Thursday, 14 January 2016

The U.S. Stock Market – Catch me if you can

Originally published in the first issue of The Crank Report on 29 March 2015.

The Fed combined with the banks have during the last 19 years managed to create no fewer than three major stock market bubbles; 2000, 2007 and the current one. Why blame this on the Fed and the banking system? For one simple reason: if it wasn’t for the inflationary policies the overall stock market growth would have been restricted to the slow accumulation of savings, much of which would be channelled into real investments as opposed to stock market speculation. As Fritz Machlup, the economist, explained in 1940:

“A continual rise of stock prices cannot be explained by improved conditions of production or by increased voluntary savings, but only by an inflationary credit [money] supply” (The Stock Market, Credit, and Capital Formation).
One would expect stock market prices to reflect the future prospects of the listed companies, which again reflects the prospects of the economy. If the overall economy is doing poorly, it would be folly to expect companies to do well. Over the longer term, bar shorter term speculation, one would expect the stock market and the economy to track closely. Not so these days. Especially during the last year, most major U.S. stock market indices have completely dislocated from a range of economic aggregates (here’s a selection from December last year, all of which are even more extreme today). Every week the Economic Cycle Research Institute (ECRI) publishes its leading economic indicator for the U.S. economy. This indicator started showing y/y declines towards the end of last year and has been in decline on that basis ever since. The stock market on the other hand relentlessly pushes in the opposite direction. As a result, the ratio between the Wilshire 4500 Total Market Index and the ECRI leading indicator has hit record highs, dwarfing the previous record from October 2007 by a whopping 92.5%. 

Yes, there have been plenty of good reasons to invest in the stock market in recent years as artificially low treasury yields and interest on savings accounts have raced toward zero. But the stock market has gone too far in its quest for relative yields and has dug its own grave. At these levels, and with earnings actually expected to contract during the first half of this year and Fed interest rate hikes looming (personally, I expect the Fed to raise interest rates only incrementally, if at all), future equity returns will be dismal, at best. Also, stock market participants tend to ignore the quality of earnings during stock market peaks, which become only too apparent when big-bath accounting practices rule during stock market troughs. Like an elastic rubber band, the stock market can contract substantially quicker than it can expand. Only continued monetary expansion and low interest rates can maintain elevated stock prices at this stage. 

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