Here at Money Morning New Zealand, we’re used to being the lone voice in the desert predicting rain.

In fact, when the financial world is feeling most confident, we tend to shout ‘Danger!’ the loudest…

But, recently it seems that even the mainstream is shifting uncomfortably in its seat.

‘Will the global economy sink into recession in 2019?’

—NZ Herald

‘Why the next recession will be bigger than the Global Financial Crisis’

—Stuff

‘Wall Street stalls as economists see US growth peaking’

—National Business Review

Maybe it’s because of Trump…

Or China…

Or Trump and China…

But like that one uncle whose hip starts to hurt when it’s about to rain, folks are starting to feel that something ain’t right.

We believe that uneasiness is well-founded…and not just because of Trump and China. Here’s why:

 

Easy money

If you haven’t heard of ‘easy money’ before, it means that central banks have lowered the interest rate, making borrowing a whole lot cheaper.

When that happens, businesses tend to flock to their loan officers…and pile on the debt.

In a recession, this can be a good thing. Businesses can use that cheap capital to rebuild and get back on track.

But when easy money is offered in a period of economic growth, it’s dangerous.

We liken it to steroids. When you’re sick or have a deficiency, steroids are healthy and helpful. They can get you back to 100%.

If you’re already at 100% and take steroids, you begin tampering with the chemical balances in your body. You might get big and strong…but it’s artificial…and it won’t last.

Here’s the thing: when the Great Financial Crisis hit back in 2008, central banks around the world used policies of easy money to get the machine started again.

But after things started to bounce back, central banks didn’t stop. They continued to dish out the steroids like a drug dealer at a bodybuilding contest.

It’s meant that economies look big and strong…but, really, they’re just being puffed up by easy money.

And when that easy money is taken away (as it must), you’ll see the business world for what it really is — weak and frail.

Specifically, you’re going to see heaps of businesses that have thrived under these conditions start to wither away once debt becomes more expensive. And with the US Federal Reserve starting on a trajectory of raising interest rates, the underlying sickness is being exposed.

In fact, Bloomberg investigated and found that US non-financial debt is at an all-time high as a share of the economy. And much of this debt is junk…it’s just been repackaged into securities called ‘collateralised loan obligations’…which use a bit of financial gymnastics to turn crap-rated loans into AAA-rated bonds.

Sound familiar? If not, check out a movie called The Big Short. You’ll quickly see how CLO-type vessels sparked what we now call the Great Financial Crisis.

This is perhaps THE greatest threat to the world economy today. [openx slug=inpost]

 

Stock buybacks

Perhaps no one has benefited more from this era of easy money as America’s leading companies.

American firms have exploded under the availability of cheap debt…and at the same time, used the opportunity to engage in a full-out campaign to inflate stock prices using what’s called ‘stock buybacks’.

In other words, they borrow money to buy their own shares on the stock market.

Now, people are divided on whether buybacks are good or bad…but let me clear it up — it’s bad.

Here’s why. When companies use cash to buy back stocks…instead of using it to build up their businesses…it does one thing — balloon stock prices. And who owns a good chunk of these stocks? The executives…

The whole thing lines their pockets…takes a toll on the business’ development…while artificially pushing up the stock value.

Sounds like it should be illegal, right? Well, American authorities have made a special exemption in the market-manipulation rules to make buyback campaigns legal. Something about it being a strategic move…

For now, it doesn’t technically hurt anybody. We’ve seen a rising tide across the whole market. But when the house of cards collapses, shareholders are going to be severely punished.

And that house of cards starts to collapse when companies can’t borrow money to do their usual buybacks…and that’s what we’re seeing today.

 

Astronomical price-to-earnings ratios

Together, stock buybacks and easy money have set the stage for a bubble in the stock market. Both activities artificially make stocks look attractive for investors…

But earnings — the actual profit the company pulls in — hasn’t been growing at nearly the same rate.

That means we’ve seen a ridiculous trend of acceptance for super-high P/E ratios.

If you’re not familiar with P/E ratios, it’s a quick-and-dirty tool that investors use to evaluate the value of a stock. Generally, you’d expect to see the ratio between stock price and earnings to be somewhere between 5–20, depending on the industry…

If you see P/E ratios creeping above that range, it means investors are getting a little riskier and buying stocks at high prices, even if the company’s earnings aren’t growing — a red flag for us observers.

Let’s use the so-called FAANG stocks as examples: Facebook, Apple, Amazon, Netflix, and Google.

  • Facebook’s P/E: 20
  • Amazon’s P/E: 85
  • Apple’s P/E: 15
  • Netflix’s P/E: 94
  • Google’s P/E: 39

As you can see, there are a couple normal ratios…and then there are some that have shot straight out to la-la land.

It’s evidence of the growing willingness for investors to gamble on stocks with disconnected fundamentals.

Think dot-com bubble, but worse.

 

Sparking the sell-off

Together, the easy money era, stock buybacks and off-the-charts P/E ratios have created a nasty situation in the global market…and for the first time in a decade, people are starting to notice.

Like the sirens of Greek mythology, the puffed-up market lures in investors with enchanting songs of returns and fortunes…just to have them crash into the rocks.

The recent sell-off might be an early crunch as our hull hits the rocky ground of reality.

If not, maybe it ought to be…

Best,

Taylor Kee
Editor, Money Morning New Zealand