Thursday, 19 October 2017

The Money Illusion - Debt-Inflated Net Worth And The Stock Market

Households' net worth relative to disposable income in the U.S. has now surpassed the previous peaks from 2000 and 2007. It cannot end well this time either.

Why? Because increased net worth is primarily driven by debt inflation (money supply expansion). House prices is a case in point when during a boom prices appreciate at a faster pace than the debt growth. Hence, when the income partly meant to service that debt grows at a slower pace (and the ratio in the chart above rises), problems must inevitably surface at some stage. Asset prices then fall, including a range of financial asset prices, while the nominal value of the debt remains unchanged. This is a nightmare for households and especially for bank balance sheets which may result in a full-fledged banking crisis. A stock market crash may follow or even precede the banking crisis.

No matter how and in what order events unfold, adding a broad U.S. stock market index to the above chart clearly indicates the risk involved when the households' net worth to income ratio reaches historic highs.

For more on this subject and the fundamental theory underpinning it, see this article:

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