After the Flood

We’re still feeling the effects of a massive increase in the money supply.?

A few weeks ago, I was speaking to a group of advisors at a prestigious investment firm. In the middle of my presentation, I veered from my prepared remarks and asked for a show of hands in the crowd from those who were bullish about stocks. Out of about 300 advisors, not a single hand went up. Maybe they weren’t listening to me. I get that a lot. In this case, though, I think it represents the foul mood permeating Wall Street.??

And that begs the question: Given such negative sentiment, how can we still have an expensive stock market?

With government and corporate bonds offering the highest yields in years, those who think a recession is coming may typically sell stocks and buy bonds. But that repricing doesn’t seem to be happening. The current overall price/earnings (P/E) ratio of the S&P 500 Index is around 17 (based on 12-month forward earnings).1 Historically, P/Es fall to a range of around 12 to 14 during economic downturns.2?

Maybe the bulls are less vocal and voting discreetly with their wallets. There’s a large difference between bearish investor survey results and the relative bullish equity allocations of many diversified products and institutional portfolios. Or maybe, as academics would argue, the high P/E ratio is just a reflection of how risk is being priced by fully rational investors.

I think there’s another explanation: The flood of money into the financial system in the past few years remains an important factor in keeping stock valuations elevated.

The chart below, depicting the surge of the unprecedented rise in money sitting in banks, shows the extraordinary amount of liquidity that was released into the economy in 2020. Other metrics, such as M1 and M2, show a similar picture.3?

“No individual raindrop ever considers itself responsible for the flood.”—John Ruskin

Where did this flood of money come from? Early in the pandemic, the Federal Reserve turned the monetary policy valves wide open by bringing short-term rates to zero and ramping up its purchases of long-term government bonds—otherwise known as quantitative easing. Then, Congress and two successive administrations raised the fiscal floodgates in the form of:

• Enhanced unemployment benefits
• Close to $800 billion in Paycheck Protection Program loans to businesses (over $700B of which were forgiven)
• Over 400 million checks of over $1,000 sent to Americans as direct payments
• And more (student loan relief, aid to states and municipalities, etc.)

As Figure 2 shows, the amount of stimulus, or “free money,” injected into the economy in 2020 was a massive outlier by historical standards. The pullback this year has also been unusually sharp but not nearly of the same magnitude.

Draining the waters will take time?

To be sure, liquidity is receding as the Fed raises rates and fiscal conditions tighten. But here’s a thought experiment: Suppose a rich uncle gives you $1 million. That would be a staggering amount of “stimulus” that would increase your consumption and would probably entice you to invest—and hopefully not some speculative non-fungible tokens or exotic crypto coins.

Now, suppose your uncle reconsiders (perhaps after a contentious Thanksgiving dinner) and asks you to give him back $300,000. According to market pundits, that would be “an unprecedented withdrawal of liquidity.”

But what would be the net effect on your consumption and propensity to buy financial assets? While you might be unhappy for a bit, you’re still up $700,000! I’d argue that’s not that different from the position the broader economy is in now. Some of us are grumbling about inflation and worried about the future, but we keep spending.?

In other words, change in the money supply matters, but so does the level of money supply. We’re currently spending a lot of time analyzing how these forces are pulling inflation and the economy in different directions, but I think many investors are not paying sufficient attention to how much money is still out there. The level of money helps, in part, explain persistent inflation.

I want to be clear: Many Americans aren’t sitting on extra cash. The data shows that consumers are adding to credit card debt with balances having increased 15% year-over-year.?

But we haven’t drained all the liquidity. As a member of our Asset Allocation Committee noted at our recent monthly meeting, the amount of money still in the system is creating higher-end consumer and corporate balance sheets that are relatively insulated from higher interest rates. It’s a recipe for sticky inflation—as he puts it, “there is still too much money.”

We’re “selectively contrarian”

I believe the best strategy is to tread carefully in this muddy landscape—to be “selectively contrarian,” as my colleague, emerging market debt investor Samy Muaddi, terms it. Overall, stocks still look expensive due to being submerged in high levels of liquidity. As I explained in a previous post, however, relative valuations for value stocks, small-caps, and high yield bonds seem to be pricing in an overly pessimistic, gloom-and-doom narrative. We’re maintaining our underweight in equities, but we’re leaning in to some undervalued markets.

References

1As of November 18, 2022. Sources: Standard & Poor’s; financial data and analytics provider FactSet. Copyright 2022 FactSet. All rights reserved.

2The forward 12M P/E on S&P 500 dipped to below 14 during the COVID recession and to around 9 during the 2008 recession. Sources: Standard & Poor’s; financial data and analytics provider FactSet. Copyright 2022 FactSet. All rights reserved.

3M1 refers generally to currency in circulation, while M2 also includes short-term bank deposits. For a more detailed description, see https://www.federalreserve.gov/releases/h6/current/.

?As of Q3 2022. ? 2022 Federal Reserve Bank of New York. Content from the New York Fed subject to the Terms of Use at www.newyorkfed.org

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