Something wicked this way comes: A financial crisis is brewing

Double, double toil and trouble;
Fire burn and cauldron bubble.

For a charm of powerful trouble,
Like a hell-broth boil and bubble.

By the pricking of my thumbs,
Something wicked this way comes.
Open, locks,
Whoever knocks!

(Macbeth: IV.i 10–11; 18–19; 44–47)

As a child I loved Macbeth. It was the one play by Shakespeare that had enough in it to keep me entertained as a child. The witch’s scene from which this set of quotes was taken is the part that I found particularly entrancing. Not only was it visually and verbally engaging it also set the scene for the really nasty stuff to follow. The bubbling brew of nasty things was an analogy for the environment Macbeth was operating in and the major tragedy that was the outcome; we have our own brew stewing today.

Until the arrival of COVID-19, for the last many decades, we had been able to avoid a real tragedy on a global basis. I worry, however, that today as we begin to recover from the very serious consequences of the pandemic, we are ignoring the elements of other impending tragedies. We do not need to have a tragedy. In Macbeth, the tragedy was precipitated by an evil decision by Macbeth and his wife; in this instance, we need to understand the elements to get ahead of them, to deconstruct the brew and neutralize it. In other articles and in a book written with my colleagues, Ten Years to Midnight, I have touched upon the major secular trends — disparity, climate, technology, polarization, distrust and demographic trends — that could result in worldwide tragedy. We focused on those risks because they were near certain, tsunamic trends that would impact every country in the world versus looking at shorter-term, more volatile trends such as the economy; but, there is one aspect of the economy, and the capital markets in particular, that is really worth looking at now.

Elements of the brew. As in many crises that occur in economics, a run of great years has sown the seeds of potential calamity — some of it human engineered and some of it a natural result of the multiplicative consequence of demography and technology innovation. We have had a remarkable combination of low volatility, low interest rates, continuously rising asset prices and pretty good liquidity. This extremely munificent environment has been with us since the liquidity crisis of 2007–2008. Solutions implemented as a result of that crisis — low interest rates, volatility hedges, adjustments to automatic trading algorithms, cooling off periods in the exchanges — have all helped to create this investor-friendly environment. Money can be borrowed inexpensively, and the consistent set of returns means that it can be applied to leverage investments with a pretty strong likelihood that the returns will be there. And if there is risk, it can be hedged. As long as that risk is not really far out in the tails (a black swan event) everything should be fine. And most recently, even in the event of what seemed a significant tail-like event, COVID-19, and the shutdown of much of the world’s economy, things returned pretty much to normal much faster than people expected. A blip and volatility returned to reasonably low levels, interest rates remained historically low, asset prices continued to rise, and liquidity was there. So, what’s the big deal?

To describe the concern, it is worth looking at two images. The first is margin debt, in billions of dollars, as compiled by FINRA, in the US capital markets over time. There are lots of other types of leverage going on besides margin debt: companies borrowing to buy back stock, using a debt instrument as collateral to raise more debt, or other forms of borrowing to finance investments. It is noteworthy, therefore, that, even on its own, the level of margin debt is by historical standards alarmingly high. However, the refrain goes that we are not in historical times. Interest rates around the world are likely to grow somewhat but remain low, because governments too are borrowing a lot of money. For example, the ratio of debt to GDP is well over 100% in many wealthy economies and surpassing the highest level of debt to GDP in the history of the statistic, just after the Second World War. Governments, therefore, need interest rates to remain low, something they can manage as long as circumstances are favorable to retaining low interest rates. Thus, an investor borrowing money to invest can presume that interest rates will remain low for a while and it seems the market is pretty impervious to shocks. The cauldron bubbles and no one seems to notice.

Sustained low interest rates have one particularly insidious impact, however. Because they are extremely low, returns on fixed income investments of most types are also very low, driving people to the capital markets. And because low returns are not what people desire — for example, endowments tend to depend upon consistent returns of 5+ percent — investors have to use leverage to get their desired returns. And, are they ever using leverage!

Mischievous behavior. If we return to Macbeth for a moment, it was not just the elements of the brew that mattered: it was an evil act by Macbeth that set the tragedy in motion. It is really unfair and actually wrong to describe the behavior we are about to discuss as evil, but it is certainly mischievous.

Millennials have come to think not very highly of the capital markets and the traditional players within them. Remember, they were the generation who grew up in the financial crisis, have assumed significant student debt, observed growing disparity in wealth and opportunity and live in a world in which it is virtually impossible to gain a foothold in real estate, the typical route to wealth creation in previous generations. As a result, they are moving quickly to invest through other vehicles such as Robinhood, and with some small sense that the markets are really just a form of poker. Their preferred vehicle for investment is called Robinhood. The primary trading strategy of many “Robinhood investors” is to use leverage to invest in trends based upon hearsay, news or short-lived events — Reddit-created flow. They are not investing based upon the sorts of fundamentals typical of the more traditional players. While some of their intentions can be lauded, including sticking it to those who have advantages the average investor does not, they act as a real uncertainty multiplier and in the end, someone will get really burned.

Consider an example. If a traditional player decides it is time to short a stock and announces they are worried, the market often treats that as a meaningful signal and trades the value of the stock down. Imagine, as has happened more than once recently, using Reddit as a coordinating mechanism and trading on margin through Robinhood, this new group of investors bids the stock up, causing the short seller to take a bath. Literally, the regular people operating as a gang beat the rich hedge fund. Classic Robinhood. This appears to be exactly what happened on the week of January 26. Unfortunately, the rich hedge fund and the Robinhood gang are not the only actors in the market. Two groups get hurt when the stock crashes to its real value after the horde is gone: the investor on the other side of the option who had to continually buy stock at higher and higher prices to manage their risk and the holder of the real stock when the song ends, typically some regular person. I will leave it to others to discuss the morality of this sort of activity, which is really a kind of pyramid scheme exercised through the stock market; my worry is volatility and the separation of stock price from inherent value. The more that happens, the greater the fragility when something really big occurs.

This is clearly not Robinhood’s intention, as they set up a very elegant platform with lots of good quality education for new investors, using insightful analogies to describe very complex ideas. Their clear goal is to help make investment easy and understandable for all investors. This blog post is speaking about what people have chosen to do with the platform, not its intended use.

The second set of slightly mischievous actors in this context are the authors of Modern Monetary Theory. The theory is a lot more complex and interesting than I am about to describe, but for the purposes of this blog post the explanation will do. The idea goes that governments with sovereign control over their currency do not really need to match expenditures to taxes; governments print money to pay their bills. Taxes serve the primary role of helping to manage inflation. Higher taxes, lower aggregate demand and thus lower inflation. A key tenet of Modern Monetary Theory is that government debt does not crowd out private players from the debt market if governments have sovereign control over their currency, because they can print the money essential to cover the costs of their programs — more currency, more money to lend.

Another reason for taxes is to keep people holding a country’s currency, a requirement if printing money to cover costs is to work. If you have to pay your taxes in dollars or pounds or yuan, then a large portion of your money needs to be held in dollars, pounds or yuan. Crypto-currency, or moving your money to other currencies, can only go so far. It is a pretty neat trick that shifts significant control over the state of the economy from the Fed to the legislature. The core argument, however, is that thinking that way permits a country to avoid significant negative cycles.

Consider how China was able to avoid the economic downturns so typical of the dramatic growth spurts the country experienced. They force the banks to lend money at very low rates during bad times and squeeze their lending capacity when things get too hot — this is not dissimilar to the idea of printing money when significant stimulus or equity reduction is needed and tightening taxes when inflation starts to occur as a result and is essentially putting your foot on or off of the accelerator as needed. It is not that you don’t ever use taxes to cover the costs of government programs, just that you do not have to.

So, what is the worry? In both cases there is a separation of decision-making from the constraints of the real world. Horde, momentum investing has nothing to do with the inherent value of the stock being invested in. Actually, it may be most effective when the stock is a dog. And, printing money with no debt obligation or tax to match the money separates government decision-making from the constraints of reality. In smart, professional hands, this is a useful tool in the larger bag of monetary tricks; in the hands of a populist, it’s a potentially dangerous thing. More to the point, both activities enhance the underlying risk arising from the massive level of leverage in the market.

There are two core problems with the amount of leverage in the market. There is less and less real value at the heart of the investments. If investment returns are increasingly based upon leverage and if we can just print money to cover government deficits; and since more and more of the productive firms in the world are held in private hands, there is really a very small thread of real things creating the massive implied value in the capital markets. A month or so ago, Apple traded at the full value of the FTSE 100, plus $500 billion; this represents pretty concentrated value. A stumble in a very few firms would be a very big stumble for the whole market. And, those firms have a few pretty serious clouds on the horizon. This creates significant fragility. Christopher Cole uses the analogy of a snake eating its tail to describe an incredibly shrinking market. It is not that the companies trading at such massive values are not remarkably successful. It is just that there are fewer and fewer real things underlying that value.

One way of looking at this is to consider the price-earnings ratio of a company trading in the market today. This simply represents the level of return an investor is receiving for the investment they are making. Robert Schiller argued that looking at such a ratio at a single point in time is problematic as lots of things determine earnings at any one point in time. He suggested using the inflation adjusted average earnings over a ten-year period. This graph represents the Schiller ratio for the S&P 500 plotted from 1875 until December 2020. Two peaks are notable in that area: 1929 was the moment before the market crash that set off the Great Depression and 2000 the time just before the dotcom bubble. The ratio today is currently 33.82, meaning that someone is willing to take a trailing 2.96% return on their money. Of course, the bet is that the firms making up the S&P 500 will continue to grow both in earnings and stock price. And, given that treasuries are trading near zero, 2.96% with a growth kicker might be a reasonable return. But it is worth noting that the historical Schiller PE ratio runs 13 to 15. We are trading at well more than double that level. And unfortunately, the cycle is reinforcing. With that sort of PE ratio, it is almost essential to borrow to get the desired level of return.

In normal circumstances, the sort of fragility implied by the leverage in the market would be fine. And we have created a host of tools to help navigate any perturbances before they get too large. The problem is that the pressing global trends I referenced earlier, i.e., disparity, climate, technology, polarization, distrust and demography, are on our doorstep and will make the navigation of moments of volatility more and more difficult. Climate change is destroying the value of corporate balance sheets at an accelerated rate and reducing the linkage between them and value creation. And it will make life harder and harder for a growing number of people exposed to its risks. Disparity and a declining sense of prosperity will put huge pressure on profits and thus forward-looking cash flows for many, many firms. And it is making life harder and harder for all of the people on the wrong end of the disparity spectrum. Technology is concentrating wealth and power with significant unintended side effects such as polarization, growing anxiety and depression in teenagers and job loss. And institutional distrust risks pitting citizen against citizen and erosion of the trust in the things that make capital markets and most other parts of life work.

Any one of these issues entails incredibly challenging policy issues and all four are a president’s, premier’s or prime minister’s nightmare. And yet, they are here and growing in importance every single day. It is a lot to ask to have our political and bureaucratic processes address simultaneously a fragile market and economy and a set of crises that are existential in kind and level. It is ironic that the mechanisms we need to use to address these crises will by definition increase the level of leverage in the system. Governments will need to borrow more than ever to deal with these issues and, therefore, keep rates low to avoid default. Which in turn will put pressure on investors to borrow more to meet their investment targets.

So, what does this mean? When there is less and less real value underpinning more and more trading activity or national expenditures and when there are a host of significant disruptive forces on the immediate horizon, bad things can happen. Something wicked this way comes. It can be diverted, but let’s be clear it is coming.