Hard money man Peter Schiff argues we're in a bubble. The stock market rally is manufactured by the Fed:
We have a completely phoney economy driven 100% by cheap money; the minute you take it away, the whole thing implodes. (emphasis added)
He's hardly alone, and, superficially, this is an attractive line of reasoning. Indeed, interest rates are at rock bottom, yields are at rock bottom, and the Fed is pumping unprecedented amounts of money into the banking system through its purchases of assets. In one thing Schiff is right -- very little of this money is trickling into the real economy.
However, once you correct the record S&P 500 for inflation, as Antonio Fatas and Ilian Mihov have done, it turns out we're not quite at record levels:
And they went on to gauge how expensive the market is with respect to earnings (via the price/earnings ratio). It turns out the market isn't terribly expensive -- it's even below where the market was priced in the previous decade:
So, it's no wonder a much more thoughtful observer like Seeking Alpha contributor James A. Kostohryz is much less definite compared to Schiff. Kostohryz argues that:
U.S. equity valuations are currently not symptomatic of a stock market bubble.
Indeed. But his article goes on to argue that a liquidity driven bubble is forming within 12 months:
...in the intermediate term time frame, which I define as 0-12 months. Specifically, in this essay, I will argue that many of the requirements for the formation of a liquidity-driven stock market bubble are currently falling into place.
He could very well be right, but it's sort of difficult to predict stock market performance 12 months out. So we have little basis to disprove his thesis, the main plank of which is excess "systemic liquidity" -- defined as a sum of eight sources of liquidity for the private sector.
His worry centers on the fact that this is shooting through the roof, while normally:
U.S. systemic liquidity as a percent of GDP behaved in a cyclical and mean-reverting fashion, just as standard economic theory would predict.
While financial innovation has put the need for systemic liquidity on a path of secular decline, Kostohryz shows that this trend was decisively broken during the 2000-03 recession when the Fed flooded the market with liquidity and never really took it away decisively.
We tried to recreate his data with the help of M2 and GDP indices from 2000, and arrive at a somewhat less dramatic picture:
Click to enlarge images.
While this liquidity certainly enabled bubbles to form (in housing and derivatives markets), it's far too strong to argue they caused it. What caused the housing bubble was lax regulation and oversight, which enabled banks to repackage dodgy mortgages and repackage these as triple-A marketable securities. That way, the normal role of banks as an assessor of credit risk was suspended, as they could shove the risks down the throat of unsuspecting others, stamp approved by the rating agencies. It then became a game of volume, or "fund-'em" as Countrywide's Angelo Mozilo's growth strategy was summed up -- whether the people who were funded by subprime mortgages had jobs or income didn't really matter all that much.
Of course, the risk didn't disappear, it became systemic instead. With investment banks having leveraged up to the hilt and the interdependence of the modern financial system, the crisis isn't terribly hard to understand. The Fed reacted to the crisis with new liquidity creation, and this is still ongoing.
To his credit, Kostohryz argues specifically:
I want to be clear: Elevated or 'excess' levels of systemic liquidity will not in and of itself cause stock prices to rise, nor much less cause a stock market bubble. Automatically making this association is a mistake that many people make... It is extremely important to understand that liquidity will not cause the prices of goods (investment and consumer) to rise if it is hoarded by households and businesses rather than spent.
We couldn't agree more. Liquidity is an enabling mechanism, not one that is causing bubbles. For that to happen, liquidity preference of households and businesses must fall in combination with continued high supply according to Kostohryz, who sees a danger of this happening in the near future when:
households and businesses gradually shed their 'bunker mentality,' they will no longer want to hold so much liquidity
Where we differ from Kostohryz is that we don't think this concept of systemic liquidity is the most useful for this context. Unlike Kostohryz, we think that the excess liquidity isn't held by households or businesses, but by banks.
This situation is the resultant of the very nature of the economic conditions, to which we now turn.
Corporate Profits and Wages
There is another side of the story. Shares are claims on corporate profits, and these are at record highs as a percentage of GDP:
So it's no wonder that the stock market is doing well, but there is much more to this. The flip side of this is that wages are not doing so well
And this, in fact, has been part of a trend that began in the 1970s:
As Mishel and Bivens showed:
the top 1 percent of households have secured a very large share of all of the gains in income-59.9 percent of the gains from 1979-2007, while the top 0.1 percent seized an even more disproportionate share: 36 percent. In comparison, only 8.6 percent of income gains have gone to the bottom 90 percent
A good chunk of this is simply a shift from labor to capital. So most households only shared a fraction of the economy wide productivity gains. In order to share in the increasing prosperity, many of these joined in by reducing savings and increase in borrowing. Without that the economy would have grown much slower.
However, this model of growth blew up in the financial crisis when households were hit by the double whammy of seeing their wealth reduced by 40%, to which they responded (or were forced by creditors) by slashing borrowing and spending in order to repair balance sheets. The reduced spending caused the economic downturn (a "balance sheet recession"), only partly arrested by fiscal and monetary policies.
Confronted with the deleveraging, a large output gap, high unemployment, and low inflation, the Fed let rates go to zero -- but this hasn't really had much of an effect. Despite record low interest rates, credit demand has only modestly revived. Hence the Fed sought other measures to revive the economy in the form of QE, the source of the liquidity boom Kostohryz fears will lead to new asset bubbles. And others, like Peter Schiff, are certain it already has. But the Fed can't push money into the economy, it can only push money into banks. But as long as credit demand doesn't revive decisively, this money just sits there in the form of excess reserves as we've seen in the figure above.
And when credit demand revives decisively, the economy will improve further and the Fed will start to take away the excess liquidity and interest rates will return to normal. But we know from previous balance sheet recessions that this is a slow and arduous process; repairing balance sheets simply takes time. In Japan it took two decades after the asset bubbles burst in the early 1990s.
Interest Rates and Margin Debt
Some have argued that interest rates are artificially low and hence stock prices artificially high. However, a balance sheet recession naturally produces low interest rates because private sector savings increase while investment decreases, creating a large private sector financial surplus. Interest rates have to be negative to equate the two under these circumstances. Therefore it's difficult to argue that the low bond yields are a bubble, and in relation to that stocks aren't overvalued either.
There is a little corner that is slightly less neat though, as margin debt is back to the levels of the mid-2000s:
Despite years of liquidity creation, nothing approaching anywhere near a stock market bubble exist, the market isn't expensive by any means as corporate profits and corporate balance sheets are at record highs. However, the flip side of that is that wage earners are not doing well (apart from the tiny top), and they are still smarting from the damage done to their balance sheets as a result of the housing crash.
Until that situation improves, excess liquidity isn't likely to flood the economy. While some of it spills into asset markets, these have a long way to go before we can argue they approach a bubble. So we would argue that investors should rejoice and join in. The biggest danger to the stock market comes from Europe or a U.S. slowdown or some unforeseen risk or disaster, not liquidity.