I recently explained why we were in Stage One of a secular bull market \u2013 the stage, comparable to the early 1950s and early 1980s, when bears capitulate and investors begin to embrace equities.\u00a0 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.\u00a0 Then there is a euphoric \u201cblow-off\u201d phase a la the late 1920s, 1968-72, and the late 1990s.<\/p>\n
How does Yellenomics fit into this?\u00a0 Her dilemma is that Fed policy is keyed to the labor market,\u00a0but employment is being strangled by tax and regulatory policy, which the Fed can\u2019t undo.\u00a0 Tax hikes on employers, the war on banks, the war on fossil fuels, Obama\u2019s anti-capitalist rhetoric, and a dearth of pro-growth policies (such as corporate tax reform) are deterring hiring.\u00a0\u00a0And next year businesses won\u2019t be eager to hire as they grapple with the chronic catastrophe known as ObamaCare.<\/p>\n
Francois Obama<\/strong><\/p>\n One indication of how Obama has \u201cEuropeanized\u201d the U.S. labor market is the employment\/population ratio.\u00a0 After averaging 62.7% from 2003 to 2007 this metric plunged to 59.3% by mid 2009, when the recession ended.\u00a0 In the \u201ceconomic recovery\u201d since then it has actually declined further<\/b>, to 58.3%.\u00a0 Even Larry Summers admits this is a disaster, though it does not occur to him that Obama\u2019s policies are the culprit.\u00a0 Whatever the cause, Yellen is dealing with a devastated labor market.<\/p>\n To counteract Washington\u2019s war on\u00a0jobs Bernanke has Fed funds at zero and is buying $85 billion in bonds each month.\u00a0 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 \u201cdeleveraging\u201d has been accomplished by most households, corporations, and state and local governments.<\/p>\n Janet in the Hot Seat<\/strong><\/p>\n All of which raises fears that the Fed will feed a stock market bubble.\u00a0 When asked about bubble risks in her Senate testimony, Dr. Yellen\u2019s response was as follows:<\/p>\n Her response is reasonable but contains an inescapable contradiction.\u00a0 Super-loose monetary policy is designed to boost asset prices.\u00a0 But that very goal would be thwarted if the Fed, perceiving \u201cprice misalignments,\u201d used \u201csupervisory tools\u201d (such as a sharp increase in margin requirements for stock purchases) to crater asset markets.<\/p>\n A Lesson from the Roaring ’20s<\/strong><\/p>\n Another problem is that such micro-prudential policies tend not to work<\/strong>, once a bubble really gets going.\u00a0 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.\u00a0 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.\u00a0 The Fed finally did raise rates in 1928, but the stock market laughed it off and headed higher.\u00a0 Finally in March 1929 the Bank used the \u201cdirect action\u201d (aka “moral suasion”) of telling banks not to lend to the call money market.\u00a0 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.”\u00a0Call money rates promptly shot up from 12% to 20% and stocks collapsed.\u00a0 But the Fed’s restrictive policy was brashly circumvented by Charles E. Mitchell, the uber-bull who ran National City Bank.\u00a0Mitchell let it be known that he had $20 million, borrowed from the New York Fed,\u00a0to lend in the call money market.\u00a0 The stock market recovered, eventually peaking in September 1929.<\/p>\n A Yield-driven Bubble?<\/strong><\/p>\n So how great is the probability of a stock market bubble?\u00a0 Fairly high, I would say.\u00a0 Two potentially interlocking mechanisms could push stocks to excessive prices.<\/strong>\u00a0 Hedge funds, which have been very late to this bull market, could drive stocks much higher.\u00a0 Because the Fed has promised not to “remove the punch bowl” until sometime tomorrow morning, they may\u00a0borrow heavily and barge into equities on the long side, even though they are no longer cheap.\u00a0 When short rates finally do rise, we could get a crash\u2014which would be all the more severe because Dodd Frank has drained capital from brokerage firms\u2019 trading desks.<\/p>\n Meanwhile, down on Main Street, individual investors may push stocks well above \u201cfair value\u201d in a quest for income.\u00a0 CDs and money market funds yield nearly nothing now and probably into 2016.\u00a0 As we have already seen with \u201cbond substitutes\u201d 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.\u00a0 For the broad stock market, I expect dividends to rise twice as fast as earnings over the next few years, and with individuals \u201cpaying up\u201d for income the market\u2019s PE multiple could rise above 20x.<\/strong>\u00a0 Consider this plausible scenario:<\/p>\n In this scenario the market rises 53% to 2750 by the end of 2016.\u00a0 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.<\/p>\n Copyright Thomas Doerflinger 2013.\u00a0 All Rights Reserved.<\/p>\n","protected":false},"excerpt":{"rendered":" I recently explained why we were in Stage One of a secular bull market \u2013 the stage, comparable to the early 1950s and early 1980s, when bears capitulate and investors begin to embrace equities.\u00a0 In the second stage stocks continue … Continue reading \n
\n