The Mother of All Stock-Market Bubbles
According to Warren Buffett's criteria, current stock prices have been the most overvalued since at least World War II. In the chart below, the ratio of the stock market value, represented by the Wilshire 5000 index of all public stocks, to GDP is over 25 percent above the previous all-time high, the peak of the NASDAQ stock market bubble in 2000 is indexed as 100 on the chart.
The seemingly unstoppable surge in the stock market coincides with central bank balance sheets, which have continued to expand since the great financial crisis. While the major central banks generally do not target stock market levels directly, one aim of their policy has been to encourage financial markets to move to riskier investments, which of course includes stocks. The global financial markets are interconnected so that the actions of the international central banks can have an impact on developments in the USA and vice versa. The following chart compares the securities holdings of the major central banks with the level of the US stock market.
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There is a close correlation between stock-market holdings and central bank holdings, but both are expected to grow with GDP. The next graph compares the ratio of stock market valuation to GDP in the first graph with a similar GDP ratio for central bank assets.
As central bank debt stocks grow relative to GDP, equity valuations rise in unison. Some analysts, including the Fed, cite low real interest rates (after inflation) as a justification for high equity valuations. Recent experience shows that although interest rates have a short-term impact on the market, in the long term the correlation between real interest rates and the equity valuation measure in the graph above is less than half the liquidity provided by the central bank for security purchases.
The overvaluation of stocks is evident to seasoned investors searching the markets for historically reasonable values. Meanwhile, the GameStop saga (and there are plenty of other examples to choose from) is uncomfortably reminiscent of some of the excesses of the dotcom bubble.
Just because the stock market is overvalued doesn't mean it can't be further overvalued. The next graph compares the US stock market of the past decade to the NASDAQ bubble of the 1990s and the Japanese stock market bubble that collapsed in the 1990s.
While US stocks are currently hitting all-time highs at Buffett Ratio, the NASDAQ and Japan bubbles rose even further from their starting points. The current bubble could do the same if central banks continue to pour liquidity into financial markets.
The first graph shows that the stock market downturn caused by the NASDAQ bubble preceded and contributed to the 2000 recession, as confirmed by Fed chairman Jerome Powell. The bursting of the Japanese bubble was also linked to a recession. However, equities are an insignificant position in the US banking system, largely unaffected by the NASDAQ bubble, even though Japanese banks have been crippled for years with extensive cross-holdings.
A greater financial risk than a stock decline is that historically high valuations permeate the entire financial system. The US stock market is a global leader in risky assets. The disparity between US government lending rates and high quality investment grade borrowers has decreased significantly and is historically quite small. Interest rates for the riskiest, sub-investment grade junk bond borrowers are at lows at all times.
Future turmoil in the bond market due to the inevitable reversal of the maximally simple monetary conditions can pose a threat to financial stability. The greatest risk to the financial system, however, is a real estate downturn like the one that occurred during the great financial crisis. Real estate is the largest single component of bank assets.
Fortunately, as shown in the graph below, which compares house prices to income, property values are about 20 percent below the exaggerated values from the GFC era.
Unfortunately, the recent rapid appreciation in house prices can alter this favorable balance. The graph below shows that home prices are growing at an annualized rate of 20 percent faster than personal income, the fastest rate ever. Of course, there is a strong upswing in the wake of the pandemic, but if that rate continues, it won't be long before homes start showing critical warning signs.
The Fed's plan for December was to keep interest rates low until unemployment was minimized and inflation topped 2 percent, which is expected to take 3 years. Should real estate prices continue to rise recently, they would get well into the GFC danger zone after three more years of maximum incentives.
The pandemic recovery is proceeding faster than expected by the Fed and many other forecasters. In March 2020, the Fed forecast a 6.5 percent decline for the year. Forecasters polled by the Philadelphia Fed in May expected a decline of 5.6 percent. The downturn in 2020 was 3.5 percent, and the same forecasters expect growth of over 4 percent in 2021, so a general recovery is in sight.
Financial markets are already starting to bring forward their expectations for the Fed's rate hike to start (around two years), and it would not be surprising if this were to be expected on an even closer date in due course. . More years of maximum stimulus would inflate the stock market bubble further and possibly create an even more deadly housing bubble.
The Fed was determined to bring unemployment down to the end before tightening, a worthy goal, but even a slight decline after the stock market bubble burst would have dire post-pandemic consequences. Creating another real estate bubble would be disastrous.
Depressed business and labor sectors may not fully recover this year, but all the monetary incentives in the world will not turn planes, bars, and restaurants into homes, flight crews, and home builders or other booming sectors. If the pandemic allows, the cash savings are extremely high and there is a lot of pent-up demand for these people and their services.
The targeted focus on just one goal ignores the significant time delays and complex effects of monetary policy in an economy. Now is the time for the Fed to plan to stabilize policies and markets. This needs to be carefully communicated and done to minimize volatility like the 2013 “Taper Tantrum”.
While inflation can rise in the short term while the recovery continues, long-term inflation has been falling for forty years so it is unlikely to be a major problem. The greatest economic risk is financial instability and, despite the great initial work to contain the pandemic panic, the greatest risk of financial instability is currently present. . . the Fed.
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