It's true. I do think that the stock market is going to go much higher if you simply measure the S&P500 or the Dow Jones Industrial Average. It could go a lot higher, in fact. However, I think that we are probably headed lower before we go higher. Allow me to explain my reasoning:
In relative terms, when you have high inflation, the average earnings multiple of the market is lower than when you have low inflation. Are you one of those people that doesn't feel any wealthier since the market bottom in 2009? Do you feel about the same? Great. You aren't crazy. Once you back out the valuation of the most reliable asset there is (gold), you can see that we haven't made any progress in this stock market creating real value since April of 2009.
click to enlarge images
Some people say that this rally over the last two years is a legitimate rally. I can tell you that businesses have come back from the brink. I can also say that there are a lot of businesses out there that I would be very worried about if the Federal Reserve decided to stop monetizing the deficit today.
Those businesses include the "too big to fail" banks. These banks effectively have a put option on the US government. The more they make terrible loans, the closer they come to collapsing. The closer they come to collapsing, the more the Fed prints money. The more money the Fed prints, the more likely the terrible loans will make a positive return if you ignore inflation. Take a look at the Adjusted Monetary Base. It just keeps growing, and growing, and growing, and ....
So you have a situation of banks --- JP Morgan (JPM), Bank of America (BAC) and Citigroup (C) just to name a few --- that I personally wouldn't own because of their systemic risk. If the Federal Reserve decides to play the responsible card, or if the political system of the US government decides not to raise the debt ceiling, or if politicians sacrifice their political career to make tough decisions that limit our spending to that which we make --- then you could see these banks run into some problems.
Just imagine the implications of real estate prices dropping 15% in the United States in dollar terms. Even with the Fed holding interest rates as low as they've ever been, it's taken housing prices a long time to stabilize. Do you think that homes will be worth more or less at higher interest rates? If you are a landlord and interest rates are higher, would you expect a greater rate of return on your apartments? I would. That's why I think real estate still has some room to drop if the Federal Reserve raises interest rates. Unfortunately, the Federal Reserve cannot raise interest rates because the "too big to fail" banks have it pinned down, forced to stabilize the economy by stabilizing home prices by dropping borrowing rates to historic lows.
We are not out of the woods. We are unfortunately on the track to monetize the deficit. Buffett has even said that paper money is not a good bet. The IMF has come out and said that we are one shock away from a crisis thanks to the high inflation that the US has exported around the world --- especially to the countries who peg their currencies to the dollar.
Discounting cash flows is great if you are working with dollars and pricing companies in dollars. That said, it is not enough when there are serious risks to the dollar. I learned this the hard way in the past when I bought into a company that was tied to the zloty and the zloty got beat up because the Polish had financed a lot of their mortgages on global currencies and when the zloty fell, their mortgage payments ballooned to the point where most could not afford to pay them and this built upon itself, destroying the market for homes there. Any company that made money in zloties was worth less because the zloty was worth less. Global monetary policy at this current juncture really likes to print money. We could be in a global currency race to the bottom, I don't know. Right now the question is: Who can print the fastest? On your mark. Get started. Go.