To be or not to be - that is the question

The US Stock market has climbed to unprecedented levels, fueled by the Federal Reserve’s next-to-zero short-term interest rates and its quantitative easing policies on the one hand and the government’s coronavirus stimulus packages for threatened businesses and households on the other.

As yet very little inflation has appeared in the real economy, since the resulting excess liquidity in the money supply has been soaked up by the US stock market.

Nonetheless, a gigantic debt bubble has formed since the Trump administration’s tax breaks of 2017, and which has continued to swell unabatedly in tandem with the coronavirus’s gathered momentum. Of course, the government’s stimulus measures are intended to curb the mounting bankruptcies and home losses attributable to a failing economy and the unacceptable unemployment level, currently at 6.3%.

The Federal Reserve’s low interest rate policy has the central objective of stimulating business projects and home ownership, as well as the stabilization of the dollar’s purchasing power as the bedrock of sustainable growth. However, this policy over recent years is destined to hem-in any future Fed action to combat inflation if and when it exceeds the 2% level. This is because any raising of interest rates would increase the cost of servicing the government’s astronomical debt, not to mention the dire impact on business and private sector loans, thus jeopardizing the government’s attempts to kick-start the economy. In other words, the Fed is a lame-duck in its fight against the coronavirus black swan.

The data below shows that the US Federal Budget Deficit is $4.6 trillion and is on the verge of adding a further $1.9 trillion. With an interest burden of $394 billion, soon to climb higher, any measure to increase interest rates are likely to be highly restrained until there is clear evidence that the coronavirus is being defeated and normal economic activity is being resumed. 

So what are the chances that this undesirable paralysis of the Fed to control inflation will actually happen? As things stand inflation is contained, but there is a growing conviction that the stock market will not be able to sustain its upward momentum and fall into correction, or worse.

It’s common knowledge that pockets of the stock market, such as the internet, computer software, specialty retail, electronics and stay-at-home products have created a particularly lopsided highly inflated stock market whereby the price earnings ratios of many stocks have gone far beyond-the-pale of the S&P 500, which many experts would never have dared to think possible.

This table shows that the trailing twelve month price to earnings ratios of these representative ten S&P 500 stocks are considerably inflated, but disturbingly shows that their forward ratios are severely forecasted downward. For this to happen, either stock prices must be dramatically adjusted downward, or there must be an equally dramatic increase in earnings. Considering the current state of the economy, the most probable scenario is that the stock market will indeed suffer significant losses, which some experts say could be in the range of 40% to 80%!

The following chart of the S&P500 index shows that the index has a p/e ratio of 38.3, thus confirming the inflated prices of its constituent stocks, itself in an extreme bubble, compared to its long-term average of a little more than 15!

In the short run it is acknowledged that stocks can and do diverge not only from their own fundamentals, but also from the real economy in an irrational fit of exuberance. However, over longer periods earnings and their future forecasts together with a company’s unique set of competitive advantages combine to facilitate the process of deflation towards a stock's mean price reversion.

Further, the prices of real estate are closely linked to the stock market. Initially, the pandemic’s damage to the job market caused real estate defaults that grow daily. But should the stock market go into free-fall, the value of real estate will plummet that will rip through the banks due to what is called the collateral ratio into the economy’s other related sectors, with deflation wave after deflation wave fanning out just like a stone causes when you throw it into a pool of water.

At some point the deflationary winter of our discontent will come to an end, and the period of over-heating will begin.

Much of the Fed’s fiat money will have been incinerated in the stock market crash, but there will still be huge swathes of liquidity swishing around in the money supply.

The conundrum for the Federal Reserve is that if this scenario becomes reality a rise in interest rates would be needed to mop up the excess money supply to prevent inflation from getting out of control. However, such an increase in rates would raise the government’s costs of funding its debt, and at the same time will cause an additional surge in business and private bankruptcies, re-triggering a further bout of deflation.

In this sense, the irony is that the Federal Reserve has already become a lamed-duck from the point when the corona black swan emerged and rapidly spread its wings across the globe a year ago.

As a warning from history, a stock market feeding frenzy also existed from the late roaring ‘20s until the 27 August 1929 crash in spite of the fact that from 1928 onwards the market began, like today, to disconnect itself from the real economy to become more and more a speculative bubble as the real economy worsened and the gross domestic product shrunk. Contrarily, in the euphoria leading up to the stock market crash it was touted by President J. Edgar Hoover that the US economy had reached a plateau of sustainable prosperity, but instead the underlying deterioration was nothing less than the harbinger of the impending depression that lasted throughout the 1930s!

Thus the prevailing irrational exuberance has created a seriously over-priced stock market at the same time as the Corvid 19-driven real economy sinks further into recession, and which is perilously threated to fall into the abyss of a depression. Some gurus, such as Jeremy Grantham, David Hunter, Jim Rogers, Peter Schiff, and Harry Dent are saying that the stock market could suffer up to an 80% loss.

So should the US economy, like Hamlet said, ‘suffer the slings and arrows of outrageous fortune, or to take up higher interest rates, and by opposing end them. Is this 'a consummation devoutly to be wished'? I guess we’ll just have to wait and see!