Today’s the day.
After months of preparing financial markets for this news, the Federal Reserve is widely expected to announce that it will finally begin shrinking its $4.5 trillion balance sheet.
I know, that probably sound reeeeally boring. A bunch of central bankers talking about their balance sheet.
But it’s phenomenally important. And I’ll explain why-
When the Global Financial Crisis started in 2008, the Federal Reserve (along with just about every central bank in the world) took the unprecedented step of conjuring trillions of dollars out of thin air.
In the Fed’s case, it was roughly $3.5 trillion, about 25% of the size of the entire US economy at the time.
That’s a lot of money.
And after nearly a decade of this free money policy, there is more money than has ever been in the financial system than ever before.
Economists measure money supply, something they call “M2”. And M2 is at record high levels– nearly $9 trillion higher then at the start of the crisis in 2008.
Now, one might expect that, over time, as the population grows and as the economy grows, the amount of money in the system would increase.
But even on a per-capita bases, and relative to the size of US GDP, there is more money in the system than there has ever been, at least in the history of modern central banking.
Again, that has consequences.
One of those consequences is that asset prices have exploded.
Stocks are at all-time highs. Bonds are at all-time highs. Many property markets are at all-time highs. Even the prices of alternative assets like private equity or artwork are at all-time highs.
But isn’t that a good thing?
Well, let’s look at stocks as an example.
As investors, we trade our hard-earned savings for shares of a [hopefully] successful, well-managed business.
That’s what stocks represent– ownership interests in a business. So investors are ultimately buying a share of a company’s net assets, profits, and free cash flow.
Here’s where it gets interesting.
Let’s look at Exxon Mobil as a great example.
In 2006, the last full year before the Federal Reserve started any monetary shenanigans, Exxon reported profit (net income) of nearly $40 billion, with Free Cash Flow (i.e. the money that’s available to pay out to shareholders) of $33.8 billion.
And at the time, Exxon’s debt was $6.6 billion.
Ten years later, Exxon’s annual report for the full year of 2016 showed revenue of $226 billion, net income of $7.8 billion, free cash flow of $5.9 billion, and an unbelievable debt level of $28.9 billion.
In other words, compared to its performance in 2006, Exxon in 2016 g 40% less revenue [due to the decline in oil prices].
Plus its profits and free cash flow collapsed by more than 80%. And debt skyrocketed by over 4x.
So what do you think happened to the stock price over this period?
It must have gone down, right? I mean… if investors are essentially paying for a share of the business’s profits, and those profits are 80% less, then the share of the business should also decline.
Except– that’s not what happened. Exxon’s stock price at the end of 2006 was around $75. By the end of 2016 it was around $90, 20% higher.
And it’s not just Exxon. This same curiosity fits to many of the largest companies in the world.
General Electric reported $13.9 billion in free cash flow in 2006. Last year’s free cash flow was NEGATIVE.
Plus, the company’s book value, i.e. its ‘net worth’, plummeted from $122 billion in 2006 to $77 billion in 2016.
So investors’ share of the free cash flow is essentially worthless, while their share of the net assets has fallen dramatically as well.
GE’s stock was actually down slightly in 2016 compared to 2006. But the minor stock decline is nothing compared to the train wreck in the company’s financial statements.
Between 2006 and 2016, McDonalds reported only a tiny increase in revenue. And in terms of bottom line, McDonalds 2016’s profit was about 30% higher than it was in 2006.
McDonalds’ debt soared from $8.4 billion to $25.8. And the company’s book value, according to its own financial statements, dropped from $15.8 billion to NEGATIVE $2 billion.
So over ten years, McDonald’s saw a 30% increase in profits, but took on so much debt that they wiped out shareholders’ book value.
And yet the company’s stock price has TRIPLED.
Coca Cola. IBM. Johnson & Johnson.
With company after company we can see businesses that are performing marginally better (or in some cases WORSE). They’ve taken on FAR more debt than ever before.
Yet their stock prices are insanely higher.
How is that even possible? Why are investors paying way more money for shares of a business that isn’t much better than before?
There’s really only one explanation: there’s way too much money in the system.
All that money the Fed created over the years has created an enormous bubble, pushing up the prices of assets to record highs even though their fundamental values haven’t really improved.
As the Wall Street Journal reported yesterday, “Financial assets across developed economies are more overvalued than at any other time in recent centuries”, i.e. at least since 1800.
Investors are paying far more than ever for their investments, but receiving only marginally more value in return. And amazingly enough they’re exciting about it.
This doesn’t makes sense. We don’t get excited to pay more and receive less at the grocery store.
But when underperforming assets fetch top dollar, people feel like they’re wealthier. Crazy.
Today the Fed formally announces that, after nearly a decade, they’re going to start vacuuming up a lot of that money they printed in 2008.
Bottom line: they’re going to start cutting the lights and turning off the music.
And given the enormous impact that this policy had on asset prices, it would be foolish to think its reversal will be consequence-free.