Andy Krieger's Thoughts on the Market - 27 April 2023

The past month has overall been a choppy month in the markets. Whether one looks at Bitcoin, equities, bonds, commodities, or currencies, the markets have essentially been in broad choppy ranges. This range-trading, however, masks the deeper stories beneath the surface.

We have seen yet another mid-sized U.S. bank, First Republic Bank (FRC), come under severe selling pressure as depositors have fled what they fear will be the next bank collapse. Once investors lose confidence in the safety of a bank, their flight from the bank becomes a self-fulfilling prophecy. The rapid withdrawal of high percentages of a bank’s assets inevitably leads to a bank’s collapse, or at least a forced takeover. On a larger scale, we have seen the same scenario play out with Credit Suisse. Put simply, our banking system is based on trust, so trust must be maintained above all.

The U.S. economy has many distortions and hidden risks that are borderline insane. When there are large misalignments between financial valuations and economic valuations, the consequences of getting these assets realigned will be severe. Put more simplistically, we have in our banks today the largest distortion ever in true valuations due to an easing of mark-to-market requirements which was implemented in 2009. Banks have discretion in how they value their troubled assets, obviating the requirement to carry these assets at accurate market valuations. Put simply, instead of showing massive unrealized losses on their balance sheets, banks have the option to hold their underwater assets to maturity and not disclose the magnitude of the problem. This relaxation of FAS 157 quite literally gives banks the legal right to conceal losses.

This bizarre policy has interesting ramifications, to say the least, when one considers the size and scope of the losses which banks are currently hiding. The current banking system in the U.S. has about $2.2 trillion in capital. That sounds fine for an economy with a GDP of roughly $25 trillion. Consider, however, the volume of underwater assets which banks are now classifying as “hold to maturity,” which is a staggering $2.8 trillion. Yes, that is right! Two Trillion Eight Hundred Billion in hidden losses are being carried as “held to “maturity” rather than marked at accurate valuations.

If one is looking for a dramatic example of kicking problems down the road, this is about as good as it gets. Over time, the banks figure they can grow their way out of the mess, and to some extent they are right. As long as their depositors don’t bolt quickly and the banks can run profitable operations, these losses can be managed. When there are dramatic withdrawals, however, these losses become exposed, as assets which the banks are holding must be liquidated to cover large volumes of withdrawals.

First Republic is just another example of the hidden dangers in the U.S. economy. We should not be naïve for a minute and think that the banks’ recent strong earnings are actually an accurate portrayal of the true stability in our banking system. In fact, I wonder how different this is from the strategy that was being used by Madoff. The primary difference is that Congress and the Federal Reserve Board have determined that certain financial institutions are simply too big to fail. The other difference is that the banks have been given a legal mechanism through which they essentially run a Ponzi scheme. Accordingly, public resources will be thrown at these institutions to save them and prevent a widespread system crisis when they show signs of cracking. If we had a truly transparent financial system, regulators would never have implemented such an intentionally distorted way of reporting bank’s true economic condition. How can one properly judge a bank’s solvency when its financial condition is intentionally opaque?

Looked at from a different perspective, First Republic Bank is just another example of a bank that is too small to save. Yes, they put band aids and bandages on it to slow the bleeding, but the mismatch between its current liabilities and its underwater long-term assets was just too big. The rapid withdrawals by depositors exposed this mismatch and forced the bank to realize large losses with the forced sale of its assets. The challenge we will sadly face at some point is how the authorities will manage the inevitable market crisis that will result when the discrepancy between financial asset valuations and economic valuations finally gets realigned. This realignment will lead to a shocking and widespread risk aversion among investors that will likely overwhelm the Fed and the Treasury for a while. The stock market is still more overvalued than the market was in 1929. The current distortion is staggeringly large, and it is only the voracious hunt for yield that is maintaining the current market levels. The stock markets are overvalued by every sensible measure, but that doesn’t mean they can’t become more overvalued before reason ensues

Over the long term, the distorted gap between economic reality and bubble valuations gets corrected through one form of economic crisis or another. Whether the adjustment comes through a market collapse or a credit crisis, the result will be the same. The expected return for equities over the next decade is dismal. It will likely average a zero total return, or worse, with dozens of zombie companies invariably being forced to shut their doors over time. The valuation in the S&P500 is further distorted by the fact that nearly 25% of the entire index is linked to the fortune of just six companies. (Apple (AAPL), Microsoft (MSFT), Amazon (AMZN), Google owner Alphabet (GOOGL), Facebook (FB) and Tesla (TSLA) are now collectively worth more than$8.1 trillion, accounting for nearly 25% of the total $33.3 trillion market value of all the companies in the S&P 500.)

The Fed’s bizarre policy choices over the past fifteen years have simply added to the extreme distortion of our financial markets. Please look at the graph of the Fed’s balance sheet as a percentage of GDP until 2012.

The Fed defended its then bloated balance sheet by comparing it to Japan’s and Switzerland’s central banks, which were even more distorted. That is hardly a sensible explanation or defense. The balance sheet has continued to expand to ever-higher levels, and its current percentage is around 37%. This is hardly restrictive! In fact, the current balance sheet is about $8.56 trillion in total assets, which is a reduction of less than 4% from its peak several years ago. Put differently, yes the Fed has raised rates, but it has not done anything remotely similar to what Paul Volcker did when he aggressively reduced the Fed’s balance sheet as a percentage of GDP to restore confidence that the Fed would show monetary discipline and adhere to a sensible policy.

Theoretically, the Fed is supposed to run long-term monetary aggregates that are consistent with the long-term potential of the economy to increase its production of goods and services. This is clearly not what the Fed has done. Rather, the Fed has increased its ratio of assets to GDP so dramatically that risk-free assets offered us essentially zero returns for over a decade. This in turn led to insane bubble valuations in stocks, bonds, and housing as investors speculated wildly to seek yields. The piercing of these bubbles is only at the very early stages. With higher interest rates, we now can see a bit better who was essentially exposed and naked, and who had proper cover. This process of exposing unprepared companies and banks is just starting.

Going forward, I stick to my big picture view that the stock market is grotesquely overvalued. There are still powerful underlying price pressures in the economy, and the Fed hiking interest rates by another 25 or 50 basis points will not fix that problem. A recession won’t fix that problem either, although over time, it is likely that a sharp economic slowdown will reduce inflationary pressures in the job market and reduce demand for goods and services. A far better predictor of these reduced price pressures and demand for goods and services would be a reduction in the Fed’s balance sheet. The Fed, however, doesn’t want to do that because it would expose the losses on many bank’s balance sheets.

Therefore, we are left with a distorted financial system that is grotesquely mispriced. Please note, though, that I am not expecting an imminent collapse in the stock market. In fact, I wouldn’t be surprised to see a bit of short-term upward price pressure in the major stock market indices. I am, however, expecting this rally to be short-lived before the next major down leg in equities begins. The size of the down leg in the stock markets will be dependent on quite a few variables, but in the big picture, the correction from the highs of late 2021 should have quite a bit farther to go.

In the same way, I am not expecting the next round of sharp yen appreciation to begin until we enter a serious period of risk aversion. We are stuck for the time being in a market that wants to sell yen and buy other higher yielding currencies to earn the interest rate differential. This selling of yen is leading to a short-term cycle of yen weakening that will be followed by a very, very sharp reversal in the yen which will see yen appreciation against all major currencies. For now, the yen is set to weaken a bit further, but its next major move will be dramatic appreciation.

In other markets, I am now expecting a corrective cycle in gold that should result in either a sharp price correction back to $1800 per ounce, or a protracted period of choppy consolidation as the market digests the recent sharp rally from $1615 to $2048 that began last fall. I will be looking to buy the next corrective sell-off and play for an even larger rally that will take us well above $2,000 per ounce.

I will write again soon. In the meanwhile, best of luck in the markets.