Even Central Bank Easing Can’t Keep Stocks Overpriced Forever

It has been said by the critics of PE10 that it hasn’t worked starting with the era of the mid-1990’s. My answer is that perhaps the current era has an inherently overpriced stock market like a mirror image of the underpriced era after the Great depression from 1932 to the early 1960’s when fear of the Depression warped investors’ judgment. The current era of excessive Central Bank easing that created an equity bubble started with the Greenspan rescue of the markets in 10-19-1987 but didn’t really begin in earnest until after the Dec. 6, 1996 “irrational exuberance” speech. Then the question is will continuous Central Bank easing keep equity prices permanently high so that fundamental valuation tools like PE10 don’t work? In order for the Fed to keep asset prices high they would need to continuously cut rates but they can’t because of the "zero lower bound” problem where rates can’t go negative. (There are work arounds to the problems with negative interest rates but they are impractical and would need Congressional approval which won’t happen in a Republican dominated Congress.) The big myth is that Federal Reserve is protecting investors by standing ready to bail them out if stocks crash. Another big myth is that Central Bank and fiscal policy since the 1930’s can act to magically prevent or minimize recessions and thus greatly reduce risk to investors. The fact is the Fed and fiscal policy failed miserably during the Great Depression and much of the 1945-1974 boom was the result of the WWII victory and not because of Central Bank and fiscal policy.  The Fed made things worse by creating massive inflation in 1965-1981 and then having massive tightening in 1979-1984 to cure the problem that they caused. The Fed’s tightening caused a massive recession in 1980-1982. What happened since 1982 was that the end of serious inflation, the end of the Cold War and the promise of the new era of the Internet created a belief system in the minds of investors that the economy was better and that in their mind stock prices should be higher. Additionally investors incorrectly believed that Fed and fiscal stimulus since the 1933 New Deal had magically reduced the risks in stocks, which is incorrect. Some of this belief system was correct but in the aggregate it was taken way too far causing investors to overpay for stocks and real estate. The overpayment to buy stocks and real estate was facilitated by the Fed’s Easy Money policies. So even though the PE10 did not perform as well as desired since the radical era of excessive investor optimism and excess Fed easing of 1997 to present, that is only a temporary setback which will eventually be overcome. At some point stocks will flatten out and experience volatility. Some investors will get angry that their unique stocks went down slightly even if the index was flat. These unhappy investors will sell but there will be an imbalance of sellers over buyers thus driving prices lower. Since the Fed has hit the zero lower bound limit then the Fed can’t come to the rescue. This will be a big letdown when investors realize that emergency Fed stimulus was meant to keep systemically important entities like banks and insurance companies alive and was never, ever meant (except in October 19, 1897) to help stock investors. The single most important reason why stocks got away with violating PE10 since 1997 was because of excessive Central Bank easing. But how can the Fed continue to ease when it has hit the zero lower bound problem? The PE10 theory was based on reviewing the decisions of investors against the earnings of corporations during an era when there was less aggressive use of monetary policy. The extreme activities of the Fed during the 2002-03 crash with negative real rates and even more extreme since the day they bailed out Bear, Stearns in March, 2008 are something never intended by security analysts who developed the PE10 model. It is tempting to think the Federal Reserve has unlimited power. In theory they could print an infinite amount of money and grant it as gift to any money losing business so that the business would never fail, but would they do that? It is not allowed and Congress won’t allow them to do that. Investors’ crucial mistake was to make a mental leapfrog in their thought that because the Fed did radical and unauthorized bailouts of Bear Stearns and AIG and massive QE that somehow the Fed could magically protect stock investors. Plenty of studies of behavioral economics have shown that many retail investors make irrational leaps of faith to incorrect conclusions so it seem logical that this happened in stocks thanks to the Fed’s policies. It is wrong to buy stocks with a PE ratio of 25 or 30. Just because PE10 failed to provide a highly accurate, fast signal that could overcome the tremendous noise generated by Central Banks doesn’t mean that fundamental analysis is not good and that investors should embrace the 1999 “new era” of internet stock metrics like “eyeball share” or claim that corporate profits don’t matter. During the 1966 PE10 top in the market certain segments of stocks such as the “Nifty Fifty” kept going higher for another 6 years reaching PE ratios of 50 or even 80 (four to six times a reasonable value) and then crashing to very low levels in 1973-74. During the 1970’s the Fed aggressively eased monetary policy to offset the effect of OPEC raising oil prices but that didn’t revive the busted bubble of Nifty Fifty stocks. Instead, on inflation adjusted basis, stocks of all types did much worse by the end of the 1970’s. Now the market is exhibiting a similar phenomena where prestige companies continue to make new highs but the typical company may have gone down from its all-time high. If someone in 1966 (when the stock indexes topped out with a high PE10 of 25) decided to buy the Nifty Fifty they would have made a profit on paper in 1972 but they might have been tempted to hold on during the 1973 crash and would have ended up losing money. Just because an asset is overpriced doesn’t mean the market will immediately make it crash. Just because statistical noise can temporarily drown out fundamental analysis doesn’t negate the wisdom of fundamental analysis. Investors need independent financial advice about the risks of stock market bubbles. I wrote an article “Why PE10 doesn’t work as intended in the great 1997-2014 bubble”.

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Don Martin

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