The Shiller’s cyclically adjusted price-to-earnings (CAPE) ratio for the S&P 500 currently stands at 34.66. This alarming figure indicates that the stock market may have completely lost touch with economic realities, surpassing the 31.48 ratio recorded in 1929, just prior to the stock market collapse and the onset of the Great Depression.
However, this isn’t a record high. The CAPE ratio has been higher on two occasions: in December 1999, during the dot-com bubble, it peaked at 44.19, and in October 2021, it reached 38.58.
To clarify, the CAPE ratio assesses stock prices in relation to their average earnings over the past decade, adjusting for inflation. This offers a long-term perspective, smoothing out annual fluctuations in earnings.
According to the current CAPE ratio for the S&P 500, stocks are extraordinarily overpriced. While this doesn’t imply an imminent crash, it does indicate that stocks are quite risky at present valuations. There is a possibility for prices to rise further, but the reward-to-risk ratio is highly unfavorable.
As the U.S. economy slows down towards summer, lingering inflation could push us into a period of stagflation—a scenario marked by rising unemployment alongside increasing consumer prices.
Given the current extreme valuations of stocks, a slowdown in the economy combined with a credit crisis could be the catalyst that bursts this bubble. We might see stock prices drop by 20 to 30 percent by year’s end, or possibly more. Regardless, any actual losses may be concealed by inflation.
Yet, central planners appear to remain oblivious to these looming issues…
A Theoretical Contradiction
Federal Reserve Chair Jerome Powell recently brushed aside concerns about stagflation, claiming he doesn’t see “the ‘stag’ or the ‘flation’.” This is surprising coming from someone who insisted that inflation was “transitory” back in 2021 when it was rapidly reaching a 40-year peak.
Powell seems to rely solely on government-generated statistics, failing to grasp the more extensive economic picture. A simple cross-country road trip could serve as a reality check for him, as would a review of history.
For instance, in the late 1970s, inflation and unemployment spiked simultaneously—something economists had previously deemed impossible. Their theoretical frameworks led them to believe that these two variables could not coexist.
The Phillips curve traditionally illustrates an inverse relationship between inflation and unemployment. When unemployment falls, inflation rises; conversely, when unemployment increases, inflation decreases.
However, the framework does not account for the rare occurrence of both inflation and unemployment rising together. When economist William Phillips first charted his curve using data from the UK between 1861 and 1957, it painted a picture of systematic order. It also provided a model for policymakers to optimize inflation and unemployment through intervention.
Yet by the late 1970s, excessive monetary intervention by the Fed and rampant deficit spending from Congress led to conditions that contradicted this theory. When unemployment began to rise in the late 1970s, policymakers, under the guidance of Keynesian principles, ramped up the deficit to stimulate the economy.
Rendered Ineffective
According to Phillips’s curve, rising unemployment should allow policymakers to stimulate the economy without causing inflation. Instead, the opposite occurred: stimulus measures failed to create jobs and instead fueled inflation.
This situation serves as a cautionary tale, highlighting the pitfalls of deriving economic theories purely from empirical observations. The realities of an economy are complex and often unpredictable. One decade, people may spend freely, while in another, they choose to save and pay down debt. No theoretical model can accurately forecast such shifts in consumer behavior.
Additionally, this era illustrated how outdated datasets could misrepresent the relationship between inflation and unemployment. Following the 1971 abandonment of the gold standard, previous relationships became distorted.
Logically, rising unemployment should signal economic decline, which would typically drive inflation down. Yet, the experience of the late 1970s contradicts this expectation—an alarming sign for today’s policymakers.
The Federal Reserve appears to be banking on a weak economy to help curb inflation back to their arbitrarily set target of 2 percent, with timing meticulously calculated to precede the elections to bolster Biden’s chances. Powell likely understands the stakes involved amid potential political change.
This Inflation Narrative Won’t Endure
This week’s CPI report revealed a 0.3 percent increase in consumer prices for April, translating to a 3.4 percent rise over the past year. This annual increase is 70 percent above the Fed’s target of 2 percent.
At an annual inflation rate of 3.4 percent, the dollar’s purchasing power is halved every 15 years. However, the signs of severe dollar debasement are evident almost immediately—just since March 2020, following government shutdowns and massive monetary influx, the CPI has surged from 258.115 to 313.548, representing a 21.5 percent increase.
Despite this, Wall Street interpreted the latest CPI data as a signal for the Fed to cut rates. Following this report, the DOW, S&P 500, and NASDAQ reached record highs, with the DOW exceeding 40,000 for the first time. What is driving this phenomenon?
In essence, this manipulated CPI information has been tailored to align with the Fed’s agenda. By indicating potential rate cuts, the Fed is boosting stock prices, which benefit government revenues. Inflated stock valuations lead to increased tax revenues necessary to manage their mounting debt obligations.
With net interest on the national debt approaching $1 trillion annually, Washington can ill afford a decline in stock prices, as President Biden aims to raise capital gains taxes to 44.6 percent. A downturn in the stock market would undermine this revenue stream, compounding fiscal challenges.
The current inflation and interest rate narrative may unfold as the planners intend, at least for the moment. However, the slowing economy and rising unemployment indicate that we may soon face a new period of stagflation—an unavoidable reality that will ultimately disrupt the scripted narrative.
A lagging economy, increasing unemployment, and a declining stock market amidst $2 trillion in deficit spending will not slow the pace of consumer price inflation as the Fed’s adherents anticipate. Instead, it may ultimately intensify it.
As income tax and capital gains tax revenues fall and renewed stimulus measures take hold, deficit spending will only grow, alongside consumer price inflation.
[Editor’s note: These developments are reminiscent of trends that have been unfolding for roughly 25 years. Recognizing this trajectory is crucial if you wish to leverage economic recessions for investment gains. If you’re interested, I’d like to share my journey with you. >> Click Here to discover how to build investment wealth during recessions.]
Sincerely,
MN Gordon
for Economic Prism
Return from This Inflation Script Won’t Last to Economic Prism
