After one of the longest Bull markets in history, investors still believe stock prices have a few more years to another decade to run higher. For most retirees who have been forced into buying stocks due to low-interest rates, another decade of rising stock prices is a huge blessing. Stock prices would need to rise parabolically or go straight up for this Bull market to continue, yet it hasn’t stopped investors from believing and putting all their investible assets, and faith, in stocks.
From a valuation standpoint, this is one of the worst times in history to be invested in stocks. Median share price to book value is in the 99% historical percentile. When looking at the total market cap to Gross Domestic Product, the S&P 500 is in the 98% historical percentile. The share price to a unit of sales ratio is also high, at 94% historical percentile. And these are just to name a few.
Investors do not believe stocks are overvalued as much as they believe the global economy is going to continue to grow, which would drive stock prices much higher. The evidence to support such a view is scant, as global economic data continues to deteriorate by the week. What is true, is that investors buying stocks at today’s prices are willing to accept a much lower return for the risk they are taking.
Facts aside, investors are no longer worried about valuations, as they truly believe the Federal Reserve has the magical ability to make stock prices rise indefinitely with their monetary wizardry. This too could not be further from the truth, as the Fed can only inject liquidity into an economy. Where the newly created money goes after the Fed eases, is up to investors to determine.
The Fed does not have the ability to rescue the economy or the stock market. If the Fed did, then by now they would have figured it out. Instead, the Fed continues to create asset bubbles on top of asset bubbles while hoping someday, somehow, it will all work out. Hope springs eternal when it comes to monetary policy, but no amount of monetary magic in history has created a perpetual economic expansion.
The monetary lags, or the amount of time it takes the economy to feel the effects of changes to monetary policy is long. While my earlier estimates pegged the monetary lag at 14 months, it appears others who suggested it was closer to 18 months are closer to the truth. Assuming the 18-month lag is correct, then the economy is starting to feel the effects of what the Fed did back in November 2017, which was the second month of Quantitative Tightening.
Further evidence the Fed can’t turn the economy is how Treasury yields do not bottom for more than two years after the Fed starts lowering the Federal Funds rate in response to a recession and six months or more after the stock market bottoms. With the Fed pausing their rate hikes and stopping their balance sheet unwind later this year, it should be clear to most investors that we are close to the Fed easing in response to an economic downturn.
The reason interest rates fall during recessions has to do with the design of our monetary system. Unlike other economies, as the world’s reserve currency the United States cannot print its way out of a financial problem. The Fed has the ability to raise and lower the Federal Funds rate and to increase or decrease the Monetary Base, but nothing else. The Federal Reserve Act of 1937 prohibits the Fed from printing currency. During recessions, when the money supply decelerates or contracts, asset prices along with interest rates fall.
The next big Bull market will not be in stocks, it will be in U.S. Treasury bonds, which rise in value as Treasury yields fall. Yields fall during recessions as lending demand falls. Interest rates are a function of lending demand, so when the growth rate of the money supply slows or contracts, the demand for lending falls with it, along with interest rates.
Unlike the last two recessions, the Fed will have to drive interest rates back to zero and use Quantitative Easing to take interest rates negative in order to save the U.S. economy from a deflationary crash. As a part of doing so, I believe the Federal Reserve will offer to buy 10-year Treasury bonds at an effective interest rate of zero percent. The Fed will be forced into doing this to inject currency into the economy, which will preferably go into risk assets, or stocks.
Due to all of the debt, I believe a massive deflationary shock is coming to the global economy. While I’ve been wrong about this call for a few years, global central bankers and governments have found creative ways to continue pumping currency into their economies in the hopes of propelling the current economic expansion even further. In a debt-based economy, such as ours and the rest of the world’s, more debt is needed to fuel an economy. There is a point where the financial system starts to fail and the economic growth engine stalls due to too much debt, which is what happened in the last two recessions.
Aside from U.S. Treasury bonds, which the “Smart Money” has been buying, the next big Bull market is in gold. The reason gold is going to start to rally and perhaps even go on a decade-long rally is that politicians and central bankers are going to face a huge problem during the next recession.
When the global economy deflates and asset prices fall, including stock prices, politicians and central bankers will have to choose between austerity and currency-printing inflation to reinflate the global economy. The reason there will not be much of a choice is that 72.5 million Baby Boomers will be facing the worst financial crisis in their lives.
In the past, there have been times countries have chosen austerity and it is not fun, but the countries that have chosen austerity often recover much quicker than those who choose to print their way out of a financial crisis. It is unlikely the United States will choose austerity because it will require 72.5 million retirees to accept lower Social Security payments, significantly higher Medicare premiums and lower pension payments, all while dealing with their retirement accounts slashed by half or more when the next Bear markets hits.
While the Fed is currently prohibited from printing currency, it is possible Congress will change the laws in the future to allow it. There is already talk in Congress about Modern Monetary Theory (MMT), which is neither modern nor a theory – it is just a form of currency printing. The idea behind MMT is to print enough currency to solve our financial problems.
The solution will be similar to our recommendations to Japan, who did not take our advice. The Fed cannot directly print currency, but they can buy an unlimited amount of obligations, or debt, of the U.S. Treasury. The U.S. Treasury could issue zero-coupon, zero-interest rate Treasury bonds with an infiltrate duration. This type of bond would not mature, nor would it require any form of regular payment. If the Federal Reserve purchased the bond and held it on its balance sheet indefinitely, then it would look and act like currency printing.
In order to spare the Baby Boomers, who will likely vote everyone out of office for failing to make good on their promises, the Fed and Congress will be forced to print currency. Inflation is a byproduct of an expansion of the currency supply, which makes hard assets, such as gold, rise in value.
The second big Bull market, which will run in tandem with the U.S. Treasury bond Bull market, will be in precious metals. Gold tends to front run currency printing schemes, which is why the “Smart Money” and global central banks have been buying large amounts of gold for the past five years.
For those who remain optimistic about stock prices, investors need to understand who has been buying and selling stocks since the Great Financial Crisis. Since 2009, foreign investors, retail investors and institutional money managers have been net sellers of stocks. Only corporations, who have been buying their own shares back, have been net buyers of stocks. Without corporations buying their shares back, the stock market would be nowhere near its current price level.
Over the past four years, corporations have been a net buyer of stock to the tune of $1 trillion and have purchased an estimated $1.2 trillion in stocks over the past fifteen months. Yet, in the past fifteen months, stock prices are roughly unchanged.
For the stock market to continue rising, corporations, or someone else, will need to keep buying stocks. In the past two recessions, corporations ran short on money and as they purchased fewer shares, stock prices fell. The Tax Cuts and Jobs Act of 2017 gave corporations a 20% tax cut, which largely went into buying stocks backs in the form of “stealth” Quantitative Easing since the Fed is prohibited from buying stocks.
Corporations do not have an unlimited amount of money to buy their stocks back. As the growth rate of the money supply decelerates, there is less currency in the system to support corporate earnings and profits. It is not possible for corporations to hit their double-digit earnings targets for the coming years when the growth rate of the money supply is half its normal rate on an annualized basis.
As the economic and credit cycle turns, investors hoping this Bull market in equities will continue will be disappointed. Even though the masses can be right for a while, the masses are never on the right side of the market. The public always buys near the top and sells near the bottom. If you are looking for the next Bull market opportunity, look at the asset class investors are shunning, such as U.S. Treasury bonds and gold.
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