The Stock Market Keeps Posting New Records: Are They Sustainable?

Includes: DIA, IWM, QQQ, SPY
by: John M. Mason


The Dow-Jone and the S&P 500 have been hitting new records recently. US Wealth is at an all time high.

The increase in wealth has been primarily gone to the wealthy and has come about due to rising stock prices and prices of homes.

Has the rise in home prices and stock prices been a result of credit inflation underwritten by the Federal Reserve?

Once again the United States stock markets hit new records. Both the Dow-Jones Industrial Average and the S& P 500 closed at new highs.

And, with these new highs we read that wealth in the United States hit new highs in the first quarter of 2014.

"Americans' wealth hit a fresh record in the first quarter amid a rise in home values and stock prices, a trajectory poised to continue as U. S. markets push higher but one that doesn't necessarily figure to rev up the sluggish recovery."

In effect, what is being said here is that the "wealth effect" that so many economists have been counting on to "goose" up economic growth doesn't seem to be working as it has in the past.

One reason why this seems to be the case is that most of the increase in wealth that is taking place is going to the most wealthy. "Michael Feroli, an economist with JPMorgan Chase, said rising stock markets and rebounding home prices aren't pumping up the economy the way they used to, largely because many of the gains are going to affluent Americans, who tend to save."

As readers of this post know, I have been arguing for the past five years that what the economic programs of the federal government have been accomplishing has been a further enrichment of the wealthy.

I have reported how former Secretary of the Treasury Timothy Geithner, in his new book, reports (on pages 311-314) about how the wealthy have benefited from governmental policies.

I believe that when all the facts are in we will find out that in the eight years that President Obama was in office, his programs to help support the middle class resulted in more skewing of the income/wealth distribution than any other president in recent history.

Faroli is quoted in the Wall Street Journal article, that the wealth effect "is roughly half as strong as that of previous economic expansions."

Notice that the reported rise in wealth has come primarily from "a rise in home values and stock prices." This seems, within the current environment, to be a little suspicious.

Robert Shiller, the Nobel prize-winning economist has already expressed concern on the pages of the New York Times that housing prices might be experiencing a little bit of a price bubble. First of all, the construction of new houses is not that strong. Builders are not experiencing a strong demand for building homes.

Second, I have written about the movement of hedge funds, private equity funds, home builders, and wealthy individuals into the acquisition of existing housing, both in terms of out-right purchases but also in terms of acquiring foreclosed properties. They are renting these homes out and have created a new security that has been sold into the financial markets using the cash flow of the rents on these properties to pay the interest on the issues. Eventually, when the current inflation of house prices is near an end, these "homeowners" are expected to flip the homes and walk away with huge profits…in the billions…not in the millions or the thousands.

And, who is it that has "goosed" up the home prices? Well, according to Allan Meltzer, the prime "gooser" has Federal Reserve Chairperson Janet Yellen.

And, what about the rise in stock prices. Shiller has not spoken out explicitly on this subject, but if one looks at the statistics that Shiller produces, the stock market is way over-valued at this time. His measure of the Cyclically Adjusted Price-Earnings ratio (CAPE) has jumped up to 25.60 in June. It has risen substantially this year. This figure is way above the historical mean for the series, which indicates that, according to this measure, the stock market will revert, sometime in the future, back to this historical mean level.

One can note that the last time CAPE was around this level was in the fall of 2007. In December 2007, CAPE was 25.95. In October of 2007 it was 27.31.

During cyclical upswings in the economy, CAPE will tend to rise because stock prices go up in anticipation of future improvements in earnings. In the current recovery, it is becoming more and more doubtful that corporate earnings will rise to meet the prices that have already been achieved in the economy.

It is very, very difficult to believe that corporate earnings will rise as rapidly as stock prices have risen while the growth rate of the real economy is so slow. The annual rates of growth of the US economy since the end of the Great Recession have been: in 2010, 2.5 percent; in 2011, 1.8 percent; in 2012 2.8, percent; and in 2013, 1.9 percent. Year-over-year for the first quarter of 2014, the rate of growth has only been 2.0 percent.

The economy is just not that strong to support double-digit growth rates in corporate earnings.

One then raises the question about what is causing the rise in stock prices? One answer can certainly be…credit inflation. And, here we get back to the primary "gooser" of asset prices…the Federal Reserve. The trillions of dollars the Federal Reserve has pumped into the economy is helping to support a credit bubble in stock prices that is unsupported by the state of the economy. And, if the major problem of the economy is one of re-structuring and not just of cyclical recovery, as I have been writing about, then it is hard for me so believe that the current level of stock prices is sustainable.

What is remarkable about the financial markets these days, given this particular economic scenario is how calm they have been. "Historical volatility for the S&P 500 has fallen to some of its lowest levels since 2007. So, too, has the Chicago Board Options Exchange Volatility Index, of VIX."

There is that year again…2007.

The article goes on…"Are things too quiet?"

Justin Lahart, the writer of this piece, argues "The recent lack of volatility stems from an economy that, while a bit disappointing, has offered few surprises over the past two years." One might add that the federal government and the Federal Reserve System have basically written a "put" under the economy…much as Mario Draghi, the president of the European Central Bank, has written a "put" for the eurozone.

But, "quiet" can mean that investors are waiting to see which way the markets move when expectations are broken in the future. As Mr. Lahart writes "When a crow gets told it is going in the wrong direction, it is easy to get trampled in the ensuing melee."

In my mind, economic growth is not going to bounce much above, if at all, the range it has achieved over the past four years. As a consequence, I cannot see corporate earnings rising to justify current stock prices. My conclusion is that something else has caused stock prices…and housing prices…to rise to the levels they have reached. This something else is called credit inflation…something that is now expected by the wealthy investors and built into their investment decisions. They can also move faster than the rest of the market…when needed.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.