- I have argued many times in these posts that the stock market seems to be overvalued.
- One thing I have never done is give a time for when a stock market correction might take place.
- I have also suggested many times that investors should not try and "fight the Fed".
- If the Fed wants to underwrite higher stock prices, don't bet against it!
I received a comment recently that I took as a real complement. The post that was being commented upon was "The Stock Market Keeps Posting New Records: Are They Sustainable?"
Here is the comment I am referring to: "This author has been publishing the same articles for five years. Take a look at hi piece from Oct 29, 2009 entitled 'On Bubbles and the Market Recovery.'"
Wow! This reader has been following my writing for five years! Or, at least he has done sufficient research on my writing to be familiar with posts that I wrote five years ago!
He even presents that fact that I have used Tobin's q ratio and Shiller's CAPE statistic to justify that the stock market may be overvalued. He writes, "He quotes the q ratio and Shiller as indicating the market is 30% to 35% overvalued."
There are two things he doesn't quote from my writings. The first thing is that one needs to be careful about using these data because they may give some indication that the stock market is overvalued and that at some time in the future there will be a "reversion to the mean" and these measures will drop back to a historical norm.
A corollary to this statement is that the "reversion to the mean" can come in one or two ways. In terms of Shiller's cyclically adjusted price earnings ratio, CAPE, either earnings will have to rise to lower the ratio, or, prices will have to fall to lower the ratio.
Usually, early in the recovery cycle, investors anticipate future earnings and prices rise ahead of earnings so that the CAPE measure will rise in value. At some future time the earnings may catch up with the prices, lowering the ratio closer to its historical average.
In the second case, earnings never catch up with prices and hence prices fall to match up with the lower level of earnings.
The second of these cases is the one where the market remains overvalued until investor expectations are broken and the market crashes to a much lower value.
The key caveat in this discussion is my statement "that the stock market is overvalued and that AT SOME TIME IN THE FUTURE there will be a 'reversion to the mean.'"
This qualification is key because in using Tobin's q-ratio or Shiller's CAPE statistic no claim is made concerning the time at which the adjustment in the ratio will occur. I have always been very careful in making use of these measures to always qualify my statements about market valuation: I always state that the analysis I present make no claims to know when adjustments may take place.
This gets us to the second thing the writer of the comment doesn't discuss: there is no discussion of reasons why the stock market may stay at levels where Tobin's q-ratio or Shiller's CAPE statistic may be interpreted as indicating that the stock market is overvalued. Thus, there needs to be a narrative concerning possible causes of the overvaluation.
One such cause that I have written about again and again is the impact that the Federal Reserve has had on stock prices.
For one, back in October of 2009 I could never have imagined that Mr. Bernanke and the Federal Reserve would conduct three rounds of "quantitative easing." I could never have imagined that the Federal Reserve balance sheet would grow from a level of $2.2 trillion on October 28, 2009…that was up from just a little over $0.9 trillion (or $900 billion) on August 1, 2007…to $4.4 trillion on June 4, 2014!
And, some of the reasoning for this acceleration of security purchasing was the effort by Mr. Bernanke to drive up stock market prices and housing prices in order to create a wealth effect among consumers so as to get them spending again so as to revive the economy. This reasoning came from research that Mr. Bernanke had conducted himself or had conducted for him.
The problem is that this "wealth creation" has had little impact on consumer spending or economic growth in the five years that the economy has been recovering from the Great Recession.
Now, I bring in another voice to provide support for the position I have been pursuing over the past five years. The other voice is that of Mohamed A. El-Erian who just published the article "What If The Fed Has Created A Bubble?"
Mr. El-Erian writes: "Essentially, the Fed has been pushing stock and bond prices up to "bubblish" levels, in the expectation that they will inspire the kind of consumer spending, physical investments and hiring required to subsequently justify them. The hope is that the convergence will occur in the context of full employment and inflation near the Federal Reserve's target of 2 percent. So far, though, the wedge between asset prices and economic reality remains large, as last week's juxtaposition of new stock-market highs and still-anemic wage-inflation data demonstrated."
The crucial concern here is "the wedge between asset prices and economic reality…." Over the past fifty years or so, Federal Reserve policymaking has created a class of investors that take Fed actions and translate them directly into asset prices. In doing so, the actions of the Fed are not transformed into bank lending that stimulates economic output…and consumer prices. These investors…hedge funds, private equity funds and other well-financed individuals…go with the flow of Federal Reserve policy. They help the Fed inflate asset prices…and make billions of dollars in doing so.
Mr. El-Erian concludes, "The danger is that the economic recovery will ultimately fail to validate artificially high asset prices, leading to significant financial instability and adverse "spillback" for the economy. The more comfortable the authorities are in their ability to counter -- and, if necessary, contain -- such potential instability, the greater their appetite for maintaining the stimulus that markets so love."
Here the key point is "the stimulus that markets so love."
Yes, I have argued over the past five years that there is a real possibility that the stock market is overvalued. I have even used the term "bubble" to describe the condition of the market. But, I have never claimed to know when this overvalued situation will come to an end.
I have made the argument over these years, "Don't fight the Fed"!