I recently explained why we were in Stage One of a secular bull market – the stage, comparable to the early 1950s and early 1980s, when bears capitulate and investors begin to embrace equities. In the second stage stocks continue to grind higher but with greater volatility as PE ratios rise, the Fed tightens, and recession risks increase; the years 1956-66 and 1987-93 fit this template. Then there is a euphoric “blow-off” phase a la the late 1920s, 1968-72, and the late 1990s.
How does Yellenomics fit into this? Her dilemma is that Fed policy is keyed to the labor market, but employment is being strangled by tax and regulatory policy, which the Fed can’t undo. Tax hikes on employers, the war on banks, the war on fossil fuels, Obama’s anti-capitalist rhetoric, and a dearth of pro-growth policies (such as corporate tax reform) are deterring hiring. And next year businesses won’t be eager to hire as they grapple with the chronic catastrophe known as ObamaCare.
One indication of how Obama has “Europeanized” the U.S. labor market is the employment/population ratio. After averaging 62.7% from 2003 to 2007 this metric plunged to 59.3% by mid 2009, when the recession ended. In the “economic recovery” since then it has actually declined further, to 58.3%. Even Larry Summers admits this is a disaster, though it does not occur to him that Obama’s policies are the culprit. Whatever the cause, Yellen is dealing with a devastated labor market.
To counteract Washington’s war on jobs Bernanke has Fed funds at zero and is buying $85 billion in bonds each month. These policies are appropriate for a financial panic and recession but are way too aggressive four years into an economic expansion, when ISM surveys are in the mid-50s, housing is recovering, auto sales are strong, the stock market is soaring, corporate profits are healthy, and “deleveraging” has been accomplished by most households, corporations, and state and local governments.
Janet in the Hot Seat
All of which raises fears that the Fed will feed a stock market bubble. When asked about bubble risks in her Senate testimony, Dr. Yellen’s response was as follows:
- The Fed carefully monitors asset markets, looking for “price misalignments” that might hurt financial stability.
- She sees no big misalignments today.
- If bubbles do appear there is “a variety of supervisory tools micro and macro prudential that we can use to limit the behavior that is giving rise to those asset price misalignments.”
- She would prefer not to use monetary policy to pop bubbles because it is a “blunt instrument” and Congress directed the Fed to use monetary policy to maintain price stability
Her response is reasonable but contains an inescapable contradiction. Super-loose monetary policy is designed to boost asset prices. But that very goal would be thwarted if the Fed, perceiving “price misalignments,” used “supervisory tools” (such as a sharp increase in margin requirements for stock purchases) to crater asset markets.
A Lesson from the Roaring ’20s
Another problem is that such micro-prudential policies tend not to work, once a bubble really gets going. Similar to today, the 1920s bubble was inflated by too-loose monetary policy, designed by Benjamin Strong to help Britain peg Sterling to its pre-World War I exchange rate of $4.86 / Pound, which was way too high. Markets were shocked in 1927 when the discount rate was cut from 4% to 3.5%, fuelling the “call money market” that financed stock speculation. The Fed finally did raise rates in 1928, but the stock market laughed it off and headed higher. Finally in March 1929 the Bank used the “direct action” (aka “moral suasion”) of telling banks not to lend to the call money market. The Fed intoned, “the Federal Reserve Act does not . . . contemplate the use of the resources of the Federal Reserve System for the creation or extension of speculative credit.” Call money rates promptly shot up from 12% to 20% and stocks collapsed. But the Fed’s restrictive policy was brashly circumvented by Charles E. Mitchell, the uber-bull who ran National City Bank. Mitchell let it be known that he had $20 million, borrowed from the New York Fed, to lend in the call money market. The stock market recovered, eventually peaking in September 1929.
A Yield-driven Bubble?
So how great is the probability of a stock market bubble? Fairly high, I would say. Two potentially interlocking mechanisms could push stocks to excessive prices. Hedge funds, which have been very late to this bull market, could drive stocks much higher. Because the Fed has promised not to “remove the punch bowl” until sometime tomorrow morning, they may borrow heavily and barge into equities on the long side, even though they are no longer cheap. When short rates finally do rise, we could get a crash—which would be all the more severe because Dodd Frank has drained capital from brokerage firms’ trading desks.
Meanwhile, down on Main Street, individual investors may push stocks well above “fair value” in a quest for income. CDs and money market funds yield nearly nothing now and probably into 2016. As we have already seen with “bond substitutes” such as utility, telecom, consumer staple, and REIT stocks, these yield-hungry investors are willing to over-pay for stocks to get that quarterly check. For the broad stock market, I expect dividends to rise twice as fast as earnings over the next few years, and with individuals “paying up” for income the market’s PE multiple could rise above 20x. Consider this plausible scenario:
- In 2013 the S&P 500 will earn about $110 and dividends will be $36, for a payout ratio of only 32%, far below historical norms. Assuming a year-end S&P price of 1810, the dividend yield is 1.9% (36/1810 = 1.9%).
- Assume earnings grow 9% next year and 5% in both 2015 and 2016, for a three-year growth rate of 6.2%. (Much faster growth is unlikely because profit margins are so high.) With shareholders clamoring for income, firms will increase dividends much faster, as they did this year. If the payout ratio rises to 41.7% by 2016 S&P 500 DPS would be $55, implying a 2013-16 DPS growth rate of 15%, same as the past three years.
- The S&P 500 dividend yield has averaged 2% since 2009, and with rates anchored near zero is not likely to rise. If, in 2016, the index yields 2% on dividends of $55, the year-end price would be 2750 (55/.02 = 2750), and assuming 2016 EPS of $132, the PE would be a lofty 20.8x (2750/132 = 20.8). Sober-minded strategists would warn that the market’s PE is too high, but individual investors would, in effect, say “We don’t care. We need the income and Janet Yellen won’t let us get it in money market funds.”
In this scenario the market rises 53% to 2750 by the end of 2016. With highly leveraged hedge funds playing alongside yield-hungry individuals there would be ample room for speculative excesses of all kinds, some of which are already evident.
Copyright Thomas Doerflinger 2013. All Rights Reserved.