in semiannual financial stability report, The Fed has issued a stock market warning as high valuations make markets “vulnerable to big drops”. lightness:
Risky asset prices have generally increased since the previous report, and in some markets, prices have been higher compared to expected cash flows. Home prices have risen rapidly since May, and have continued to outpace increases in rents. However, despite rising home valuations, there is little evidence of deteriorating credit standards or highly leveraged investment activity in the housing market. Asset prices remain subject to significant declines if investor sentiment deteriorates toward risk, progress in containing the virus is disappointed, or the economic recovery stalls.
Is the Fed’s stock market warning justified?
The Fed says valuations, as prices for “risky” assets continue to rise, are constantly making the stock market more vulnerable to a crash. that it “stability / instability” The paradox.
What could cause asset prices to crash? The Federal Reserve specifically notes:
- Another mutation, or variant, of the COVID virus,
- economic recovery has stopped, or;
- Investor morale deteriorates towards risk
Given that the Fed’s interventions boosted the stock market and ‘Investor sentiment’ Withdrawing this support may be a problem. As discussed in Bob Farrell’s Rules of the Quantitative Easing Market:
“The great correlation between financial markets and Federal Reserve interventions is all you need to know to navigate the market.“
those direct or psychological Interventions It is the basis for justifying all speculation “risk” Investors can muster.
The ‘irrational exuberance’ led by the Federal Reserve
There is no doubt about it “full of dangers” Assets are rising, driven by the confidence of speculative investors. This speculation is popping up all over the market, from standard call options to “me me” Stock prices rise.
But not only the retail investor is piling into stocks, but even professional managers are doing it now “All inEquity risk pool.
Of course, this speculative appetite is not surprising because the monetary policy of the Federal Reserve created Pavlovian’s response to “risk”. Or, more commonly known as:
“Don’t fight the Fed.”
And ‘Fighting the Federal Reserve’ Retail investors did not. As shown below, household ownership is skyrocketing, reaching $30 trillion.
Before you marvel at the accomplishment of family stock ownership, you need to remember two critical factors.
- The top 10% of earners own 90% of those assets, and;
- It took $43.5 trillion in cash to create that “wealth”.
Due to the amount of “liquidity” In the stock market, the Federal Reserve must bear the responsibility of investors “irrational exuberance.”
Reviews are extreme by almost every measure
Across most asset classes, The evaluation procedures are high in relation to historical standards. Since the Financial Stability Report in May 2021, stock prices have risen even more.” – Federal Reserve
The description of assessments by the Fed is somewhat misleading. When saying something is elevated relative to historical standards, its meaning is lost without a particular context. In this case, context comes out better from historical charts of various rating scales.
The most obvious is the Shiller CAPE ratio that takes a dividend from current prices with 10 years of earnings. This method smooths out the fluctuations in earnings that can occur on an annual basis. At 40 times consecutive earnings, current valuations are higher at the market’s peak in 1999.
Taking a look at the market capitalization of an economy also gives you some sense of “excess” in the markets. Given that profits and revenues come from economic activity, the market cannot “overrun” economy in the long run.
Finally, price to sales (what happens on the top line of the income statement) It is also very extended.
While stock prices can advance, earnings are ultimately a function of economic growth and sales. Therefore, when abuses occur, eventually a return must and will occur.
The only question is timing and motivation.
Hope to get a “soft landing”
In the Fed’s notes, ratings were raised; In their stock market warning report, they outline several risks to the stock market.
The Fed’s report, which highlights the more prominent risks that could undermine the financial system, has shed light on many of the previously mentioned concerns. Those included “structural weaknesses” in money market funds. fixed coins, Which the central bank is now using as a public warning about the risks associated with cryptocurrency adoption, inflation, and the erosion of financial support.
But, as always, the Fed hopes it can coordinate a “soft landing” for the stock market.
Unfortunately, the Fed has a strong track record of these outcomes.
Richard Thaler, the famous University of Chicago professor and Nobel laureate in economics stated:
“We seem to be living through the most dangerous moments of our lives, and yet the stock market seems to be in a nap. I admit I did not understand it.
I don’t know about you, but I’m nervous, and it seems that when investors are nervous, they are prone to panic. Nothing seems to scare the market.”
This is always the case, before something happens.
History always rhymes
While ratings for the Fed’s notes are high, the crucial message for investors is getting murky. From current valuation levels, the expected rate of return for investors over the next decade will be low.
There is a large group of individuals who suggest differently. They justify this case.”bull market It can last for years longer. But, unfortunately, no rating scale supports this claim.
This does not mean that markets will produce single-digit rates of return every year for the next decade. The truth is that there will be great years to invest. Unfortunately, there will also likely be a few tough years in between.
This is the nature of investing. It’s just part of The complete market cycle.
The economic cycle, demographics, and debt and deficits also suggest that optimistic views are unlikely.
“History does not repeat itself, but it often resonates.” – Mark Twain
Unfortunately, despite the Fed’s warning to the stock market, the market will eventually deal with it “irrational exuberance,” Just like I did every time before.
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