Bubble, Bubble, Toil and Trouble ...

Yeah, I know what you're thinking: "It's not even October yet, and the Curmudgeon is jumping on the bandwagon with Wal-Mart, Target, et al and posting about Halloween."  Fear not; that's not the subject of this post.

It's the Fed, which is scarier than Michael, Jason, and the Zombie Horde all rolled into one.

So Bernanke & Co. have launched QE3, buying $40B of mortgage-backed securities (MBS) a month, hoping to bring mortgage rates down (which they have - read on to learn how you can take advantage of this), in further hopes that this will spark a wave of refinancing (which it won't, as I'll explain), in even further hopes that that will spark a surge in consumer spending (which it won't, as I'll also explain).

First, let's review a little history.

In the summer of 1998, I predicted a recession, based on my read of various manufacturing indicators that I follow, which happen to be pretty reliable leading indicators of economic downturns.

Okay, I was wrong.

What I didn't count on was the Greenspan Fed intervening to ease monetary policy, at a time when policy was already easy. Let's review the history of the Fed funds target up to that point.

In July 1992, in the aftermath of a credit-driven recession, the Fed cut the funds target 50 basis points (bp; recall that a basis point is 1/100 of a percent) to a then-unprecedented 3.25%.  Very few economists predicted that move.  One notable one was Lacy Hunt, one of the most astute Fed-watchers of our time.

Another was yours truly.  I had just started as an analyst with my current employer in late May of that year, and I wrote my first newsletter article for the company in June, predicting that the Fed would cut the funds target 50 bp.  I was right (sometimes you're good, sometimes you're lucky, and sometimes you're good and lucky, as the saying goes).

That helped to kick-start the recovery, and after cutting the target another 25 bp in September of that year, they began raising it to cool things off.  From that point until February 1995, they raised it to 6.00%.

Then, they began to ease again, cutting the rate to 5.50% by March 1997.  They stood pat after that, as the economy perked along in "Goldilocks mode": not too hot, not too cold.

Then, in September 1998, the Greenspan Fed made history.  If you're a student of the Dismal Science, mark that date in your memory.  For it was the first time (that I'm aware of; admittedly I only began actively watching the Fed during the Volcker era, and you can be assured that Mr. Volcker would never have done this) that the Fed intervened to influence the markets.

In the Fall of 1998, a hedge fund (something that was largely unheard of theretofore) called Long-Term Capital Management (LTCM) began to experience large losses.  A number of large US and foreign banks had big positions in LTCM, which is a problem in and of itself that begged action by banking regulators, including the Fed.

By "action," I mean limiting banks' ability to invest heavily in hedge funds, and maybe keeping in place the Glass-Steagall Act of 1933, which separated banks' traditional banking and trading functions, but was (stupidly) repealed in 1999.

Anyway, the Greenspan Fed chose instead to cut the funds target from 5.50% (already having eased by 50 bp over the course of two years) to 4.75%, a drop of 75 bp, in just 49 days.  That was one of the most aggressive moves in Fed history, and it had nothing to do with the underlying economic fundamentals, it was merely meant to stimulate the financial markets to overcome the effects of the LTCM debacle.

Again, do not miss the significance of this event: the Fed, for the first time, intervened to manipulate the securities markets.  This is not the Fed's job (recall their dual mandate to control inflation and promote full employment), and for them to do so is, in my book, unconscionable.

But they didn't ask me.

What followed was the fueling of the dot-com bubble.  Chairman Greenspan failed to see this coming.  We should have been headed into a recession, by all indications from the data.  But the unsupported accommodation had an unintended consequence.

Money became uber-cheap (by the standards of the day, anyway), and liquidity flooded the market.  So venture capital firms were awash with cheap money, which they threw at dot-com start-ups that didn't have a viable business plan, but had cute sock puppets as mascots and bought expensive Super Bowl ads to show them off.  (Give me the Bud Light Lingerie Bowl any day, for a variety of reasons.)  Greenspan himself drank the "this time it's different" Kool-Aid, arguing that technological advances made productivity higher than in previous cycles, therefore higher stock market valuations were warranted.

To which I say balderdash, and repeat my oft-stated maxim that this time is never different; the fundamentals of supply and demand that drive macroeconomic trends have not changed since we were all wearing animal skins and trading rocks.

Of course, the Emperor's new clothes in which those companies were attired were soon revealed, and their sudden nakedness resulted in the bursting of the dot-com bubble.

Note this:  the dot-com bubble was fueled by a cut in the Fed funds target to 4.75% for a period of just seven months, after which the Fed began to tighten again.

So the dot-com bubble burst, resulting in a recession that ensued in 2000, and persisted for about a year, though the subsequent recovery was dubbed "the jobless recovery," and in reality it took until about 2003 for things to get perking again.

And perk they did.  By that time, the Fed had cut the funds target to 1.00% - a new ridiculous low - where the Greenspan Fed held it for a full year.  And that fueled another bubble, one that Greenspan again failed to anticipate - in fact, in hindsight, he was quoted as saying, rather bewilderedly, that he had no idea it was coming.

The asset bubble this time was housing.  Aided and abetted by excessively lax lending standards intended to increase homeownership -

An aside here.  There's a natural rate of homeownership in this country, and if you try to monkey with things to get it higher, you're taking risk.  Let's face it; some people should be renters, plain and simple.  Who are they?  People who can't afford to buy a house, who can't make mortgage payments.  But Barney Frank et al wanted to nudge homeownership rates higher.  In fact, in arguing that Fannie Mae and Freddie Mac should buy subprime mortgages, Barney actually said:

"When it comes to increasing homeownership, I'm willing to gamble with the taxpayers' money."

In my humble opinion, any lawmaker who openly expresses willingness to gamble with the taxpayers' money should be waterboarded, just for starters, then drawn, quartered, burned at the stake, tarred and feathered, and ... well, you get the idea.

Okay, back to our story.  Aided by the subprime lending craze, those record low rates, for a record long time, fueled the housing bubble, whose bursting had catastrophic consequences for the global economy, consequences from which we've yet to recover.

So the Bernanke Fed responded by cutting the funds rate to the unheard-of level of 25 bp - where they've held it for an unprecedented period of nearly four years - and pledged to hold it there for another three years.

(That pledge carries unintended consequences of its own, among them stifling the very housing recovery the Fed hopes to spark, by signaling to would-be buyers that mortgage rates are going to stay low for another few years, so they might as well wait until home prices bottom - which they may not yet have done, in spite of recent data, which is probably seasonal.  So they'll remain largely on the sidelines, stalling the housing recovery further.)

And at the same time, the Fed has grossed up its balance sheet three times, to about $3 trillion, and with the latest round of quantitative easing, they'll probably jack it up to $4 trillion, merrily printing money all the way.

So here's the point of tonight's post:

If holding the funds rate at 4.75% for about two quarters fueled the dot-com bubble, and holding it at 1.00% for four quarters fueled the even larger and more damaging housing bubble -

How can we not believe that by holding the funds target at 25 bp for seven years isn't inflating the Mother of All Bubbles?

I guarantee you, it is.

So where's the bubble this time?

In bonds, for one; there's undoubtedly a bubble in Treasuries, and by extension, in corporate bonds.  To wit: junk bond yields have fallen, in some cases, to below 5%.

That's nuts.

Also, I fear, in gold, though that depends on what happens to inflation, which could very well skyrocket as a result of the Fed's beyond-easy policy (especially if - er, when - Treasuries get downgraded again).  I'm not sure about the gold bubble theory, but it's what's kept me out of gold; every time I think, "Yeah, I'd better jump on the gold bandwagon," I get skittish.

And I'm quite sure there's a bubble in stocks.

How do I support this theory, when savants like Jim Cramer are telling us that every stock out there is a screaming buy?

For one, we're starting to hear the same nonsense that we heard during the dot-com bubble: "things are different this time," and historical P/E ratios no longer apply.

Poppycock.

For another, the market rallies every time the Fed launches a round of QE.  Graph the Dow Jones average since 2008, and draw vertical lines marking the start and finish of each of the three rounds of QE to date (QE1, QE2, and Operation Twist, which has been extended into the recently-launched QE3).  You'll see a clear pattern of the market rising, then trending sideways as traders (also known as stimulus addicts) anxiously await the next fix.  When the crack dealer (the Fed) supplies it, off the market goes again.

And the most recent run-up is counter to the underlying fundamentals; earnings have been on the decline, and the cuts in analysts' estimates of future earnings that usually come late in the fall have hit early this year.  That should spark a correction, but no; we're seeing quite the opposite, as the crack fuels another bout of buying euphoria.

The third reason for my assertion that stocks are a bubble is that the Fed itself has signaled this.

Bernanke freely admits that one of the Fed's strategic objectives in providing more stimulus is to push savers into riskier assets - i.e., stocks.  In other words, if you can't earn squat in a savings account, or buying relatively safe Treasuries, you'll buy stocks instead.

Even that's not working, as domestic equity mutual fund flows have been markedly negative for quite a few months now.  But the Fed is intentionally trying to drive investors into the stock market.

Why?

They hope that the resulting buying pressure will in and of itself spark a rally, defying the crappy fundamentals, and that people will see their swelling portfolio values and respond to the so-called wealth effect: if I feel rich on paper, I'll spend more money on crap I don't need.

Well, for one thing, again, the average Joe isn't drinking the Kool-Aid, and is pulling money out of equity mutual funds.

And for another, the "new normal" - which, as I've said before, is really just "normal"; my Dad's normal of living within your means, is keeping people from the consumerist behavior that dominating the American household economic psyche from about 1982 until 2008.

True, much of the "balance sheet repair" that has brought the average household's debt service burden down to about 10% has been forced, through defaults on credit cards, home equity lines, mortgages, etc.

But however the burden got that low, households are loathe to ratchet it back up again.  Memories are long when you've been burned.

More to the point, THE FED HAS NO BUSINESS TRYING TO PUSH PEOPLE INTO THE STOCK MARKET.  That's not their flipping job, and for them to do so is as unconscionable as Barney gambling with the taxpayers' money.  So in my view, Bernanke should join Barney in the waterboarding/drawing and quartering/tarring and feathering experience.

So, how do you profit from this mess?

Simple: refinance.

You can now get a 30-year, fixed rate mortgage for 3.25%.  We've never, I repeat NEVER, seen a rate that low.

If you're in the 30% tax bracket, that means that your effective rate is less than 2.3%.  So, somebody wants to sell you money at 2.3% interest, for 30 years?  Take it.

I know, you're thinking, "Gee, I'm nervous taking out a 30-year loan.  How about fifteen years?"

Here's an analogy: let's say you invented a car that would run maintenance-free for five years, then suddenly just quit running altogether.  How much would you charge for that car?  Your answer doesn't really matter, so let's say you would charge $20,000.

Now, you've also invented another car that will run equally maintenance-free for ten years, then quit running.  How much would you charge for that car?  Most of you will say $40,000, or something around there.

So the bank will make you a 15-year mortgage for about 2.625% today.  In other words, you'll have use of that money, with no additional cost, for 15 years, then you'll have paid off the loan and you won't have use of the money anymore.

Now, you'd expect the bank to charge twice as much for doubling the term of utility of their money.  But no, they're only going to charge you 23.8% more for doubling your utility term.  Why wouldn't you take that deal?

If you're worried about your home's value, don't.  For one thing, while house prices aren't going to rise at anywhere near the rate they did during the bubble (in part because we won't see another housing bubble of that magnitude in our lifetimes, and in part because of the demographics - boomers are going to be downsizing their housing, to the point where eventually their place of residence will be a six-foot-long box), they've pretty much bottomed out.  And besides, your house isn't an investment, it's a place to park your butt, so if you wind up "upside down" for a brief period of time, it's not the end of the world.

Okay, so you're going to take my advice and pull equity out of your home (don't worry about pulling too much; these days, the bank won't let you, as the days of the 100% loan-to-value mortgage are history), borrowing at an after-tax rate of about 2.3%.  So where will you invest it at a rate that will earn more than that, without taking risk?  After all, I've just told you that stocks, bonds and possibly gold are the next bubbles.

The answer?  You won't.  You'll suck it up and accept the fact that, for a brief period of time, you're going to pay 2.3% after taxes for your money, and earn a fraction of that in a nice, safe insured savings account at your local bank, thrift or credit union.

But rates won't stay this low forever.  In fact, if Washington doesn't get serious about deficit reduction (and if you believe they will anytime soon, I've got some ocean-front property in Iowa to sell you), Treasuries are going to get downgraded again.  And when they do, rates are going to go up, and you'll be able to park your excess money in an insured savings account earning much more than you're paying on your mortgage, especially after taxes.

Ah, but what if I'm wrong?  What if the Fed's stimulus works, and the economy takes off like a rocket?  Again, that will result in rates going up, as the Fed will have to abandon its dovish posture and start raising the funds target.

Either way, rates are going up.  And you can take advantage of it.

A quick note on taxes: I've said that your after-tax rate will be lower than the nominal rate you're paying on your mortgage.  That assumes that the tax deduction for mortgage interest remains in place.  But in a quest to raise revenue to fund the record deficit, lawmakers have been making noise about taking that deduction away.

Don't worry about it.  For one thing, that would be a complete reversal of the mindset of Barney Frank and his ilk, and while Barney has done us all a favor and gotten his worthless arse out of Congress, there are still plenty of his ilk in place.  And until we weed all of them out of Washington, which I'm afraid I'll never live to see, the mortgage interest deduction is sacrosanct, in spite of all the talk about removing it to raise revenue and prevent another housing bubble.

Make no mistake; I don't believe mortgage interest should be tax-deductible, for a variety of reasons.  However, as long as it is, I'm gonna claim it, and you should, too.  I do think they'll take away the deduction for second homes, and probably for second mortgages and home equity lines, at some point.  But again, the mortgage interest deduction on first mortgages on a primary resident is a sacred cow that isn't likely to be slaughtered.

How confident am I that this is a good move?  I paid off my mortgage a couple of years ago, leaving me happily debt-free, and I'm planning to take the plunge myself, pulling a chunk of equity out of my house (not too much) for a 30-year term, to avail myself of record low prices on money.  So I'm putting my own money where my mouth is.

The caveats:  don't pull too much equity out - make sure you still have at least 20% equity in your home, and if your mortgage is paid off, don't borrow even half the home's value - and make sure you can afford the monthly payments.

Then sit back and laugh as the next bubble(s) burst.  Hey, if you're lucky, the US banking system will collapse altogether, and you'll never have to pay the money back.  You can abscond with it and follow me into ex-pat retirement someplace cheap and beautiful, like Reunion Island or Mauritius.