A Permanently High Plateau For Stocks?

    Since 1996 the central banks have been increasing the money supply and the amount of debt to GDP by a factor of two. In the last century debt/GDP ratio was around 125% to 75% except for WWII.  Now it is double the 20th century average at 345%. This is why stocks are so seriously overpriced even without the mania symptoms of 1999 which Jeremy Grantham says are proof that it is not a bubble. I disagree with Grantham. A bubble can still happen without an explicit mania because the circumstances of the low growth very weak recovery have acted to camouflage the enthusiasm for stocks that are evidenced by those who enjoy participating in momentum style short term trading.
Central banks have accidentally created this bubble, then revived it after the tech crash of 2001 during the low rate era of 2002-2003, let it die out in 2008-09 and then revived it with QE1, QE2, and QE3 along with the “Operation Twist”.   If the increase in the money supply had been in the form of paper currency that was lent out instead of the book entry fractional reserve banking system then this money (assuming it wasn’t destroyed by fire, etc.) would continue in existence in perpetuity; by contrast the book entry money supply created by bank lending is destroyed when a borrower repays his loan. In recessions many people repay loans if they decide there are no projects worth investing in and that the cost to use borrowed money to hold low risk assets like short term bonds outweighs the benefits. If too many borrowers decide there is nothing to invest in and they react by paying down debt then they will have less liquidity with which to buy stocks. The growth of liquidity is the key to understanding stocks’ non-fundamental reasons for rising to extreme heights in the last 20 years. If this source of liquidity from borrowed money were to reverse, as it does, during recessions, then stocks would lose support and would go down as an imbalance of sellers seeking cash and not finding enough buyers, would make prices go down.
When recessions occur the Federal Reserve will try to cut rates to encourage borrowing and encourage an increase in the money supply. This would contribute to making stocks continue to go up after a crash. However now that global central banks have reached the zero bound limit they can’t cut rates low enough to truly motivate new borrowing. Also, rate cutting to stimulate only works in mild recessions. In a deep recession potential borrowers may fear inability to repay a loan and thus they will forgo a loan despite enticements of huge rate cuts. Thus the Federal Reserve’s power has already been broken and they have already begun withdrawing their position to a more defensible territory of more traditional levels of real rates. The next moderately or significantly serious recession the stock market won’t be able to get help from the Fed and thus there will be no dramatic growth of the money supply and thus no help reflating stock prices after a crash.
One possible way to do the equivalent of deep rate cuts, when stuck near the zero bound limit, is to have targeted beneficiaries of rate cuts who would get a gift subsidy of printed money (for use in paying traditional rates) in return for promising to expand plant, equipment, and hiring, or home buying, etc. Then the rate for these borrowers would be negative but the lenders would still be able to function with reasonable real rates.  The Fed’s biggest problem with the zero bound limit is that insurance companies and banks can’t survive and thus such a program would destroy the economy. If the Fed merely extended the gift of ultra-low rates to privileged borrowers it might be that their increased money supply would not flow into stocks and then stocks would not rise above post-crash lows. Then finally the 20 year reign of central bank stock market bubble making would come to an end.
Other ways to get past the zero bound limit would be for the Fed to donate funds to financial institutions and retirees living on bonds, giving them a windfall to offset the problems caused by negative rates. That would be very socially divisive to give huge subsidies to rich banks and insurance companies as well as to affluent retirees and thus unlikely to happen. Usually gimmicky things don’t work and will trigger anger by those who don’t get benefits.
A key error most people make is to assume that because society is so very financialized and in need of permanently high stock prices to prop up pensions, endowments, retirees, etc., that people leap to the conclusion the Fed simply must rescue stocks from a crash. If people complained enough in a crash perhaps the Fed would resort to buying stocks with printed money. If retirees and pension managers complained they can’t survive because of a 50% stock market crash then society might pressure Congress to set up a rescue program where the Fed buys stocks at inflated high water mark prices. But there is no guarantee this will occur or that it will occur with today’s low capital gains tax rates. Instead in a severe crisis perhaps leftists will be in control of Congress and they will only authorize an engineering of a stock bailout in return for exorbitant capital gains taxes. If a rescue like this were to occur perhaps there would a limit on the bailout, for example, the Fed setting a goal to only help stocks to recover to the midpoint between the high and the low, etc.
Investors need to understand that central bankers’ actions have hijacked or swamped the forces of traditional fundamental analysis, resulting in cynical, short sighted momentum traders being in control of stock prices. Once the Fed decides they have distorted the economy too much and have done so without achieving their goals then they will (they already have) back away from bubble making and then stock investors will be forced to rely on fundamentals for valuations. Then PE10 will start to work, and a lot of early retirees will start to work in the sense that since their stocks failed to recover from a 50% crash they have to go back to work.  Investors need independent financial advice about the risk of being fooled by central bank bubbles.

2017-04-11T13:20:26-07:00 April 11th, 2017|mayflowercapital blog|Comments Off on A Permanently High Plateau For Stocks?

About the Author:


Donald Martin has a B.A. in Accounting and M.B.A. Finance, and has passed the rigorous CFP® exam and met the experience requirements needed to become a CERTIFIED FINANCIAL PLANNER™ professional. He has been employed in the financial services industries for 30 years and has been investing for his own account for 38 years.
Donald Martin’s 19 year career in lending prepared him for fixed income analysis, Securities analysis, and macro-economic analysis used for investing. Donald Martin founded Mayflower Capital in 1993 to provide independent financial advice and implementation of advice about loans. In 2005 Donald Martin changed the company’s mission to providing independent financial advice about investments and financial planning and stopped providing loan services.
Donald Martin has a B.A. in Accounting and M.B.A. Finance, and has passed the rigorous CFP® exam and met the experience requirements needed to become a CERTIFIED FINANCIAL
PLANNER™ professional. He has been employed in the financial services industries for 30 years and has been investing for his own account for 38 years.