If you live by the sword, you die by the sword, or so the saying goes (or a variant of it). Perhaps more true is this: If you live by the central bank, you die by the central bank.
This may be something that stock investors should pay attention to.
Zero Hedge recently ran an article discussing Deutsche Bank’s calculation of how much the S&P 500’s value is due to central banks. The conclusion is that central bank policy is responsible for about 40% of the total value of the S&P.
Therefore, if this is true, a return to normal would result in a massive drop in the index to somewhere around 1,400. It is currently close to 2,200.
The article gets a bit technical and really focuses on interest rates. It is true that low yields can help drive up stock prices, as people look for higher yields. The low yields drive people into taking bigger risks than they otherwise would.
My only issue with this is that central banks are not currently driving the low interest rates, or at least not directly. It is the Federal Reserve’s prior policies that are largely responsible, but its actions today (or lack of actions) are not directly driving the low rates.
QE3 ended in October 2014 – almost 2 years ago. The Fed has not been buying government debt except for rolling over maturing debt. Therefore, the Fed is not directly holding down interest rates. It is private buyers or foreign central banks that are keeping rates low.
In fact, if the Fed “raises rates” – which means increasing the rate paid on bank reserves – it could actually lead to lower market rates. It could drive more fear. It could lead to investors seeking to lock in longer-term rates for fear of an economic slowdown.
I think the big factor here is the money supply. The Fed increased the adjusted monetary base by a factor of almost 5 from 2008 to 2014. While much of this money has been bottled up in bank reserves, it is inflationary nonetheless. Just because we have not seen big consumer price inflation, it does not mean that we don’t have asset bubbles.
The Fed has had a tight money policy for almost two years, despite what you may hear from others. The Austrian Business Cycle Theory tells us that this tightening will eventually expose the malinvestments from the previous artificial stimulus.
This should be the biggest concern right now for stock investors. Maybe the really low yields have contributed to this stock rally lasting longer than it normally would. But if it is unsustainable – which I believe it is without more monetary stimulus – then it will eventually turn.
In other words, unless the Fed fires up more QE or the banks start lending massive amounts of new money, then the stock market bull days are numbered. Maybe it will hang on for another 6 months or a year, but extreme caution is recommended at this point.
The earnings, or lack of earnings, are not justifying these big rallies in stocks.
It is also interesting to note that stocks live off of monetary inflation in the first place, especially over the long run. In a world without any significant inflation, the broad stock markets generally wouldn’t go up much, if at all. People would own stocks for dividends. Individual stocks would go up and down, but the overall market would not trend up, at least in nominal terms. People would buy index funds for the purpose of dividends and increasing purchasing power.
Stocks have lived off of central bank inflation for the last 7 years. They are going to die from the central bank’s tight money (which is the correct policy).
If stocks crash, then we can expect the Fed to step in and start its digital printing press again. Then we can start the whole cycle all over again. It seems to get more extreme each time.