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Summary

  • The S&P 500 index hit another record last week.
  • It is hard to find economic justification for the levels the index is trading at.
  • Seems like all the money created by the Fed is just circling in the financial sector of the economy.
  • Maybe this is the new financial economy of the information age.

Once again, last Thursday, the S&P 500 index hit a new record by closing at 1,987.98.

Investors just can't seem to stop pushing the stock market up to higher and higher peaks.

Still, there seems to be little in the way of economic justification for the continued rise. The most recent posting of Robert Shiller's measure, the Cyclically Adjusted Price Earnings Ratio, CAPE, has risen to a value of 26.05 for July 2014.

The last time this figure was above 26.00 was in October 2007. At that time the measure was going down.

But, October 2007 was before quantitative easing… before any quantitative easing.

Quantitative easing is supposed to end in October 2014. Still there will be $40 billion more securities purchased by the Federal Reserve System by the end of September. This was more than 4.0 percent of the Fed's balance sheet back in October 2007.

The stock market represents wealth and the Federal Reserve under Chairman Ben Bernanke, and followed up by Chairwoman Janet Yellen, has specifically targeted growing wealth as a major goal of monetary policy because the economic models that Bernanke and Yellen have worked with indicate that wealth is a major factor in stimulating consumer spending.

So, Mr. Bernanke and Ms. Yellen are achieving the intermediate goal…the stock market has risen dramatically and set new records… and, this means that the wealth of the nation has been growing and growing.

One problem. Consumer spending has not responded to the same extent that wealth has been growing and, consequently, economic expansion has been no more than tepid.

One problem is that the economic models being used for policy discussions are based on historical data and more and more analysts, it seems, are coming to realize that the financial economy has taken on a life of its own.

That is with the growth of the modern financial sector, more and more financial transactions take place almost solely in the world of assets and not in the world of the production of goods and services. And, this development has been playing more and more of a role in the economy over the past twenty to thirty years and information technology has evolved and financial innovation has accelerated.

The velocity of monies flowing through the financial circuits of the economy have seemed to take on a life of their own and have very little spill over into the velocity of money going into the transactions people make to acquire goods and services.

The problem with the wealth created within the financial circuit, as I just heard someone say last week, is that it can expand when the prices of the assets go up… but, it can decrease just as rapidly as the prices of the assets go down.

Another point one can make about the rise in asset prices is that the buyers/holders of assets tend to be wealthier individuals to begin with. Thus, their activity in asset markets has little to do with actual the consumer spending that would spur on the economy.

This leaves us short when we come up for the justification for the stock market being at the level it has attained.

In terms of Shiller's CAPE measure, the numerator of the ratio, the price of stocks, can rise before the denominator, the corporate earnings that justify the price of the stocks, rise.

The problem is that some time in the future, the corporate earnings must rise in order for the value of CAPE to fall…and revert back to the mean.

If all the money created by the Federal Reserve is just floating around the financial circuit of the economy and very little of it spills over into the production of goods and services, the earnings will not rise to justify the higher stock prices.

In this case, the wealth created will just be "financial" wealth and nothing else. And, as a consequence, the future of this "financial" wealth will primarily be dependent upon what goes on within the financial circuit of the economy. That is, we should not just look for results from the "real" sectors of the economy to justify the level of stock prices.

Where we should look, then, for factors that might disrupt the stock market is in other areas of the financial circuit that might impact the future.

For one, the situation the Federal Reserve is in is a very crucial element in the future of the banking system and the financial markets. When and how the officials of the Fed decide to "raise" interest rates is a major factor that should be watched.

Note, here, the op-ed piece in the Wall Street Journal by Richard Fisher, the president of the Federal Reserve Bank of Dallas, "The Danger of Too Loose, Too Long." But, how will a market that has relied on all the liquidity provided by the Federal Reserve System going to react when the environment changes?

This raises the question about the ability of the Fed to raise rates in the current environment.

For another, how are things going to work out in the eurozone with respect to the policy of the European Central Bank and re-structuring of the European Union banking system?

And, what will be the fallout of the financial sanctions of the European Union, on top of those of the United States, on Russia?

And, in this troubled world, there are more financial sector problems that need to be watched.

I have heard one analyst claim that the financial world is no longer driven by the business cycle and the productive sectors of the world. Further, however, one might go one step more and contend that the financial sector of the world has become so large and so technology driven, that the policymakers of the world, even in the United States, have very little control over this financial sector.

That is, the financial sector primarily feeds off itself.

So, keep an eye on the financial sector.

Source: The S&P 500 Just Keeps On Setting Records