The stock market is overvalued. The bond market is overvalued too. All the indicators are screaming overvalued.
The Buffet Indicator is yelling overvalued, overvalued.
Stocks are way beyond the overvaluation levels witnessed during the 2000 dot-com bubble.
Debt is at an all-time high.
It is understandable that all these metrics have gone up due to the market interventions by governments and central banks to stem the effects of the pandemic.
People are worried about these valuation levels and debt metrics. Everyone can see that markets are due for a correction and that the growth in debt needs to slow down.
Fundamentalists are calling for central banks and governments to slow down on the money printing and stimulus packages as they drive financial markets deeper into overvalued territory.
Whilst that is theoretically the right call, the right thing to do, many do not fully comprehend what that really means in terms of the first-order and second-order effects.
When I wrote about the need for a Debt Jubilee, I asked the simple question. Whom does the world owe this much debt?
We owe it to each other. Every single dollar of debt is an asset in someone’s books. The stock markets that are overvalued are regarded as assets in someone’s balance sheet.
Financial markets are increasingly becoming playgrounds for retail investors. Retail fingers will get burned if and when a correction happens. Hedge funds, family offices, and other investment vehicles that rich people use are residents in these markets as well. If they get burned, they won’t lose sleep as much as the little retail guy.
The biggest investors in financial markets are insurance companies and pension funds. They invest mostly via fund managers.
A stock market correction means fund managers lose money, the money that belongs to pension funds and insurance companies.
Regarding pension funds, I previously wrote on how we are globally sitting on a time bomb due to the size of Unfunded Pension Liabilities.
If stock and bond markets crash, they will take down everyone who has invested in those markets, and pension funds will not be spared. Insurance companies won’t be spared as well.
When we scream, “it’s overvalued, it’s a bubble, the bubble has to pop” we have to be careful what we wish for. Yes, it’s a bubble, we all can see it. But do we really want the central banks to stop supporting the markets? Are we ready for the second-order effects?
Make no mistake about it, when these bubbles pop, they will take down everything connected to them as they go down.
Insurance and pension systems are basically resources we have stored up for the future. Since every debt is an asset in someone’s books, and the world owes $300 trillion, and pension funds and insurance companies are the biggest holders of debt, the high debt is essentially what we owe to our future selves. Crashing the markets (popping the bubbles) is effectively netting-off the debts against the assets. It’s a book entry of realizing that we effectively do not have any savings, it’s all phantom numbers.
However, the psychological effects and third-order effects of the impairment event (market crash) cannot be underestimated. If we crash the pension system and the insurance system, how else are we going to mobilize savings en masse? How are we going to rebuild the lost trust in those systems?
That stock and bond markets are joined on the hip with insurance and pension systems is obvious. What’s not obvious is the connection with banks and real estate.
Banks are the originator for most of the borrowing and lending that occurs in the economy. This includes stock market margin facilities. This borrowing and lending are secured using the assets, at times liquid assets, which are stocks and bonds.
If stocks and bonds are falling, the value of the security is falling. Margin calls all over. The value of the security could quickly go below the value of the loan in a panic selloff. It’s a liquidity event. Even if the bank resorts to grabbing the security, the loss upon default is high given that the security itself is falling. Banks will be in hot soup. A banking crisis could easily and quickly ensue.
During a liquidity scramble, investors try to sell anything that they can sell in order to get some liquidity to cover the due debts. This is the transmission mechanism to the real estate. A fire sale of the house to cover some margin calls. With an avalanche of liquidity-seeking sellers dominating the housing market, it becomes a seller’s market and prices fall.
Thus, you cannot let the stock and bond markets go down, at this point in time, without taking down everything connected to those markets which are:
- Your Pension System
- Your Insurance System
- Your Banking System
- Your Real Estate Sector
In the same vein, you cannot let interest rates go up, you cannot stop quantitative easing and you cannot withdraw any liquidity without taking down a couple of financial systems.
Food for thought.