In my previous three posts, I examined the pricing fundamentals of the US stock market. In this post I will look at possible explanations for the pricing.
- Don’t fight the Fed
The argument here is that the Fed is active in monetary policy to offset the negative effects of the recession. In the recessions of 2001 and 2008, interest rates were around 6% and could be slashed giving a huge boost to the economy. In addition, in 2008, the Fed began its expansion of its balance sheet and continued it with QE in 2010.
In the recession of 2020, the Fed’s tools are more limited but it is fair to say they are using them as aggressively as they can and have managed to get long term interest rates to fall despite the vast surge in government debt issuance. The question remains of why the Fed will be so much more effective now than in previous recessions as the forecasts and pricing suggest.
The argument that yields have fallen and so the yield on all assets should follow is decent and intuitive but doesn’t explain why pricing is so much more optimistic than in previous recessions. In the other recessions of 2001 and 2008, we also saw sharp falls in interest rates but the impact of the drop in growth and thus earnings vastly overwhelmed this. The argument to justify the current situation would have to be rather different, that earnings will not drop very much (unlike previous recessions) and that Fed intervention will be huge and long-lasting, despite a rapid recovery of the economy.
It is true that Fed intervention this time around is truly monumental, the increase in the size of their balance sheet is over $3trn in the past quarter alone. If you can remember as far back as the Global Financial Crisis, the increase of $1trn in the balance sheet was seen by many as dangerous and would inevitably lead to hyperinflation. It may indeed be true that this huge intervention has flowed through to other asset markets, driving this stock market rally, but I do not expect the rise to be permanent. I do not expect the Fed to keep buying $3trn a quarter in financial assets to support the markets, particularly if the analysts are correct in expecting profits to immediately bounce back.
- Private investors
This is an argument I find rather appealing. Fiscal transfers from the US government, in response to Covid, have been massive but poorly targeted. For example, the PPP (Payroll Protection Programme) came in the form of forgivable loans which did not have to be fully spent on payroll. Much of $500bn PPP has been in effect gifts to affluent people who do not need it to support spending.
Overall transfers from the government have been over $1trn, whilst spending has fallen by nearly $400bn. This leaves a lot of extra cash sitting in the bank accounts of affluent people and since they are not spending it, they are investing it. I would suggest in equities and putting that much money into the US market in a short time is going to have a large impact on the price.
Looking more closely at the typical small investor in the US, there has been a recent move to choosing their own stocks. They will tend to pick stocks they have heard of, that has been rising rapidly, that is sexy. They buy tech stocks like Amazon, Apple, Google, and Facebook. They even buy Tesla because Elon Musk is so often in the headlines and he makes it sound like a tech stock.
This is a classic bubble environment. A rapid influx of new money causes a spike in prices, whether it is art, vintage cars, fine wines, or stock markets. Tesla is now worth more than all the other car manufacturers in the world combined while producing less than 1% of the cars. It takes a lot of effort to find a fundamental rationale for that.