QE, Stock Prices, and TINA

The U.S. economy as quantified by GDP has been sputtering along in slow growth mode for a number of years. It took a huge hit in 2020 due to covid shutdowns and has not nearly recovered. But stock prices have been rocketing upwards, and this past year is no exception. Markets took a cliff-dive in March, but have since way overshot to the upside.

Here is a plot of the past five decades of U.S. GDP and of the Wilshire 5000 index, which approximates the total stock market capitalization in the U.S.:

Chart Source: St. Louis Fed, as plotted by Lyn Alden Schwartzer

These two curves have crisscrossed each other over the past five decades, but in recent years the stock market has roared to the upside. One of Warren Buffet’s favorite metrics as to whether stock are overvalued is to consider the ratio of these two quantities, i.e. the market-capitalization-to-GDP (Cap/GDP) ratio:

Source: Lyn Alden Schwartzer

The ratio is much higher than it has even been. The last time it got this high was in 2000, and that did not end well.

Well, maybe high stock prices are justified because corporate profits, as a percent of GDP, have gone up (thanks to lower corporate taxes, low wage increases, etc.). Here is a plot of price to earnings ratio, where the earnings are averaged over the preceding ten years. This is the Shiller cyclically-adjusted price-to-earnings (CAPE) ratio:

Source: Lyn Alden Schwartzer

The only times in the past hundred years that P/E ratios have been this high were in 1929 and 1998-2000. Again, these years marked the culmination of epic bubbles which then popped and were followed by years of lower stock prices.

But….maybe “This time it’s different” ?? There are a couple of possible “This time it’s different” factors. One is that much of U.S. industrial production has been hollowed out and moved offshore (mainly to China), and global trade in general has risen, so that a larger fraction of American corporate profits are derived from foreign operations. These operations do not show up in U.S. GDP, so there may be a secular step down in the denominator of the stocks/GDP ratio, and hence a secular step up in the ratio, which would not necessarily correspond to overvaluation in stock prices.

A large part of the elevated price/earnings is probably due to the Fed hammering interests down to historically low levels. The Fed has signaled that it will keep short term rates near zero and will keep purchasing bonds as necessary, unless inflation takes off.

Dan Caplinger notes:

The Fed’s actions have essentially made mainstream alternatives to stocks impractical for most investors. Those who want to keep cash available can expect little or no interest at all, and with inflation still positive, that means savers are losing purchasing power every month on their cash savings. Even those willing to lock up money in bonds or CDs for five to 10 years can’t expect to get much more than 1%, which again isn’t enough to keep up with rising prices even at their currently subdued levels.

This is the “There Is No Alternative” (TINA) justification for ever-higher stock prices.

I have seen some pushback against the idea that large-scale bond purchase by the Fed, so-called quantitative easing (QE), can move asset prices. The argument goes like this: “The Fed typically purchases bonds from banks, and when they do so, they merely credit the banks’ reserve accounts. This does not get money out into the general economy, where it might be used to buy stocks.” But this reasoning fails to consider the full picture.

First, the money in banks’ reserve accounts is not stuck there permanently. It can be loaned out, or used to turn around and purchase more bonds from the public, which does put more cash into the hands of the public. Furthermore, as the Fed sucks bonds out of the financial system, it is reducing the amount of investible securities. All other things being equal, this drives investors into purchasing other securities, such as stocks. Again, TINA. And, “Don’t fight the Fed”. Plots of stock market capitalization versus Fed holdings and versus money supply show strong correlations.

This discussion is not a complete explanation of market dynamics, but it goes a long way toward understanding how stock prices have seemingly defied economic gravity in the past decade and especially the past year.

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