufficient to derail further speculation, it’s worth observing that present valuations are much closer to those prior peaks than is widely assumed.