Stock Market Prices Dislocate From Bank Balance Sheets

Atle Willems, CFA profile picture
Atle Willems, CFA
662 Followers

Summary

  • Bank balance sheets and the stock market are directly linked as both respond to bank credit expansion.
  • The ratio between stock market prices and bank balance sheets is therefore an important indicator of stock market valuations.
  • Today, the ratio has surged above the 2007 peak and is now near the record highs from the dot.com bubble.
  • The near record high ratio suggests future returns could be dismal at best and that the risk of a major stock market correction has increased substantially.

The dot.com and the subprime bubbles had at least one thing in common; years of substantial bank credit growth preceding the busts.

During the eight year period stretching December 1992 to December 2000, lending by U.S. commercial banks increased a total of 84%, or an average of 7.9% per year. During the six year period spanning December 2001 to December 2007, lending increased nearly 72% in total, or 9.4% per year. In both cases, most notably last time around, lending growth collapsed shortly thereafter.

The stock market also collapsed on both occasions. This is no coincidence, but instead a consequence of bank credit and stock market prices being directly related though there are leads and lags involved. Stock market booms and busts are in fact created by the banking system. The elastic money supply employed today means credit growth is not driven by increased savings, but instead by banks' willingness to create additional credit unbacked by savings. That is, banks can lend new money into existence with a few touches on a keyboard, no savings required: debit loan and credit deposit. This new deposit credited to the customer account is for all intents and purposes money and is therefore spent as such by recipients. The quantity of money in the economy increases as a result pushing higher most aggregates measured in monetary terms, including GDP and stock prices.

But this credit and money supply expansion cannot continue undisturbed forever. Banks must protect their limited reserves and the Fed will tighten monetary policy should price inflation get out of hand. The former is an ever-present problem since banks are always highly leveraged (assets/equity ratio is typically above 9.2) 1 while the latter has not really been a policy issue for years. At some stage banks will have to reduce credit growth as

This article was written by

Atle Willems, CFA profile picture
662 Followers
Atle Willems, author of "Money Cycles", is an analyst with Liabridge Economic Research. He holds a masters degree in finance with distinction from Nottingham University Business School and a BSc in Business Administration from Drake University.

Disclosure: I/we 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.

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