What is the Floor for Stock Prices?, 4/28
They should fall until inflation recedes
Until recently, stock prices had a high floor. Investors believed in something called the “Fed put.” The thinking was that if the Fed saw stock prices dropping, it would be willing and able to do something to stop the fall.
I doubt that the Fed has such sublime control over stock prices. But if investors hold such a belief, it does not have to be true in order to work. Suppose you think that once the S&P gets below 4200, say, the Fed is going to wave a magic wand and make it go up again. Given such a belief, if the S&P falls below 4250, you figure you should buy, before it starts heading up again. In this frame of mind, investors are inclined to “buy the dip,” that is to buy stocks any time there is a brief drop. The very idea that the Fed creates a floor under stock prices becomes a self-fulfilling prophecy.
By now, it is fair to say that investors and politicians are convinced that inflation is higher than desired. My view of how inflation got out of hand is that the ratio of paper wealth to GDP got too high. Too much money chasing too few goods, except that “money” includes stock market wealth and government debt.
Government debt is not expanding as fast as it did in 2020 and 2021, and you can thank Joe Manchin for that. But it is not receding, either. So if paper wealth is going to fall, the stock market has to take most of the hit. I think of the bond market as doing the hitting, but most people prefer to believe that the Fed is the causal agent. For my purposes here, it does not matter which. The bottom line is that interest rates have to rise, and at higher interest rates stock valuations are going to fall.
How far does the stock market have to fall in order for inflation to return to the levels people had gotten used to before last year? I don’t think that there is a reliable, precise way to answer that question. I’ll take a wild guess and say that if the S&P drops to 3200, which is about 1/3 below its peak, that this will be sufficient. I’ll guess that if it stays above 4000, that will be insufficient.
What is happening now is that the markets have lost confidence that the Fed is going to prop up a high floor. So the floor is lower than it used to be. Where is it? Note that my guess does not constitute a floor. The floor is not 4000 or 3200. The floor is whatever the markets say that it is.
I am old enough to have lived through the '70s and spent the '60s working in Brazil, which was undergoing an inflationary instability: we played Monopoly using real money for fun. What is not included in most present analyses is the dynamic effect, i.e., the huge delay times between effectively creating excess money and observable inflation. It is like filling a dam. You see no change in the flow down stream for quite a while. Then, suddenly, the dam overflows, floodwater is released and the dam itself may be destroyed in the process.
The feds have been creating money equivalents for years, but being a reserve currency has allowed the dollar to pile up with little apparent inflation or interest rate effects. This has come at the cost of effectively negative interest rates and decreases the real value of the dollar. These lower-value dollars are chasing real-value goods and are finally revealing the heretofore not apparent inflation. This inflation will accelerate, as everyone tries to off-load their increasingly less valuable cash by converting it to "real value goods". This causes the system to go unstable. A decrease in world trade will decrease the demand for dollars and add to the torrent of dollars entering the market. In Brazil, people horded steel reinforcing bars, because they had real value. The government paper money and economic activity so distorted the value of the currency that the military took over: a new currency was issued. Everyone caught with cash lost 90% or so.
It took huge interest rates (Fed funds rate 21% in '81) and a depression to handle the '70 money printing cycle and dollar devaluation. What will it take this time? Little 0.5% increases in interest rates with a 7+% inflation still makes a negative 6.5% real interest rate, and you pay taxes on the imaginary 0.5% interest income.
In the case of Brazil, we could still do some economic planning (building factories) by using dollars in the plans, but if the value of the dollar is unstable, how can one make rational economic decisions to invest in the future, given no idea of the value of the dollar a decade from now?
Arnold, you seem to be saying the inflationary 70s are calling. But a huge difference is that not just money was chasing goods, but new Baby Boomers entering the economy were chasing real goods. Houses and furnishings for those houses, and cars, and clothes for work.
The fact that most production has a significant energy cost component means that higher energy prices look like generally higher prices, which is what inflation is defined as - same as 70s energy price shocks.
"the ratio of paper wealth to GDP got too high" seems likely true. Since the end of the 2008-9 recession ended, lots and lots and lots of money creation has been going into stocks & bonds, and Bitcoin, and houses. We've had high asset inflation (almost-hyper) throughout Trump, with low normal consumption inflation, excluding housing in good areas (such housing is becoming a rich only good; housing in high crime areas remains affordable but undesirable).
The pandemic, plus other Dem policy messes with the supply, especially energy, pushed a reduction in production, and thus an expected increase in prices. Biden is also blaming Putin's war, now, which is certain to disrupt many trade expectations and make some large price/supply changes in some areas like wheat & neon (used in semi-conductors, made in Ukraine).
There has been quite a bit of price stickiness against increasing prices, and losing customer loyalty (?), but as general inflation goes up over 8%, this seems to allow the really reduced supply products to go up by 20, 50, 100%, or whatever the new real supply-demand market clearing price is. (I like "market clearing price" rather than "equilibrium"; one of the reasons I'm sure Kling is more correct more often than other economists.) In this respect, the supply shocks will be 6 - 24 month long "temporary" price increases, not quite inflation - but embedded within and being somewhat hidden by real general price inflation.
Looking at a NYT chart of prices since 1980, we started getting a stock boom in '92, as part of the "peace dividend", and possibly as part of too many middle class investors were chasing too few shares (of good S&P 500 companies):
1992 ~ 450 1996 ~ 550 2000 ~ 1500 (peak 1; ~850 bottom 2003) 2004 ~ 1000
2008 ~ 1500 (peak 2; ~650 bottom 2009) 2012 ~ 1300 2016 ~ 2000
2019-2020 ~ 3450 (peak 3 & 4 with ~2250 bottom in 2020 as well);
But the chart doesn't say, so these numbers are nominal (non-adjusted!)
This advisor chart is adjusted to June '21 dollars, and is consistent but with the added alarmism of hugely increasing margin debt, from just under 200 billion in '97 to a 2018 peak of 660, drop back to 500 in 2020, then exploded again to 860 by June 2021.
So I looked for more Margin Debt, here is a good article from Feb, 2022 (see title):
[Chart peak is over 900, "WTF"]
"The only measure of stock market leverage that is reported monthly is margin debt at brokers, via FINRA. Much of the stock market leverage isn’t reported, such as Securities Based Lending, and even banks and brokers that fund this leverage don’t know the leverage in the overall market, or even the leverage of their client if that client is levered as well at other banks."
Later they explain its importance:
"Margin debt is the great accelerator on the way up because it creates buying pressure with borrowed money, and on the way down because it creates forced selling pressure."
Few analyst journalists follow margin debt, but it's hugely important on the trend driving margin.
Wolf agrees with my priors, so I believe him!