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In the prior essay in this series, I demonstrated that US systemic liquidity is at frighteningly high levels and that this could become a key factor that enables the formation of a stock market bubble, as risk aversion and liquidity preference declines. In this regard, it will be helpful to review the following chart of systemic liquidity available in the US economy (the details of this metric are fully explained in the aforementioned essay):

(click to enlarge)US Systemic Liquidity

In the present essay I will show why the extraordinary levels of excess liquidity available in the US economy, under current conditions of declining liquidity preferences, could be extremely dangerous to the long-term health of the US economy.

The thesis of this article is that given the current course of events, broad stock market indices such as the S&P 500, Dow Jones Industrials and Nasdaq could very well rise by 30% or more within the next 6-12 months. However, such spectacular gains, far from acting as a harbinger of economic health (as most assume), would only be symptomatic of highly damaging relative price distortions that are ravaging the US economy from within.

Some investors may be able to profit from such circumstances on an intermediate term time frame (0-12 months) even if the long-term implications are less sanguine.

Can Excess Liquidity Hurt When Unemployment Is So High?

Some analysts, including many that are sympathetic to the so-called Modern Monetary Theory, argue that due to high unemployment, extraordinarily high levels of liquidity do not represent a danger to the US economy. Their line of argumentation, which tends to be fixated on wages and aggregate measures of consumer price inflation, misses the point entirely.

First, while there might be excess capacity in some economic sectors caused by an oversupply of available labor, some sectors are already experiencing tight supply fundamentals (shortages of skilled labor and other non-labor inputs). Due to varied supply/demand fundamentals in different economic sectors, excess liquidity can enable price inflation in some sectors (with tight supply fundamentals) while other sectors with ample supply fundamentals exhibit stable or even declining prices. The result is dislocations in relative prices.

It is important to note that distortions in relative prices are actually more dangerous to the economy than across-the-board price inflation. This is because relative price distortions render certain economic activities uneconomic due to a contraction in profit margins. Production shut-ins by the affected sectors cause the incomes of laid off workers to vanish and supplier incomes to be reduced, and this in turn causes ripple effects in other sectors of the economy. Indeed, relative price distortions have historically constituted the single most important cause and/or trigger of economic recessions and depressions.

Second, even if it were true that excess systemic liquidity failed to cause or trigger general price inflation or price distortions in wholesale or retail markets for goods and services, it does not follow that price inflation will not occur in the market for investment assets. Indeed, as the US learned twice in the span of one decade (2000-2007), asset price inflation - even in the context of relatively tame consumer price inflation -- can be incredibly damaging to the overall economy. The mispricing of relative risks and rewards causes capital flow to be misallocated, resulting in destruction of wealth.

No further evidence is needed than what is occurring presently to prove that consumer price inflation asset price can and do often run on separate tracks. At a time when the rates of both producer and consumer price inflation are actually decelerating, asset price inflation in the form of stock prices and housing prices are currently advancing at a frenetic pace.

Thus, while the current apologists for easy money might be more or less correct with regards to the prospects for consumer price inflation under conditions of high unemployment, they are clearly wrong about the potential deleterious effects of excess liquidity to the economy via relative price distortions and asset price inflation.

Excess Liquidity and Relative Price Distortions

There is a widespread idea that when the quantity of money or liquidity grows at a faster rate than the quantity of goods or services available in the economy that general price inflation will necessarily result. This is a myth. Under conditions of rising liquidity, prices will only rise if the marginal preference for liquidity declines relative to the marginal preferences for other goods (including investment assets such as stocks).

Even if the marginal preference for liquidity declines relative to the marginal preference for other goods, it does not follow that all prices will rise. The question is: What prices; what goods? The marginal preference for liquidity relative to some goods may fall, while it remains the same or rises with respect to other goods.

The divergence between the prices of consumer and investment goods that is currently being experienced in the US economy is merely one symptom of a more general tendency for relative prices to diverge under conditions of excess liquidity coupled with declining liquidity preferences.

How is it that the prices of consumer and investment goods diverge? The most general answer is that investment goods and consumer goods are simply different kinds of goods with very different sources and structures of supply and demand. Many explanations could be proffered, but a few examples should suffice.

For example, consider how liquidity-enabled demand emanating from the household sector can affect the prices of different types of consumer and/or investment goods. As risk aversion and associated liquidity preference declines, relatively wealthy households that have been fortunate enough to be able to hoard liquidity will tend to devote a far greater portion of their accumulated liquidity towards investment goods than consumer goods, fueling inflation in the former and leaving the latter unaffected. Furthermore, in terms of the differential impact on prices within the investment goods sector, as relatively cash-rich households assess the investment landscape, the exceedingly low real rates of return offered by fixed income instruments, means that they will increasingly tend to turn (at the margin) to equity investments such as stocks and real estate. This will tend to push up the prices of stocks relative to bonds.

In the corporate sphere, consider how companies are currently managing their excess liquidity. First, data reveal that companies are already investing at a fairly rapid pace. Yet relatively little of this investment can be expected to drive increases in employment and wages since the bulk of investment has been focused on the purchase of labor-saving investment goods such as robots and other automated devices. Second, companies have been making it abundantly clear that as their liquidity preference wanes, marginal liquidity is more likely to be devoted towards stock buybacks and dividend increases rather than expanding labor intensive expansion of production at a high rate.

One reason that companies are relatively unenthusiastic about expanding capacity for production of consumer goods and services (which represent 70% of the US economy) is that US consumers are relatively impaired by debt and because given low savings rates, it will be difficult for consumers to grow their spending beyond the real growth in income. In this regard, overall real income growth is expected to rise only modestly due to stagnant real wages. Therefore, given relatively unexciting final demand prospects, the liquidity-driven expenditure of corporations is likely to fuel asset price inflation via stock buybacks and M&A activity while leaving wages and the prices of other wholesale inputs - and ultimately retail prices -- relatively unaffected.

In sum, analysts that claim that high levels of systemic liquidity are not harmful as long as unemployment is high are missing the point entirely. High systemic liquidity in the context of declining liquidity preferences can enable large price distortions between and amongst consumer, producer and investment goods. And these sorts of relative price distortions can be very harmful to the economy.

I will put things in more colloquial terms: When there is too much systemic liquidity under conditions of declining liquidity preference, households and businesses start doing stupid things with their money. People start look at their checking and savings account and "all of the sudden realize" that they do not need or want so much cash. They therefore start becoming more careless with their spending and start buying consumer goods that they don't need and "investing" in stuff that they have no business getting involved with. All of this leads to relative price distortions, capital misallocation and, ultimately, wealth destruction as the value destroying expenditure comes back home to roost.

Prospects For Stocks

We are currently experiencing an early stage of divergences of relative prices amongst and within the prices of consumer and investment goods.

Excess liquidity is enabling demand for stocks from two sources, as liquidity preference wanes. First, companies such as Apple (NASDAQ:AAPL) and JPMorgan Chase (NYSE:JPM) are starting to disgorge their accumulated cash hoards in the form of accelerated stock buybacks as well as dividend distributions. Second, mutual fund inflows and other data seem to indicate that for the first time in many years, the appetite of households for stocks and other relatively risky investments is starting to awaken. Indeed, recent data suggest that even global central banks, concerned by the meager and even negative real returns that they are earning on their foreign reserve assets, have started to get in on the stock market action by being large net purchasers of equities in the past year.

It is fairly clear that this mean-reverting process of normalization of risk aversion and liquidity preference is still in a quite early stage, particularly amongst households. Equity exposure as a percent of total portfolio assets is very low amongst both individuals and pension funds. Furthermore, various intermediate term indicators of risk-aversion such as the relative P/E ratios of value versus growth stocks show that investors are, on the whole, still in a cautious mood by historical standards.

What all of this means is that to the extent that risk aversion continues to decline in mean-reverting fashion and liquidity preference continues to collapse, the prospect of a runaway stock market bubble becomes very real.

In the very short term, various indicators of macro and micro-level fundamental deterioration have been holding back the collapse in liquidity preference and otherwise tripping up what probably would have been an even more dramatic market advance to this point. To the extent that this deterioration in short-term fundamentals proves to be temporary - as the consensus expects - it is likely that the stock market rally will continue at a frenetic pace in the intermediate term. Indeed, if the economy were to show signs of acceleration in the second half of 2013 as the consensus currently expects, the current advance could well morph into a full-fledged bubble.

In my view, there are essentially only two things that can prevent a major stock market bubble from materializing in the next 6-12 months. The first would be decisive action by the Fed to reign in systemic liquidity from its current exorbitant levels. Unfortunately, this is highly unlikely to occur. The Fed has already said that it is unlikely to engage in asset sales (reverse QE), which would be the most direct way to withdraw liquidity from the system. As a result, the Fed's main tool will be the manipulation of the Fed Funds rate as well as the rate of interest paid on excess bank reserves. Unfortunately, these mechanisms are unlikely to achieve anything more than a halt in the rate of systemic liquidity growth; they will not actually reduce systemic liquidity as a percent of GDP.

The second thing that could prevent a major stock market bubble from forming would be a major exogenous shock of sufficient magnitude to reverse the ongoing contraction in liquidity preferences. Examples of such shocks would be acceleration of the financial crisis in Europe, political instability in oil-rich MENA countries or conflict on the Korean Peninsula.

In the absence of either of these two types of scenarios that could reverse the decline in risk aversion, economic theory would predict that as liquidity preference declines and excess liquidity remains elevated, transactional velocity will increase causing a bidding up of the prices of consumer and/or investment goods. It is my expectation that this inflationary process will mainly manifest itself through increased transactional velocity in the stock market (increased volume) and a concomitant bidding up of stock prices. Real estate prices are also likely to be boosted in this scenario.

It is important to recall that the overall level of systemic liquidity is never altered by the mere purchase and sale of stocks no matter how high stock prices rise; cash merely moves from one hand to another while the overall quantity of liquidity remains unchanged. Therefore, once a bubble dynamic gets going, driven by increased transactional velocity, it is very difficult to stop it unless excess liquidity is actually removed from the system. As I alluded to earlier, the Fed is unlikely to do this in an early stage since any significant withdrawal of liquidity could jeopardize two of the Fed's primary mandates, which are full employment and the health of a still-fragile financial system. As long as consumer prices remain stable, the Fed is virtually obligated by law to do everything in its power to lower unemployment - even if it is at the expense of creating an asset bubble. Please recall that asset price stability is not a Fed mandate.

Conclusion

I want to reiterate something I said at the outset of this series: Stock valuations are currently not symptomatic of a stock market bubble. This essay is about the potential for a stock market bubble to form in the intermediate term (0-12 months).

Until now, despite unprecedented levels of systemic liquidity, stock prices have not reached bubble-like heights due to the extremely high degree of risk-aversion that was triggered by a succession of financial and sovereign debt crises in the US and Europe between 2007 and 2012. However, as "crisis fatigue" sets in, and US investors in particular become increasingly comfortable with the prospects for the US economy (even if projections be only modest) risk aversion will tend to decline and liquidity preference will collapse. In this scenario, the unprecedented amounts of liquidity on household and business balance sheets will be increasingly deployed towards discretionary consumption and/or increasingly risky investments. In particular, given the low real yields on fixed income instruments, I would expect a very large portion of the excess systemic liquidity to be deployed to equity investments and stock market investments in particular, via ETFs such as S&P 500 SPDR (NYSEARCA:SPY), SPDR Dow Jones Industrial Average (NYSEARCA:DIA) and PowerShares QQQ (NASDAQ:QQQ).

In the short term, deteriorating fundamentals in the second quarter of 2013 could trip up the current stock market advance. However, in the intermediate term (12 months), in the absence of an exogenous macro shock that would reverse declining liquidity preferences, or decisive Fed action to reign in excess liquidity, many of the requirements of a major stock market bubble appear to be coming together.

In my view, the US Federal Reserve's short-sighted pursuit of its full employment mandate is on the verge of unleashing serious asset price inflation in certain investment goods sectors as well as precipitating relative price distortions in various consumer and producer goods sectors. Such relative price distortions ultimately lead to damaging wealth destruction that cause very large problems for the economy in the long term.

A final note: The window of time in which stock prices are likely to rise most quickly is between now and the fall of 2013, when a tapering of the current rate of monetary accommodation is likely to occur. In addition, Fed officials may attempt to slow down the rate of ascent in stock prices via periodic "jaw-boning" to the effect that they are concerned about rising asset prices in some sectors, and/or that a tapering of monetary accommodation is being considered by the FOMC. Thus, the prospective inflation of a stock market bubble may not be as smooth of a ride as the current market surge since November of 2012. However, smooth or not, given the massive amount of excess liquidity in the US economy, coupled with declining risk aversion and associated liquidity preferences, the risk of the formation of an asset bubble, including a stock market bubble is very real. So too is the risk of long-term damage to the US economy via relative price distortions and capital misallocation.

The next article in this series will develop a working definition of an asset bubble, as well as guidelines that will enable investors to spot one as it is forming.

Source: Beware Long-Term Damage From Stock Market Bubble Forming Now