The Fed’s Musical Chairs

8/9/2016 – Today’s marketplace is a peculiar one. When I look at the current market, I like to think that it is similar to the children’s game of musical chairs. As long as the Fed and the other major central banks are playing their tune, everybody is happy to play along. In fact, I don’t think investors have much of a choice. However, once the music stops, it is important to make sure that your aren’t the only one left standing.

Perhaps I’m being a bit dramatic, but I think the major central banks are playing a dangerous game. Low interest rates and Quantitative Easing do not come without a cost. What that cost is, nobody knows for sure. But I suspect this debt, despite its form or who is issuing it, is just like any other type of debt. It is borrowing from the future. In the Fed’s case, by creating record low interest rates, returns (stock returns, bond returns, etc.) are brought from the future and consumed today.

“Debt is future consumption brought forward. Once debt is incurred, consumption that might have happened in the future won’t happen…We forget that debt used for consumption doesn’t create new supply. It simply pulls supply forward in time. The problem is that debt can’t do this forever. Pulling your consumption forward to the present means you will consume less later.”  – John Mauldin

Yes, returns since 2009 have been impressive. Chances are, if you’ve purchased an asset (of any type) within the past 5-7 years, you’ve done quite well. Stocks are at an all-time high. Bond yields have sank as their prices have rallied with stocks. Real property prices have rebounded.

When asset prices increase, investors assume they will continue to increase into perpetuity. It is natural to expect this. It is within our human nature to find trends where they might not exist. Though, I doubt if returns will continue to be this rich, especially if precautions are not taken.

The Problem With Complacency & Linear Forecasts

The current investment landscape reminds me of the housing market in 2006. In 2006 investors assumed that money couldn’t be lost if you invested in real estate. Of course, this was not case as it sparked the Great Financial Crisis. The investment landscape is obviously different now than it was a decade ago, but it seems that the “cruise-control” investor mindset has reemerged.

  • The mindset in 2006: “Don’t worry if your monthly mortgage payments are a little bigger than what you’re used to. You qualify for the loan. And besides, you don’t plan to keep the house for very long anyways. Housing prices only go up. Just hold on long enough until prices rally to where you can sell the property.” This example might be a little campy, but it shows the speculative nature of the real estate “investors” in the mid-2000s. And with rates so low and accessible cheap capital (thanks to Mr. Greenspan and the others at the Federal Reserve), the incentive to invest in real estate was too great to ignore.
  • The mindset in 2016: “The stock market is the place to be. With rates so low, there really isn’t anywhere else you can go to for a decent return. It’s a TINA market – There Is No Alternative. With bonds so expensive and the rest of the world slowing down, the U.S. stock market is clearly the safest place to put your money. Besides, the Fed has propped up the market in the past and they will continue to do so. It’s ludicrous to bet otherwise.” (Sidenote: These are not real quotes. They are made up by yours truly to help portray the current mindset of the common investor.)

Again, people tend to forecast returns in a linear fashion. For example, let’s assume that an asset is generating on average a 6% return for the past 3 years. It seems logical to assume that this investment will continue to give you 6% annually for the next 3 years, even though we may not have a solid basis to make this assumption.

Of course, returns are volatile. An asset may give you 10% one year and -13% the next, especially when considering stocks. When forecasting returns, volatility, for some reason, is usually not accounted for. This practice not only happens within the Investment Management community, but also within the Equity Research community. I spent a summer at Wedbush Securities within the equity research department as an intern while studying for my MBA at UCLA Anderson. My primary job at Wedbush was to create Revenue, Cash Flow, and Balance Sheet projection models for various publicly-traded securities. How did we forecast revenue/expense/cash flow streams for these companies? You guessed it. Straight-line/linear projections. And if the output of those models didn’t give us the desired price, we “tweaked” the numbers until it produced the desired effect. Of course, the inherent danger in forecasting returns in a linear fashion is that it never pans out the way you hoped it would.

Central Banks are Creating Another Bubble

According to Investopedia, “A bubble is an economic cycle characterized by rapid escalation of asset prices followed by a contraction.”  When one thinks of economic bubbles, plenty of examples come to mind. Think of the Dutch Tulipomania, the dot-com bubble, and the housing bubble. There always have been and there always will be booms and busts.

However, central bank intervention, especially recently, is exasperating this cycle. The Federal Reserve, the European Central Bank, the Bank of Japan, and others have adopted a monetary policy that has pushed asset prices beyond reasonable levels. All of this is in an attempt to spur demand/growth and to create sustainable inflation. The central banks have created an asset bubble not linked to just a single sector, asset class, or commodity, but one that is linked to all major asset classes. Some have dubbed it the Everything Bubble.

How are the major central banks creating a bubble? In short, they have a highly accommodative monetary policy in an attempt to boost spending and to spur inflation (usually a 2% target). Most major central banks already have an aggressive asset purchase program (QE – Quantitative Easing) and record low interest rates. In fact, over 1/3 of all major central banks have adopted a policy zero or negative interest rates.

Central bank rates 2016


A zero interest rate policy (ZIRP) and a negative interest rate policy (NIRP) is a new and untested method. Because QE is already running its course and its effect is beginning to wane, central banks are looking for alternative methods to spur demand. The ECB and the BOJ are currently buying approximately $180B in assets every month. It is important to note that this figure does not include the newly announced Bank of England QE program which is expected to start soon.

QE 180B per month

All of this, of course, has consequences. The most immediate and obvious consequence is that bond yields are at records lows.

10 yr yields

Things have gotten so out of control that Japanese, German, and Swiss bonds now have negative yields, which means that investors have to pay the bond issuer for the right of owning the bond! In fact, 1/3 of all government bonds are currently yielding a negative return.



What about the stock market? Are stocks cheap relative to bonds? Yes. The S&P 500 currently yields more than the 10-year Treasury (2.04% vs. 1.59%). But that does not make the stock market cheap. By its own right, the stock market is very expensive, especially when margins will normalize. I’ve written about this in great detail recently and you can read more about it here.

What’s Next?

One of the great mantras on Wall Street is, “Don’t Fight the Fed.” This means that it is better to invest in a way that aligns with the Feds policy rather than against it. And for the most part I think this statement is true. However, a favorite saying of mine is, “everything is fine… until it’s not.” In October 1929, Yale economist Irving Fisher declared that “stock prices have reached what looks like a permanently high plateau” days before the market crash. In 2006, everything was fine with the housing market until housing prices began to fall in 2007. In March 2010, everything was fine with Greece until it “suddenly” needed a bailout from the EU in April 2010.  It is fine to look to the past in terms of economic expansion and government intervention, but it is also foolish to not at least consider the future. Today’s actions have consequences.

Chances are, the major central banks will continue to play its music by keeping rates low and by buying assets. For the time being, investors have no choice but to dance to its tune. However, I think it is important to note that the Fed or any other central bank cannot change major economic and demographic trends. It alone cannot reverse the trend in government outlays (specifically Entitlement Spending), an aging baby-boomer population, nor the perpetual increase in asset prices. At some point, the music will stop. This is a fact. And when the music stops, it is important that you are not the last one without chair.


Ryan Hughes
Bull Oak Capital
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