After the taper: Abnormally high supply of accumulated liquidity + normalization of liquidity preference = surging asset prices.
Almost by definition, the taper will end just as risk aversion and liquidity preference have barely begun to normalize.
In this context, stock prices will probably rise sharply for 1-2 more years, but with valuations already stretched, this will be an unprecedented and treacherous time in US history.
Many analysts seem to be under the impression that the stimulus from QE that has affected economy and financial markets will come to a halt when the Fed ends the "taper" and stops purchasing securities. This is a faulty conclusion that flows from an incorrect understanding of monetary economics. Contrary to popular belief, it is likely that the stimulative effects of QE will kick into high gear when the taper ends. This will have profound implications for the US economy as a whole and for broad stock market indices such as the S&P 500 (NYSEARCA:SPY) and the Dow Jones Industrial Average (NYSEARCA:DIA).
In this essay, I will explain how this works and why.
Monetary Stimulus Depends On Liquidity Preference
As I have explained in several prior essays, the effectiveness of monetary stimulus depends entirely on the evolution of liquidity preference (i.e. demand for liquidity). If the money supply is increased by a large amount but liquidity preference increases by an equal amount, then the increase in the money supply will not exert any net positive stimulus to the economy or asset prices. Indeed, in an atmosphere of economic/financial crisis and its aftermath, it can occur that a very large increase in the money supply will be insufficient to satisfy the increase in the demand for liquidity, in which case the stance of monetary policy, which seems to be expansive, will actually be acting as a drag on economic activity and asset prices.
Liquidity preference is largely a function of risk aversion. As confidence in the ongoing economic recovery deepens and consolidates, risk aversion on the part of households and businesses will tend to decline, and one symptom of this will be a decline in liquidity preference by these economic actors. What this means is that households and businesses will tend to feel like they don't need to hold as much of their assets in cash and a cash equivalents; they will prefer to hold less cash and more of other types of consumer and/or investment goods.
As I have documented elsewhere, at the present time, virtually all measures of the money supply and/or liquidity are at extremely elevated levels relative to national income and production. In this context, the normalization of liquidity preferences creates a portentous situation: On aggregate, households and businesses will attempt to spend down their cash balances to more "normal" levels, but they ironically can't. The cash spent by some households and businesses will simply enter the coffers of others - the total amount of liquidity in the economy will not change (except via credit, which is likely to expand). At this point, the "excess cash" becomes a sort of "hot potato" whereby households and businesses repeatedly attempt to spend down their cash balances to levels that they are more comfortable with, and do so with increasing quickness. The irony of the situation is that no matter how hard economic actors attempt to spend down their cash balances, on aggregate, they are unable to do so. The total amount of liquidity in the economy may remain relatively unchanged, but the total volume of economic transactions (i.e. demand) increases substantially.
The Root and Essence of Inflation
The increased desire to reduce money holdings relative to holdings of other goods and services is the basic root of inflation. What happens when the supply of a good is unchanged but the demand for it falls? The price of this good falls. In the case of a monetary good, like any other good, this means that its value will decline. Specifically, the exchange value of money expressed in units of non-monetary goods and services will decline. This is the essence of inflation.
Now, it is important to understand that inflation is not an even process that affects all goods equally. Excess cash will not be spent on all goods and services equally - some goods will be in greater demand than others. What sort of goods will households and businesses tend to accumulate as they attempt to reduce their money balances? This is a very important question.
For various reasons, in a relatively wealthy nation, where basic necessities have largely been met, households and businesses are relatively more likely to seek to exchange their cash balances for investment assets and/or high level consumer goods as opposed to the sorts of basic level consumer goods and services that tend to constitute the consumer price index or CPI. This means that asset price inflation and luxury good price inflation will be more pronounced than headline CPI inflation.
It is clear that these trends towards inflation in luxury goods and asset prices have already been underway in the USA for some time. So the question is: How much longer will this process go on, particularly with respect to asset price inflation?
In accordance with the analysis outlined above, it will go on as long as: A) Liquidity preference is normalizing, and; B) The Fed does not take aggressive steps to withdraw the excess supply of liquidity from the system that it introduced via QE.
In this context, it is my belief that asset price inflation in general and stock price inflation specifically are likely to persist for quite some time. First, the Fed has already signaled that it does not plan to directly withdraw liquidity from the system anytime soon via asset sales (i.e. reverse QE). Second, it is my view that households and businesses that are inclined to reduce excess liquidity balances to more normal levels are unlikely on aggregate to be lured into "immobilizing" this excess liquidity via purchase of short-term fixed-income instruments whose yields rise by a mere 100-250 basis from currently low levels. Moves in liquidity preference tend to be discontinuous rather than following a smooth linear path. For this reason, the Fed increasing the Fed Funds rate is unlikely to substantially counteract the already-underway shift in preferences away from cash and cash substitutes and favoring more illiquid and risky investment assets including capital goods, private and public equities.
Inflation is a measure of the changing value of money. Like any other good, the value of money is a function of its supply and demand. For this reason, statistics that attempt to measure the supply of money say absolutely nothing about the potential evolution of inflation without a simultaneous understanding of the demand for money, or liquidity preference. Furthermore, analysts erroneously focus far too much on changes in the money supply rather than on the interaction between the accumulated stock of monetary assets and the demand for those assets relative to other goods and services.
When we focus on the stock of monetary assets, we can clearly see that they are currently at levels that are far above normal. As liquidity preference normalizes (i.e. falls), the demand for certain types of goods and services will rise and inflation in the prices of these goods will tend to occur. This process has been going on with stock prices for some time now and it is likely to continue to occur as long as the total stock of money remains abnormally high and liquidity preferences continue to normalize. This process could take one to two full years to fully run its course.
Exactly how to navigate through this environment of asset price inflation will be one of the main focuses of my writings here on Seeking Alpha and especially in my free newsletter. It may well be that in one or two years from now, this process may not end well. But in the meantime, investors need a serious plan to navigate through this very treacherous period which is really very much unlike any other in US history.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.