It’s been a similar story over the last five years, as the U.S. stock market roughly doubled and the bond market increased more than 60%. During these five years, the official estimate of nominal (before-inflation) Gross Domestic Product growth in the U.S. was less than 20%.
How does an economy with 20% nominal growth over five years see a 100% stock market gain over the same period? And how does a strongly rising stock market coincide with a strongly rising bond market (traditionally associated with weak economies and markets) over the same period? The answer to both questions is the same: easy money. It has been well known for generations that speculative monetary activity can generally - to a point - be increased by both increasing the money supply and lowering interest rates.
With lower interest rates, certain economic activities that would not have been feasible at higher, normal interest rates become “reasonable”. Ten years ago very low (or no) interest adjustable-rate mortgages seemed reasonable to policymakers, lenders, and borrowers in the midst of the real estate and financial market melt-up of the mid-2000s. Today, stock market valuations near historic highs seem reasonable based on ultra-low interest rates. In turn, zero and even negative interest rates that fly in the face of logic seem reasonable in an era of united and unlimited Central Bank money-creation and bond buying.
The Federal Reserve has also used easy money - or the threat of easy money - to manage stock market declines. We saw that earlier this year, the Federal Reserve did not raise short-term interest rates in March (or April, May or June either) despite strongly outlining such intentions to do so just months and weeks earlier. The Fed’s explicit intention in December was to raise rates by .25% or so every quarter of 2016. It reiterated such intentions in the early part of 2016, but after a modest decline in the financial markets, those rate rises were taken off the table.
And it did not hold off on those increases because of weak or negative economic growth. Real (after-inflation) economic growth was said to have been 2.0% for the last quarter of the year and 2.1% in the first quarter of 2016, both roughly in line with average growth over the previous five years. During the same periods, the unemployment rate continued to fall. So clearly it wasn’t the economy that had changed so much that it necessitated an about-face for the Fed and interest rates.
No, the motivation to abandon the Fed’s intentions came primarily from the stock market, which corrected about 13% over the first couple months of 2016. In the past, such a stock market decline would not have been enough to change monetary policy. However, because of the degree to which today’s economy is dependent upon the financial markets, the Federal Reserve was unwilling to let the stock market decline further. So to rejuvenate the stock market, the Fed showed its true colors and gave in to the bankers and Wall Street.
The Federal Reserve has two stated, official, economic goals (a “dual mandate”): to maximize employment and to stabilize prices. But while inflation and employment may still be considerations to the Federal Reserve, it has become much more of a micromanager into the financial markets to achieve those goals, and others. Several years ago I read an article in a business magazine about the activities of then Federal Reserve Chairman Ben Bernanke. The article described Mr. Bernanke’s work environment and commented that he had three Bloomberg terminals in his office with real-time quotes on nearly every financial market desired in the U.S. and overseas.
I found it curious that someone who is supposed to be concerned about long-term trends in the economy – specifically inflation and unemployment – would need to know the up-to-the-minute levels of the various financial markets from around the world. What I gathered from that was that the Federal Reserve, though it professes to be interested in long-term trends in the economy and inflation (and perhaps was in years past) has come to be acutely interested of every aspect of the financial markets. And not just interested in the markets either, but making every effort, through interest rate and financial market manipulation as well as jawboning through the media its intentions and expectations of the financial markets.
Every stock trader is hoping for lower interest rates and fears higher ones. The former leads to more speculation and generally higher financial markets (at least in the short run), while the latter, leads to risk aversion. It’s interesting when politicians and even Federal Reserve officials complain about income inequality in America, when they directly control the amount of money and speculation flowing through its financial markets, and the resulting reallocation of financial assets from such actions. If Federal Reserve officials were truly concerned about inequality in America, especially financial asset inequality, they would allow the money supply and especially interest rates to revert to natural levels. In other words, markets would decide where interest rates belong, not unelected quasi-government officials.
The reason they don’t is because of fear. Fear of what taking some juice out of the stock, bond, and other financial markets would do. Either they are simply afraid of upsetting their fellow bankers and others in the financial markets, or they really do believe that the U.S. economy cannot function well without high levels of speculation in the financial markets. More than any economic indicator, I believe those two factors have the most influence on Fed policy.
By the government’s own reckoning, nominal Gross Domestic Product has risen less than 20% over the last 5 years. But at the same time, the U.S. money supply (M2) has expanded more than 40% (see graph below).
Where has that extra money supply gone to, if not the real economy? We all know the answer. When interest rates are pushed to artificially low levels and money supply is similarly increased, money will flow into near every financial sector imaginable: Treasury bonds, corporate loans, housing, stock and bond markets, commodity markets. All of these markets and more have been the beneficiary of such money printing. And as the volume of money rises beyond productive uses for that capital, buyers become increasingly indiscriminate as to what financial assets they buy. The result is higher prices, which ironically is what the Federal Reserve is supposed to protect against.
The median price-to-sales ratio of the U.S. stock market recently reached the highest level ever recorded, and the stock market as a whole in the U.S. is at roughly 50%-100% higher than average historical valuation measures, based on reliable valuation metrics (for more on where the stock market is currently based on historical valuation metrics I again refer you to the fine work of John Hussman.
Government bond yields are near all-time record lows, as are corporate bond yields. And the riskiest of those bonds, high-yield “junk bonds”, have soared as well over the years, to the point where their yields are below what in the past could have been earned with nearly zero risk. Commodity speculation has also been alive and well over this economic cycle as oil, gold and many other commodities soar, crash and recover amid cycles of speculative fervor and exhaustion.
I believe the Federal Reserve now sees itself as the market manager, allowing froth on the upside, but through monetary policy and manipulation of the financial markets, preventing even modest market corrections. Below is a graph of U.S. market declines going back to 1940. There were 36 declines of 10% or more during this 76-year period, or roughly one every two years. Specifically, there were six in the 1940s, five in the 50s, five in the 60s, seven in the 70s, four In the 80s, two in the 90s, three in the 2000s and three thus far in the 2010s. (There are sometimes multiple corrections in a single year, if the latter is proceeded by a brief market recovery.)
Twelve of those declines were greater than 20%, meeting the standard definition of a Bear market. However, four others were “near-Bears”, declining 19%. Adding those near-Bears to the official Bear markets and we get sixteen, or roughly one Bear Market every four and a half years. Big Bear markets, those declines over 30% have occurred six times over the last 76 years, or about once every twelve years (although five additional 30%+ declines occurred in the decade preceding these statistics, the period of 1929-1939).
Notice that after the Big Bear market of 1940 (a 35% decline), there was not another decline over 30% until 1968, a twenty-eight year gap. Instead, what we see are more frequent, smaller corrections, fourteen to be exact. For much of this period the markets and the economy were growing strongly. But the frequent corrections (averaging one every two years), allowed some of the excess and froth to be let out of the stock market. Despite the frequent modest declines, this period of 1940 to the mid-1960s was the least volatile stock market in the last century, from the perspective of avoiding devastating market crashes.
In the 1990s we saw very different volatility from earlier periods. There were only two corrections in the entire decade (and fairly minor ones that, not even reaching the official definition of a Bear market). But as we all know now, there was plenty of stock market froth building under the surface. Federal Reserve Chairman Alan Greenspan spoke of froth and “irrational exuberance” in the financial markets as early as 1996, and within a couple years financial and speculative excesses would be glaringly obvious to the most casual observer.
The stock market correction of 1998 resulted from the failure of the Long-term Capital Management hedge fund and would likely have turned into a significant Bear market as excesses were shaken out of the market. Instead, the Federal Reserve panicked and sharply lowered interest rates. That fueled the last and most speculative burst of the stock market bubble in the 90s. Two years later, the market would have its say, in the form of a nearly 50% decline overall (and much steeper 70%, 80% and 90% losses in the more speculative area of the marketplace, notably technology stocks). A similar scenario followed over the following years as there was only one minor stock market correction over the following seven years, but which was then followed by a 56% market decline.
The 20-year era of extreme valuation and extreme market crashes continues today as financial markets march far in advance of economic growth or logic. Over the last 20 years we have seen massive stock market crashes because Fed officials allowed and encouraged speculation to reach dangerous levels. It is no accident that based on reliable valuation measures the two most expensive stock markets in the last 80 years were in 2000 and 2007, just prior to devastating declines. In the last year, there have been two minor stock market corrections, but because of ultra-loose monetary policy (i.e., near-0% interest rates and massive money-printing), the U.S. stock market has reached similar extreme valuation levels with 2016 levels now comparable to 2000 and 2007 (I refer you again to John Hussman’s work).
Geologists understand that it is primarily the many small earthquakes that ease the pressure from colliding faults. For every large earthquake there are thousands of smaller ones dissipating energy. If not for so many small earthquakes, larger ones would be both more frequent and more powerful. If scientists were somehow able to “manage” the earthquake environment, and prevent some small and moderate earthquakes from occurring, there might be fewer earthquakes overall but the ones that remained would be that much more devastating.
Monetary policy is increasingly being used to guard against Bear markets and market corrections, but the problem with such intervention is that eventually it fails. The Fed was excessively praised for easy monetary policy during the 1990s until the market crashed. Ditto in the 2000s. Things work until they don’t. When markets are held or pushed too high, the ultimate crashes are that much more extreme.