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Stock Bubble Expanding With Fed's New Paradigm

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EDITOR NOTE: Fed backstops and FOMO fools will likely supply the stock market with plenty of buying support, launching the stock market to heights perhaps greater than the one we’re seeing now. Remember that the market can stay irrational longer than you can stay solvent, especially if you’re trying to short the market. But still, a bubble is a bubble is a bubble. That’s the main point of the article below as it takes a circuitous path toward what most of us already know. At this point, remaining unhedged or staying on the sidelines with no growth prospects isn’t the best play. It’s a matter of not missing out on the wrong opportunities. There are other assets that can hedge a collapse in purchasing power (something the Fed aims to do, by the way...that is, collapse the value of your hard-earned dollar). Allocations in physical gold and silver have always been an effective way to add additional return sources with added benefits in growth and capital preservation, especially in times of “artificial” economic expansion or “real”  recession.

Valuation are not only high, they are among the highest on record.

The Laws of Investing

The Wall Street Journal asks Has the Fed Rewritten the Laws of Investing?

It has been an odd year with the Covid-19 crisis hammering the economy, but stocks recovering from sharp losses and then powering to new highs. As a result, standard measures show valuations are at rarely-seen levels that have typically ended in tears.

The S&P 500 trades at 22 times analysts’ expected earnings—its most expensive level since the dot-com bubble. It also trades at its richest multiple to its inflation-adjusted earnings over the past decade—the valuation method popularized by economist Robert Shiller —in nearly 20 years. The total value of U.S. stocks as a percentage of the U.S. economy, which Warren Buffett once called “the best single measure of where valuations stand at any given moment,” is now higher than at any point during the dot-com years.

Stocks vs Interest Rates

Some suggest stocks may not be as expensive as they seem because that interest rates are extremely low. 

John Hussman has pointed out the fallacy of that theory many times. The Journal explains the fallacy this way.

The 10-year Treasury largely reflects investor expectations of what the overnight rates set by the Fed will average over the next decade. The Fed responds to what is going on with the economy, setting rates higher when it is trying to cool things down, lower when it is trying to heat things up. So low yields are tantamount to a low-growth, low-inflation economy—one in which profit growth would be low, too. Why pay up for stocks under that scenario?

Stocks vs Bonds

Some argue that stocks are cheap compared to bonds. But that is like saying truffles are cheap compared to moon rocks. 

It sounds good on the surface but makes little sense if you think about it for more than a few seconds.

TINA

Then there's TINA: There Is No Alternative. The idea behind TINA is people have to invest somewhere, they want to be liquid, so they pick stocks and bonds making bubbles out of both.

The problem with TINA is that it is based on the discredited sideline cash theory, all this cash on the sidelines has to go somewhere. 

No it doesn't. Someone has to hold every dollar, every stock, every bond, every bitcoin, every Euro, and every ounce of gold 100% of the time.

It is impossible for money to flow into any of those instruments. 

If I take $100,000 and buy Bitcoin, gold, stocks, bonds or even real estate, I have whatever I bought and someone else has $100,000. 

All that has occurred is a swap. I have an asset and someone else has cash. Thus, it is possible for individuals to reduce cash levels, but impossible for cash levels to drop in aggregate as a result of asset purchases.

Fed's Commitment 

Let's circle back to the WSJ for a new theory.

The Fed this year revamped how it sets policy, abandoning its practice of pre-emptively raising rates to head off inflation. In its efforts to help the economy recover, it has committed to hold short-term rates near zero until inflation reaches 2% and “is on track to moderately exceed 2% for some time.” That means that rates over the next several years will be lower than they would have been under the Fed’s previous policy. Perhaps stocks can carry higher multiples and still be reasonably valued.

The rules of investing have changed in the past, after all. Investor and financial historian Peter Bernstein noted how veteran Wall Streeters blanched when the dividend yield on stocks fell below the yield on the 10-year—a sure sell signal, they told him. What they missed was the phenomenon of companies reinvesting more of their earnings rather than paying them out. It would be a half-century before dividends surpassed Treasury yields again.

Maybe the Fed’s actions this year have changed how investors should think about valuations, but it is early going and that hypothesis has yet to be put to the test.

Valuations Stretched For Years

That explanation might help explain the quick recovery this year, but valuations have been stretched for years. 

For example, the Shiller PE was 33.31 on January 1, 2018. It's only a tad higher today at 33.74.

Not Hyperinflation

It's not a function of the US dollar either, and please do not bring up the ridiculous notion of hyperinflation.

The US dollar is not going to zero vs the Yen, Euro, Gold, etc. etc. etc. 

Do You Understand the Ramifications of Passive Investing?

Please consider Do You Understand the Ramifications of Passive Investing?

I post some excellent video clips thanks to @TheBondFreak @GratkeWealth @DiMartinoBooth and @profplum99 and others.

In regards to passive investing, there is one case in which sideline cash can matter. That is cash on hand at mutual funds. 

The bulk of cash on sidelines is either active players or players who do not want to be in the markets for whatever reason. These people are price sensitive, or at least sensitive to something. 

Mutual funds, largely representing buy and hold passive investors, have no cash on the sidelines. They get money in and have a mad rush to put it in play. 

Simply put, the Mutual Funds buy and someone else has the cash. But what happens when people panic? Stocks drop, then again, then again. Redemption requests come in. The funds have to sell, but to who?

Not One Thing

So, take the Fed, free money from Congress, Robin Hood day traders who have never seen a bear market, etc. and you have this massive sentiment that stocks will never go down.

Passive investing and the Fed fuel the sentiment that nothing can go wrong. 

These factors are all in play. And it is impossible to figure out in real time precisely why people react the way they do.

But bubbles by definition burst. Don't ask me or anyone else when. This has gone on far longer than I thought would happen.

Finally, please note that stocks do not crash from valuations or in overbought scenarios. There are too many dip buyers waiting on the sidelines.

Stocks crash in oversold setups in which redemption requests come in and the pool of dip buyers has dried up.

Originally posted on The Street

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All articles are provided as a third party analysis and do not necessarily reflect the explicit views of GSI Exchange and should not be construed as financial advice.

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