The stock market has been climbing, although of late it has tended to levitate near old highs.
The economy is recovering to be sure, but it is not clear what will happen when all the stimulus checks get fully worked into the system, and further transfers to consumers cease.
Meanwhile, economists debate whether inflation, which is currently increasing rapidly, is transitory or entrenched.
Those who argue it is transitory, suggest it is temporary because of supply chain issues caused by the lockdown response to Covid-19, while others believe it is going to be entrenched because money and fiscal stimulus is excessive.
Oddly, both could be right at the same time.
The Biden Administration seems to have adopted a “no deficit is too big” attitude, engendered by their embrace of Modern Monetary Theory (see our review on this subject in the archives). That theory posits that inflation cannot get worse unless the economy outruns its productive capacity. Critics believe the theory is faulty and that too much money chasing too few goods, is a more accurate description. And clearly, the FED and Congress can create money faster than real goods can be created.
That debate aside, private watchdog indices such as the Everyday Price Index kept by the American Institute of Economic Research, show inflation at about 6.5%, up quite sharply from the 2% or so level typical of the last decade. With hardly any yield on money, real interest rates are deeply negative.
Government figures often do not catch inflation that well, especially the Consumer Price Index. There are multiple reasons for that. Among them is so-called “hedonic” accounting, which adjusts real prices for quality improvements. The CPI also does not handle shrinkflation well, which is the reduction of the size of a product while holding the price supposedly constant. And, the CPI is a basket of consumer items and does not catch the rise in the prices of assets, such as stocks, bonds, and housing.
The Federal Reserve announced that they are aware of the inflationary pressures, and suggested interest rate hikes could be forthcoming in 2023. While that seems a long way out, it appears that any hint that the FED would move away from its ultra-loose policies seems to induce anxiety in the markets or what some call a taper tantrum. As the FED tapers off its purchases of bonds and mortgages and allows interest rates to rise, markets retreat violently because it appears the easy money era is closing.
Last week, the stock market suffered its worst losses so far for the year. While the market reaction is mostly sensitive to talk, one can only think about what would happen if there was actual FED action.
Many asset classes are historically elevated in price due to years of zero or extremely low-interest rates.
Jason Goepfert, who publishes Sentiment Trader, also points out that households own stocks at a higher percentage than normal. With few alternatives given low-interest rates, there has been a kind of “everything bubble”, where stocks, bonds, art, real estate, commodities, and cryptocurrencies, have all risen substantially.
In the case of stocks, household holdings of equities relative to total financial assets, show the public holding the highest percentage in stocks since 1952.
Pension funds as well, have loaded up on stocks with equities near the all-time record as a percentage of pension assets.
Margin debt is at all-time highs, indicating both the public and institutions, are so confident, or so greedy, they will borrow money to get into stocks.
Other measures, such as the value of equities versus GDP are elevated as well. Stocks are currently over 181% of the total value of all output, a record high reading. This measure of equities versus GDP is reportedly Warren Buffet’s favorite indicator. If so, it might be making for some sleepless nights for the oracle of Omaha.
With stocks at lofty levels, and with the public and institutions fully committed to the market, the FED is walking a tightrope.
To continue to ease and stimulate in the face of resurgent inflation, would convey they either don’t care or don’t know what is going on in the economy.
On the other hand, if they cut back, they will catch multiple markets at record highs, with considerable evidence that stocks are fully owned, and perhaps dangerously leveraged with record debt. It seems difficult for them to do anything, that potentially could not upset the economy.
This is an odd situation. The FED is supposed to moderate excessive swings in the economy, but they seem positioned now to create turmoil no matter what they do. Critics say this is because the FED has maintained emergency policies for far too long.
And Congress, which is supposed to deficit spend during economic downturns, finds itself running huge deficits in times of prosperity. The FED seems to accommodate the spenthrift politicians at every turn. As one observer put it, the FED is supposed to have the nerve to take away the punchbowl. Now, they are the punchbowl.
While not predicting immediate difficulty, Goepfert notes that when stocks get heavily owned as they are today, “there has been a clear negative correlation, meaning that as households allocate more of their assets to stocks, future returns on those stocks decrease.”
Historically, excessive stock market gains in the short term tend to reduce performance in the longer term. This is because over time markets tend to regress to the mean. And as a corollary, when households and institutions are already loaded to the gills with equities, they don’t have the ability to take much more on. Once stocks are fully owned, that demand is already reflected in their prices.
Neland D. Nobel is a retired portfolio manager and Certified Financial Planner.