Be careful about touting stock prices as a sign of Trump’s success, because the Fed is about to squa

By —— Bio and Archives--January 17, 2018

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Be careful about touting stock prices as a sign of Trump's success, because the Fed is about to squash them
If all you want to do is grab onto anything that helps you win an argument today, then sure, the 26,000 peak the Dow just hit is yet another indication of Donald Trump’s economic success. It’s never been that high, and at least some of the current market rise seems tied to the reality of what the corporate tax rate cut is going to do to corporate after-tax earnings.

That’s a more real and sustainable increase than momentary reactions to tangentially related items in the news, or the equivalent market drops when traders start panicking about something. That sort of thing usually corrects itself quickly. When stock prices are on the rise because corporate earnings are rising and likely to stay on the upswing, that’s real and worth noting.

But . . . markets still rise and fall, and when they get too overheated, they always correct themselves. Sometimes the correction is jarring. Sometimes you can’t see it coming.

But sometimes you know something’s about to happen that will almost certainly bring about a correction, and this is one of those times. We’ve talked many times in this space about how the Federal Reserve has kept interest rates artificially low since the 2008 mortgage market meltdown. The Fed also went on a buying binge, acquiring bonds and securities like never before in the hope of helping to stablize markets and give the economy time to recover.

We can debate all day long whether this was the correct role for the Fed, or whether then-Chairman Ben Bernanke employed the correct strategies to bring about the economy’s recovery. We never did see robust growth during the Obama years, which we attribute mostly to Obama’s own anti-growth policies. But one consequence of that is that the Fed kept interest rates awfully low for an awfully long time, and it built up quite a balance sheet.

Neither of these situations can endure forever, and the Fed has already signaled the long-overdue correction is likely coming this year. In today’s Wall Street Journal, economist Martin Feldstiein - who was chairman of the Council of Economic Advisors under President Reagan - explains why this will almost certainly trigger a stock market correction:

To deal with the Great Recession, the Fed cut interest rates to a historic low. The short-term federal-funds rate hit 0.15% in January 2009 and stayed there until the end of 2015. In a strategy aimed at reducing long-term rates, the Fed under then-Chairman Ben Bernanke promised to keep short-term rates close to zero until the economy fully recovered. The Fed also began buying long-term bonds and mortgage-backed securities, more than quintupling its balance sheet from nearly $900 billion in 2008 to $4.4 trillion now.

Mr. Bernanke explained that this “unconventional” monetary policy was designed to encourage an asset-substitution effect. Investors would shift out of bonds and into equities and real estate. The resulting rise in household wealth would push up consumer spending and strengthen the economic recovery.

The strategy eventually worked as Mr. Bernanke had predicted. The value of equities owned by households increased 47% between 2011 and 2013, and overall household net worth rose nearly $10 trillion in 2013 alone. The S&P 500 stock index gained more than 200% in the seven years from 2009 to the month before the 2016 election. By now the total increase is more than 300%.

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Stock prices rose much faster than profits did. The price/earnings ratio for the S&P 500 is now 26.8, higher than at any time in the 100 years before 1998 and 70% above its historical average. Although some of the market’s recent surge reflects improved expectations since the 2016 election, the P/E ratio just before the election was already 49% higher than its historical average.

The high price of stocks reflects the very low returns available on fixed-income securities. Though the federal-funds rate has been raised since 2015, its real value is still negative. The 2.5% yield on 10-year Treasury bonds approximately equals expected inflation over the next decade, implying a real yield of zero. Historically the real yield on 10-year Treasurys was about 2%.

When interest rates rise back to normal levels, share prices are also likely to revert to previous norms. If the P/E ratio declines to its historical average, the implied fall in the market would reduce the value of household equities held directly and through mutual funds by $10 trillion. If every dollar of decline in household wealth reduces annual consumer spending by 4 cents, as experience suggests, spending would fall by $400 billion, or more than 2% of gross domestic product. The drop in equity prices would also raise the cost of equity capital, reducing business investment and further depressing GDP.

Well that’s a Johnny Raincloud perspective, isn’t it? But it’s not something we should refuse to listen to. It’s reality.

When your household wealth is measured by your stock portfolio, it’s mostly theoretical. You would only actually have access to that wealth for spending purposes if you sold your portfolio on that given day. Markets rise and fall. If you’ve ever invested in a mutual fund, you’ve probably experienced the incredible high of seeing it soar for weeks on end, making you think, “I’m rich!” . . . only to have your heart sink as it then proceeds to fall back to where you started.

That’s the nature of investing, and it’s the nature of financial markets. When stock prices are rising faster than profits, the market is going to correct, and people’s theoretical wealth will be revealed to be far less than their actual wealth.

But here’s the good news: The economy’s real growth drivers are in place. The real value of investments will rise as corporate earnings rise, and both the corporate and individual tax rate cuts are going to spur that rise in earnings. The mistake we sometimes make is in thinking that when the stock market is soaring, that’s incontrovertible evidence of real wealth creation. It’s not. It only reflects the demand for certain stocks at a moment in time, and the next moment may very well bring a change in that demand for all kinds of reasons - some of them more rational than others.

I believe we can still achieve 4.0 percent growth on a consistent basis if we continue to pursue growth-friendly policies. But it’s not going to come from one overheated explosion in stock prices. And those who want to tout the success of the Trump economic agenda need to understand that putting forth the 26,000-level Dow can be turned around on you in a month or two when it’s fallen to a much more realistic level (if it even takes that long).

By the way, here’s another impact of rising interest rates: Deficit spending by the federal government is usually refinanced every few years. For the past decade or so, interest rates have been artificially low so the government has been able to refinance its borrowing very cheaply. When interest rates return to more realistic rates, you’re going to start seeing a huge spike in that budget line item known as Interest On The Debt. In 2017, we spent $266 billion paying interest on our debts. That is not a small number. In fact, it’s more than half the deficit.

But that’s an artificially low number. When the Fed finally raises interest rates, the cost of interest on the debt is going to soar, and that will put a lot more pressure on the federal budget than the tax cut.

The economic news is generally good, but there are landmines out there and we’re going to have to deal with them at some point. The coming corrections by the Fed are first up.

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Dan Calabrese -- Bio and Archives | Comments

Dan Calabrese’s column is distributed by HermanCain.com, which can be found at HermanCain.com

A new edition of Dan’s book “Powers and Principalities” is now available in hard copy and e-book editions. Follow all of Dan’s work, including his series of Christian spiritual warfare novels, by liking his page on Facebook.

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