A crisis appears to be on the horizon. While stocks have soared to unprecedented levels over the past five years, many view this as a sign of triumph — we consider it a warning signal.
Somewhere along the way, the stock market has diverged from the actual economy. In essence, the economy has stagnated while the stock market has surged. The uncertainty of what lies ahead is palpable.
Stocks may continue their upward trend, remain stable, or gradually decline. However, much like an errant satellite, we fear a swift disintegration could occur.
Wall Street’s prevailing logic suggests that with the Federal Reserve injecting $55 billion monthly into the economy and maintaining an almost nonexistent federal funds rate, inflated stock prices are here to stay. The popular belief is that a significant drop is not feasible. Naturally, we have our doubts.
We recognize the reasoning behind the Fed’s support of the market. The abundance of cheap credit and liquidity promotes risk-taking and elevates stock prices. Yet here at Economic Prism, we also have faith in the principle of gravity.
Matchstick Investing
Over time, cheap credit transforms risks from calculated bets to reckless gambles. Initially, shares of profitable companies yielding around 3% get pushed up in value. Soon, however, investors begin borrowing to stake claims on speculative assets, such as Twitter shares.
Consider this: the Russell 2000 is currently trading at over 80 times its earnings. Yet, speculators are eagerly scooping up these volatile stocks, convinced they can sell them to others at inflated prices before getting burned. What do we make of this trend?
“Stock prices have reached what looks like a permanently high plateau,” predicted economist Irving Fisher on October 17, 1929. Tragically, what he considered a plateau turned out to be a peak. Just days later, the stock market crashed, along with his fortunes and reputation.
An epic downturn may not be inevitable this time around, but the possibility looms large. This is particularly true given that the relentless rise in stock prices has been fueled by vast amounts of credit and debt.
Recent figures from the New York Stock Exchange reveal that margin debt has hit a new high of $451 billion. This surpasses the previous record of $381 billion set in July 2007. Recall that shortly thereafter, the S&P 500 plummeted by 56.4% between October 9, 2007, and March 5, 2009.
The End of Carte Blanche Bailouts
On the way up, debt can amplify the rise of stocks beyond their natural limits. However, if the trend reverses, it can trigger a catastrophic decline. This is the downside of excessive margin debt.
Such significant margin debt compels investors to rapidly liquidate their holdings, leading to a cascading sell-off. The ensuing panic creates a self-reinforcing cycle, resulting in a rush for the exit and a subsequent crash in stock prices.
Perhaps the Fed can sustain the bubble a bit longer. Their ability to maintain this inflated market for so long is commendable. Nonetheless, the reality is that the market will eventually correct itself — it must. But what then?
This time around, the Fed has failed to significantly stimulate consumer demand. A genuine economic boom, akin to the housing surge of the early 2000s, hasn’t manifested outside the stock realm. The lesson learned by Main Street from the Great Recession is clear: you cannot borrow your way to success.
Regrettably, stock market investors appear oblivious to this truth. Once again, they have leveraged large amounts of money to speculate on stocks. Their fortunes are precarious, and soon their paper gains may translate into real losses.
In the aftermath of the next downturn, the public may hesitate to grant the Fed and Treasury unrestricted authority to bail out major banks. Still, history suggests they will attempt it once more, likely for the final time.
Sincerely,
MN Gordon
for Economic Prism
Return from The End of Carte Blanche Bailouts to Economic Prism
