"Every bubble has two components: an underlying trend that prevails in reality and a misconception relating to that trend."
—George Soros
"In a speculative market, what counts is imagination and not analysis."
—Benjamin Graham
On September 1st, 1715, the most powerful monarch in Europe, Louis XIV, passed away just four days shy of his 77th birthday. His reign of 72 years and 110 days is the longest of any sovereign. His reign was characterized by constant wars and extravagant spending at Versailles, which left the finances of the state in a perilous condition. At the time of his death, France was nearly insolvent from constant wars. The state had defaulted on much of its debt and cut back on interest payments on the balance.
The king had outlived his son and grandson, and the succession went to his great-grandson who took the name Louis XV. The young king was only five years old at the time of his great grandfather’s death. France was ruled by a regent, Phillipe II, Duke of Orleans until the young king’s maturity at age 13. Burdened by massive debt from wars and lavish spending at court, the regent was desperate for solutions to France’s financial woes. He brought in a Scottish financier named John Law who provided the regent with a financial solution. Law was appointed Controller General of Finances in 1716. He then went on to establish the Banque Generale.
Bubble History Lesson
Law’s plan to bail out the indebted nation was to create a central bank that would take in deposits of gold and silver and issue paper money in their place. Initially, the banknotes were redeemable in gold and silver. The Banque built up equity through the sale of shares to investors and through the management of the government’s finances. In 1717, Law acquired shares of an ailing Mississippi Company and merged it with Banque Generale. France had granted the company a trading monopoly with the French colonies in what was then known as French Louisiana. The company raised capital by selling shares to investors. The purchase of those shares was paid for by banknotes or with government debt.
Eventually, Law created a plan to restructure most of the national debt by exchanging government debt for Compagnie shares. The shares of the company were offered to the public in 1719 at 500 livres. Soon a mania developed with the share price rising 1,900 percent to 10,000 livres by the end of the year, a price well beyond the company’s actual value. Everyone was getting rich, nobles and the common man alike. By January 1720, investors began cashing in their shares for gold and there was a run on precious metals and a flight out of paper money. Inflation was now running rampant as the number of banknotes had increased by 186% in one year due to the massive issuance of paper notes to fund share purchases. The result was hyperinflation. The price of goods doubled between July 1719 and December 1720.
The amount of paper notes issued was so large that the notes were no longer backed by precious metals (like President Nixon’s severing of gold backing of the US dollar in August of 1971). In 1720, after four years of widespread inflation, the bubble burst with share prices dropping from 10,000 livres to 500 livres by 1721. The collapse in share prices wiped out all shareholder gains with many former millionaires losing their entire fortune. The collapse of the bubble was followed by a depression, and another financial crisis leaving the state worse off. Eventually by the end of the century, mounting debt, inflation, and stagnant economic growth would lead to the overthrow of the monarchy and the French Revolution.
We know this event as the Mississippi Bubble; however, it was more than just a bubble. It was a failure of monetary policy that led to excessive money supply growth and inflation. A story we have seen repeated throughout human history when Kings, Pharaohs, Presidents, or Prime Ministers try to inflate their way out of excessive spending and debt issuance.
US Debt – Up, Up, and Away
March 26, 2024, the national debt crossed the $34.6 trillion mark. Since the beginning of this new century, US debt has gone from $5 trillion to today’s $34.6 trillion and is on pace to grow by $1 trillion every 120 days. Like Louis XIV’s wars, the US has been engaged in constant wars the last half century from Korea, Vietnam, and the first Gulf War to this century’s second Gulf War, the War on Terror, to proxy wars in Afghanistan, Ukraine and the Middle East.
Social Security, Medicare, national defense, and interest on the debt make up the bulk of the US government’s budget. When it comes to national defense, there are currently around 750 US military bases spread across 80 countries (the exact number of bases is not known as the Pentagon does not make all bases public). To support those bases there are 170,000 US troops stationed overseas. The estimated military budget is running over $870 billion and growing, not including supplemental spending bills for the War in Ukraine. The US military budget alone accounts for 40% of global military spending.
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In addition to military spending, Medicare/Medicaid, Social Security, and interest on the national debt account for another $4 trillion in spending, which when combined with defense, exceed total government tax revenues of $4.7 trillion. This means the rest of the government’s budget from running the three branches to the various agencies is paid for with borrowed money. Government spending is 23.1% of GDP while tax revenues are estimated to come in at 18.5% of GDP with the difference financed through large amounts of borrowing.
MMT on Steroids
Like John Law’s France, today the US has embarked on a grand monetary experiment known as Modern Monetary Theory (MMT). Or, as Ed Yardeni characterized it—who previously worked for the NY Fed and US Treasury—the US is now implementing MMT on steroids. The key economic tenet of this theory is that deficits don’t really matter; governments that control their own currencies like the US, can create and spend money freely without being constrained by taxation or borrowing. Regrettably, through their policies, both parties have effectively adopted this perspective, whether admitted or not.
This is the main reason why we are dealing with inflation today. The merging of fiscal spending with monetary policy has now led to fiscal dominance battle between higher inflation vs higher economic growth. Normally, this amount of spending would be reserved in times of a recession or financial emergency (like 2009 or the 2020 Covid crash) but is getting extended far beyond mere emergency measures as a matter of ‘modern’ conventional policy. The result is inflation in the price of goods and services, wages, and asset prices.
At the time this article was written, the inflation report again came in hotter than expected, the third consecutive month of rising inflation. It surprised the markets as Wall Street was hoping for three Fed rate cuts. Now those cuts remain in doubt. Though far from consensus at the moment, former Treasury Secretary Lawrence Summers is talking about further rate hikes instead of the much wished for rate cuts. Instead of going away, inflation—at least so far—is on the rise again. The buzzword on Wall Street for inflation right now is “sticky.” Something we saw take place in the 1970s, which of course was exacerbated by a series of supply shocks, policy mistakes, and wars in the Middle East (see Déjà Vu: Ten Striking Parallels Between the 1970s and Today). What does this mean for the financial markets?
Monetary Outlets
When the Fed prints money, it has three outlets. It can remain stationary (essentially as cash on bank balance sheets). It can find an outlet in financial markets and inflate asset prices (possibly leading to a bubble), or a third outlet is the money can be spent in the economy leading to an increase in the cost of goods and services. The problem with the second outlet is when it leads to a financial bubble, which feels good for many on the way up but not on the way down, often wreaking havoc and devastation in their aftermath. That brings me to today in what I believe is the final stage of what could end up being the largest financial bubble in US history.
The origin of this financial bubble dates to November 3, 2010. At that time the Fed was faced with a dilemma. Economic growth was anemic at 1.2% and the unemployment rate was at recessionary levels at 9.6%. The Fed leadership considered a radical experiment of goosing the economy with easy money, pushing more money into the banking system. This changed the Fed’s role as the primary catalyst of boosting economic growth. The decision to start printing money became QE (quantitative easing) I, another fancy financial term for simply printing money out of thin air and buying government bonds to drive down interest rates. QE I led to QE II, QE II led to QE III, which eventually led to QE infinity (open-ended easing as required or needed). During the pandemic, QE went in overdrive with the Fed printing $120 billion every month; its balance sheet exploding as a result.
For the years following 2008, the result of continuous QE was the Fed would effectively take interest rates down to zero and keep them there for an entire decade other than a brief moment under Powell when he made attempts to normalize. At one point, interest rates globally even went negative for the first time in history with close to $17 trillion in negative interest rate yielding bonds. Something never seen before where lenders paid borrowers, mainly governments, to lend them money.
Throughout recorded human history, interest rates ranged between 3-6%. Rising to the higher end during periods of war and inflation then receded back to a normal range hovering around 3%. Under the Bernanke/Yellen/Powell regime, they were zero and kept there for almost an entire decade. Wall Street and consumers loved it. Homebuyers were able buy homes or refinance their mortgages at 3%. Companies refinanced their debt at the lowest interest rates since the early 1950s, and zombie companies were kept alive through low interest rate loans. Wall Street was giddy with the stock market rising every year in one of the best decades for stock returns in nearly half a century.
Wall Street has enthusiastically embraced these, which have generated substantial amounts of money. This money initially flowed to the major banks, sparking a surge in the stock market, but also to a wide variety of sectors. Due to the increase in prices, not just for goods and services, but also for a wide range of assets, some have characterized where we are today as an "everything, everywhere bubble."
The Five Stages of a Bubble
Here’s how the economist Hyman Minsky identified the five stages of a bubble. His breakdown is as follows:
- DISPLACEMENT: This sets the stage for a bubble by an event that shifts investor sentiment. Displacement events can be:
- A new exciting technology
- Historically low interest rates
- A surge in a particular market sector
- BOOM: Money rolls in as enthusiasm increases about the potential money that can be made in a particular asset or sector.
- EUPHORIA: During this stage, excitement spirals out of control with intense and widespread optimism among investors.
- PROFIT-TAKING: At this stage, the bubble reaches a peak, and the smart money starts selling. This can trigger a domino effect as asset prices stop rising and begin at first a gradual descent.
- PANIC: When enough investors start to sell, a rapid, waterfall-like decline ensues as everyone rushes to exit. Panic sets in among investors who bought at the peak, only to witness a sharp drop in the value of their assets.
These stages of an asset bubble are a general framework for understanding the evolution of an asset bubble over time. There are no clear-cut definitions as to how long each stage may last since each bubble will have slightly different characteristics. However, in my opinion, we are within the euphoria phase of an AI bubble and it remains unclear as to whether it will be overtaken by a gradual descent of profit taking, eventually leading to a waterfall decline, or if the exciting and phenomenal developments will allow continue to propel valuations higher. The catalysts that could bring an end to the euphoria over AI are another resurgence in inflation, a spike in interest rates or oil prices, or an exogenous event like a war leading to another supply shock. All of these, of course, can occur together at the same time or in a series of episodic waves, which is what we saw during the 1970s.
Follow the Money
Looking back to 2010, we can see this fiscal and monetary bubble take root with the Fed’s balance sheet ballooning from $2 trillion after the Great Financial Crisis to nearly $9 trillion at its peak in April of 2022. Government debt rose from $12.3 trillion in 2010 to today’s $34.7 trillion, an increase of 182%. Corporate debt ballooned from $6.5 trillion to $13.6 trillion, up 110%, and consumer debt rose from $14.4 to $19.6 trillion, a rise of 36%. The era of zero interest rates fueled a frenzy of debt issuance in all sectors of the US economy. That debt continues to accelerate exponentially at the government level, which is typically only seen during periods of war or recession. Never have we seen this level of spending with low unemployment and a growing economy.
So where has all the money gone and what have been the consequences?
- Large corporations used low rates to leverage up and buy out competitors or buy back stock.
- Wealthy Americans (top 1%) share of wealth rose to 45.8%, creating a large wealth gap between the rich and poor.
- Cheap money funded high risk speculators from private equity to hedge funds.
- Large banks became even bigger with the top 3 banks controlling 20% of the nation’s deposits.
- Too big to fail got even bigger and became CAN'T AFFORD TO FAIL.
- Zombie companies were kept afloat with cheap debt and are now at risk with higher interest rates.
- CLOs (Collateralized loan obligations) replaced CMOs (collateralized mortgage obligations).
The result is we now see inflated asset prices and potential bubble setups in many areas:
- Bonds
- Stocks
- Stock buybacks
- Index funds
- Real estate / home prices
- Debt: Government, corporations, and consumers
Bubble-Popping Catalysts
What will bring this bubble to an end? Most likely an exogenous shock to the system as there are numerous candidates from Fed rate hikes, a spike in oil leading to inflation, or an outbreak of war. For now, MMT is on steroids endorsed by both parties in Washington, Wall Street, and the financial media.
So, given the prevalence of bubbles in many asset categories, what should investors do? To begin with, looking at what is cheap, undervalued, unloved, and under owned. In my opinion, this would be commodities, along with the resource and mining sector more broadly. As shown in the graph below from Goehring and Rozencwajg, commodities are as cheap as they've ever been relative to financial assets over the past 100 years.
In our high-tech society that we live in, it still takes raw materials, energy, and resources to make things and grease the wheels of the world’s economy. This is currently being ignored and certainly not the in-favor areas of investment on Wall Street, but economic realities are beginning to re-emerge. Other areas that provide a hedge against a longer-term inflation regime and geopolitical turmoil are precious metals. Here we see some surprising bulls. Wall Street investment banks Goldman Sachs, Citibank to UBS have all raised their price targets for gold this year. Gold once again is resuming its role as a currency as BRICS nations (Brazil, Russia, India, China, South America and others), look to gold to settle oil trades or diversify their large Treasury holdings. It appears that we truly are seeing a long-term monetary regime change from the petrodollar to petroyuan and petrogold.
Other areas that can serve as inflation hedges are investments in dividend aristocrats that increase their dividends every year—a core strategy I employ for clients. For bond holdings, I prefer a laddered bond portfolio with short to intermediate maturities to protect from losses triggered by rising interest rates and inflation. With a laddered bond portfolio, as bonds mature, assuming they are high-quality, they can be reinvested into higher-yielding bonds if interest rates rise alongside inflation.
Investors face a challenging landscape with fiscal dominance pushing bond yields and inflation, while geopolitical turmoil disrupts markets. Rising interest rates aim to curb inflation but can hurt stock valuations and bond prices. A diversified portfolio with exposure to inflation-hedged assets, value-oriented stocks, and shorter-term bonds might be suitable given an investor’s risk tolerance. Focus on long-term fundamentals and stay informed to navigate this volatile period.
In conclusion, I am reminded of a quote from Charles Kindleberger's book "Manias, Panics, and Crashes: A History of Financial Crises," where he states, "Speculative periods come to an end when the facts become inconsistent with the story."
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Copyright © 2024 James J. Puplava
