Rudi Fronk and Jim Anthony - Tue, Oct 24, 2017

Popping the Bubble

The stock and bond markets are in a massive bubble, that the bubble will pop, and gold and gold stocks will soar as they have in the aftermath of previous bubbles, say Rudi Fronk and Jim Anthony, cofounders of Seabridge Gold.

Some investors will get the timing right and short the market. We think there is the potential for a 60% decline in the broad stock the range of the declines we saw after the bubble collapses of 2002 and 2009. In a collapse, we expect gold stocks will once again rise considerably more than the stock market falls.

The stock bulls do not agree with us, of course. If they argue valuation at all, they contend that historic low interest rates justify historic high valuations. They do not, in our opinion. In the long run, equity valuations reflect the discounted value of future earnings. Although low interest rates suggest a low discount rate which boosts valuations, they also coincide with periods of poor growth in the economy and lower earnings, facts which the bulls ignore. Can you keep the discount rate advantage while projecting rates of growth and earnings that never revert to the mean? Having your cake and eating it too? We don't think so.

The stock market gains of 1996-1999 came when quarterly GDP growth averaged 4.6% and the gains of 2003-2007 came when quarterly GDP growth averaged 2.96%. In contrast, between 2010 and 2017, GDP growth has averaged only 2.1%. Central banks have replaced growth as the primary driver for stocks with their creation of $15 trillion in fresh liquidity since 2008. And now, they want to take it back.

Can the stock and bond bubbles outlive the reversal of the monetary stimulus that created them? We are about to find out.

The Federal Reserve and the European Central Bank have been two of the biggest liquidity creators and both have stated they intend to reverse their policies in the short term, transitioning from "Peak Quantitative Easing" to Quantitative Tightening. Francesco Filia of Fasanara Capital calculates that these policy changes will force a liquidity withdrawal of over $1 trillion in 2018 alone. Deutsche Bank has issued a similar estimate that central bank liquidity injections will collapse from this year's annual rate of $2 trillion to zero in 12 months.

This is not a distant future scenario. The Fed has already announced that its balance sheet "normalization" will begin next month and reach a level of $50 billion monthly in a year. Until this month, the Fed has been replacing maturing securities with new purchases, thus maintaining a significant bid in the market despite QE ending in late 2014.

Meanwhile, the ECB program begins to take on reality as soon as this Thursday, October 26, when the ECB is expected to announce a significant reduction in its asset buying. Bloomberg has reported that ECB policymakers see room for little more than €200 billion of purchases under the institution's bond-buying program in 2018, down sharply from €720 billion this year. The calculation is not difficult: the established limit to bond buying is €2.5 trillion under the current rules and purchases are expected to reach €2.28 trillion by the end of 2017. Germany is unlikely to allow for an increase to the limit.

The ECB bond-buying program has immensely distorted world debt markets. Since it began in March 2015 (and later expanded to include corporate debt in June 2016), the ECB has created enough money out of thin air to purchase €1.89 trillion in bonds with no consideration for price.

ECB Holdings of Euro-denominated bonds
ECB holdings of Euro-denominated bonds with monthly change
Click on image for larger size.

Meanwhile, over the entire QE period, net European bond new issuance amounted to only €394 of what the ECB bought. In fact, through much of 2016 there was hardly any net issuance at all according to Citi data.

Net issuance of Euro-denominated bondsNet issuance of Euro-denominated bonds
Click on image for larger size.

Any private investor who sold to the ECB and wanted to continue to hold debt would have to bid into a declining supply against a dominant price-insensitive buyer or move money out of Europe. How could this unprecedented crowding out of private investors not create a bubble? Here is the proof. Bond purchases by the ECB have forced the yield on EU junk bonds down to the same level as 10-year U.S. Treasuries.

10-yr Treasury yield vs Euro high yield index
10-yr Treasury yield vs Euro high yield index

Is it any surprise that EU investors have markedly increased their purchases of equities this year?

In short: the ECB purchased €1.5 trillion in bonds in excess of new issuance with no regard for prices, thereby virtually assuring booked profits for the sellers who then turned around and purchased overpriced domestic debt and equities and foreign investments.

And so, with the ECB set to taper its purchases, what will happen to yields? And where will the liquidity come from to hold bond and equity prices aloft? Are central banks about to pop the bubbles they have created?

This article is the collaboration of Rudi Fronk and Jim Anthony, cofounders of Seabridge Gold, and reflects the thinking that has helped make them successful gold investors. Rudi is the current Chairman and CEO of Seabridge and Jim is one of its largest shareholders. The authors are not registered or accredited as investment advisors. Information contained herein has been obtained from sources believed reliable but is not necessarily complete and accuracy is not guaranteed. Any securities mentioned on this site are not to be construed as investment or trading recommendations specifically for you. You must consult your own advisor for investment or trading advice. This article is for informational purposes only.

1) Statements and opinions expressed are the opinions of Rudi Fronk and Jim Anthony and not of Streetwise Reports or its officers. The authors are wholly responsible for the validity of the statements. Streetwise Reports was not involved in any aspect of the content preparation. The authors were not paid by Streetwise Reports LLC for this article. Streetwise Reports was not paid by the authors to publish or syndicate this article.
2) Seabridge Gold is a billboard sponsor of Streetwise Reports. Streetwise Reports does not accept stock in exchange for its services. Click below for important disclosures about sponsor fees. The information provided above is for informational purposes only and is not a recommendation to buy or sell any security.
3) This article does not constitute investment advice. Each reader is encouraged to consult with his or her individual financial professional and any action a reader takes as a result of information presented here is his or her own responsibility. By opening this page, each reader accepts and agrees to Streetwise Reports' terms of use and full legal disclaimer. This article is not a solicitation for investment. Streetwise Reports does not render general or specific investment advice and the information on Streetwise Reports should not be considered a recommendation to buy or sell any security. Streetwise Reports does not endorse or recommend the business, products, services or securities of any company mentioned on Streetwise Reports.

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