A Three Legged Stool

The financial markets are like a three legged stool, the legs being the equity market, the bond market, and the property market. If any of these legs breaks the whole stool collapses. The only question is, which it will be.

Back in 2010 I argued that I thought a huge crisis would arise because of a crisis in the property market. I still believe that will be the case, but it may not be the property market that is the first of these markets to crack. Since 2010, the property market in the US did continue to collapse, down by 60% in places, the property market in Ireland collapsed taking down its banks, and as it bailed them out, almost bankrupting its state. The property market in Spain has fallen by around 50%, and its banks, along with others in Europe affected by it, have either gone bust, been merged, been nationalised, or else cling on to life, only because the ECB has provided masses of liquidity via the LTRO's, that have enabled the banks to liquidate their bad property loans over the intervening period. In Britain, the property market outside London continued to fall, despite record low mortgage rates made possible by state intervention, which in turn have caused what everyone now recognises as an unsustainable and soon to burst bubble in London.

But, as I've pointed out more recently the factors that led to falling rates of interest and inflation over the last 30 years, have now reversed, and despite massive money printing continuing, global interest rates are rising. Put the other way round, Bond Markets are falling. Given that Bond markets, like Equity Markets, and Property Markets are in one of the biggest bubbles seen in history, the likelihood of the Bond markets declining in some kind of gradual orderly fashion are pretty low. But, if Bond markets fall heavily, the initial effect may be to cause a “great rotation” from bonds to equities, but, on the other hand, as happened in 2008, it may simply result in a rush away from all asset classes, particularly if those caught out in the Bond Markets, have to rush to liquidate their shares, property, gold etc. in order to obtain cash. Whichever occurs, the fall in the bond market would cause interest rates to rise sharply, which means that property prices would collapse, as people default on their mortgages.

As with any Ponzi Scheme, its not when people start selling that causes the crash, its when they stop buying in sufficient quantity to provide the new money to pay out, to the initial investors, or to inflate their fictitious capital.

But, it may not be the bond market that collapses first. As I've pointed out over recent months, one of the effects of the low rates of interest produced on the back of the high rates of profit of the last 30 years, has been that firms have bought back their shares, even borrowing money to do so, in order to boost their share prices – and with it the bonuses, and share options of directors. Equity markets, that had already ballooned during the 1980's on the back of huge amounts of money printing and low interest rates, have been blown up once again over the last 3 years, way beyond any real increase in the growth of economies or the real value of companies.

The real measure of that is given by the Price-earnings ratio. As I've pointed out before, the P/E figure given by the business channels, that generally act as cheer leaders for rising markets, are highly misleading. They frequently are based on forecasts of future earnings, but that in turn is based on projections of economic growth that is unlikely to materialise. Already, we've seen in the recent earnings season that actual earnings have been disappointing. The profit margin of companies like Apple has declined sharply.

But, a more accurate measurement of the P/E ratio is that provided by Robert Shiller. That is the Cyclically Adjusted P/E, or CAPE. On that measure, it currently stands at over 24. In other words, the average price of shares is 24 times the earnings (profits) per share. On every occasion this measure has been at that level there has been a stock market crash. The only times this measure has been at levels higher than this were in 1929, and 2000.

Other measures suggest that stock markets are overvalued. For example, using Tobin's Q, which measures the current market value of shares against the current reproduction cost of the capital they represent, Andrew Smithers has calculated US non-financial stocks to be about 58% overvalued.

The current levels on both measures put stock markets as being as overvalued as they were in 1987, when the biggest crash in stock market prices ever, including 1929, occurred.  If stock markets crash, then this could also be the spark for a bond market crash, as well as a property market crash, all three interacting. For example, if there is a sizeable stock market crash, that would provide, when the dust has settled, a solid basis for a rotation of money out of bonds, and property into shares. But, as money moves out of bonds, that would cause interest rates to rise, which may cause share prices to fall once again.

It would certainly cause property prices to fall, for the reasons described earlier. But, if property prices drop substantially, then especially in conditions like now, when Central Banks have already stuffed as much liquidity into the market as they can, any dramatic fall in property prices, will expose the banks as bankrupt, as their property loans go bad, and the value of their balance sheet collapses. In financial markets where the share price of banks is so significant any such collapse of the banks, which would be on a greater scale than in 2008, would be bound to send stock markets down even further.

The contradictions that have been built up in financial markets over the last 30 years, as a result of massive money printing, and the inflation of these asset price bubbles have not been resolved after 2008. On the contrary, they have been made worse, by even greater money printing. At some point one of these legs of this three legged stool will wobble, and the stool will collapse.