By Dan Calabrese ——Bio and Archives--January 17, 2018
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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%.
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.
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