Stock Market Prices Dislocate From Bank Balance Sheets

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 loan delinquencies rise. This is a necessary consequence since the increased level of spending and investment made possible by credit expansion is not sustainable. Why? Because savings, which also serve as a cushion against adverse economic developments, are drained and at some stage banks and the economy react to the distortions created as a result. An expanding ratio of credit to saving may serve as a useful indicator of the extent of economic distortions - the higher the ratio the bigger the imbalance. It is therefore not uncommon to see the ratio peak prior to a GDP recession.

These economic distortions ultimately reveal themselves in the form of a significant portion of borrowers having difficulties generating enough income to repay the loans. Many (partly) default and banks then experience liquidity problems. Lending growth falls and stock markets contract, sometimes substantially. A banking crisis follows, its size partly a reflection of the amount of economic distortions preceding it. This, in short, is why financial crises and stock market booms and busts originate in the banking sector (I explain this whole process in detail here).

Bank assets grow during the credit expansion phase. So too does the net asset position (assets minus liabilities) for most banks. Since this is a reflection of an increased quantity of money "circulating" in the economy, broad stock market indices will typically follow suit and increase as well. The two, bank balance sheets and the stock market, are therefore necessarily linked. It is hence both natural and justified that stock prices in general increase with time and in tandem with expanding bank balance sheets.

However, undisturbed bank balance sheet expansions are an impossibility due to the factors mentioned above. This means that not only stock market prices but also corporate earnings will at some stage experience setbacks. Future returns are therefore likely to decline when the stock market gets ahead of itself and when prices do not discount these likely setbacks. If stock market prices were truly efficient, they would reflect these likely setbacks. As the past demonstrate, the stock market is at times myopic and ignore the inevitable problems banks will experience. When the setbacks occur, often at the eve of the bull market (here), they are explained away as "shocks". For those understanding the workings of a fractional reserve banking system however, these correct will not come as a shock.

The "shock" will however be that much bigger when stock prices move above what even inflated bank balance sheets might suggest is reasonable. In the more recent past, the stock market has greatly dislocated from banks' net asset positions on two noteworthy occasions: Q1 2000 and Q3 2007. In both instances, the stock market plunged shortly thereafter. But history repeats itself, and the stock market has once again dislocated sharply from bank balance sheets. Today, the ratio of a major U.S. stock market index to bank net assets dwarfs the peak hit in 2007 and is now back towards the historically high levels from the dot.com era.

The stock market is today hence valued near historical highs relative to banks' net asset position, and 39% and 46% higher than the average and the median based on data since 1987. Historically, such elevated ratios have been very bearish for stocks. Of course, both bank balance sheets and this ratio can stay inflated for longer and both might even inflate further. But both theory and historicals suggest future stock market returns are likely to be poor and that the risk of a major stock market correction at this stage is significant (also see this indicator). Bank credit growth is already declining substantially, perhaps an early sign that banks and borrowers have once again issued and taken on too much debt as the first chart above currently might indicate.

¹ The bank assets to net assets ratio has the averaged 9.21 during the last 12 months. Over the last ten years the leverage ratio has averaged 9.15 while it as of last week stood at 9.25.

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.