The Two Pins That Will Pop The Stock Market Bubble

The Two Pins That Will Pop The Stock Market Bubble by Lance Roberts for Real Investment Advice

Yes. We are in a stock market bubble. The only question is, what will be the issue that eventually pops it? We alluded to this answer in Friday’s #MacroView discussing why more “Stimulus Won’t Create Economic Growth.”

As discussed in our previous article, if market bubbles are about “psychology,” as represented by investors’ herding behavior, then price and valuations reflect that psychology.

In other words, bubbles can exist even at times when valuations and fundamentals might argue otherwise. Let me show you an elementary example of what I mean. The chart below is the long-term valuation of the S&P 500 going back to 1871.

Pop Stock Market Bubble, The Two Pins That Will Pop The Stock Market Bubble

Notice that except for only 1929, 2000, and 2007, every other major market crash occurred with valuations at levels LOWER than they are currently.  

Secondly, all market crashes, which resulted from the preceding bubble,  have been the result of things unrelated to valuation levels. Those catalysts have ranged from liquidity issues to government actions, monetary policy mistakes, recessions, or inflationary spikes. Those events were the catalyst, or trigger, that started the “reversion in sentiment” by investors.

There are currently two “pins” that could pop the current market bubble.

The Inflation Pin

To fully explain why the Fed is now trapped, we must start with the inflation premise.

The Federal Reserve has consistently argued that monetary policy is a function of their two mandates: full employment and price stability.

While the Fed has stated they are willing to let “inflation” run hot, their biggest fear is a repeat of the runaway inflation of the 70s. However, the basis of the entire bull market thesis is low rates.

As Oliver Blanchard of the Federal Reserve recently stated concerning Biden’s $1.9 trillion stimulus package:

“How this number translates into an increase in demand this year depends on multipliers. If the average multiplier is 1 (which I think of as a conservative assumption), this implies that demand would increase by 4-times the output gap.

If this increase in demand could be accommodated, it would lead to a level of output at 14% above potential, which would take the unemployment rate very close to zero. 

Such would not be overheating (i.e. inflation), it would be starting a fire.”

Using the money supply as a proxy, we can compare the money supply changes to inflation.

The chart below advances M2 by 9-months as compared to CPI and the Fed Funds rate. If the historical correlation holds, the Federal Reserve will start talking about tapering monetary policy, and hiking interest rates, within the next year.

Pop Stock Market Bubble, The Two Pins That Will Pop The Stock Market Bubble

Of course, the last time the Fed started discussing similar policy changes was in 2017, which lead to the great “Taper Tantrum” of 2018.

Pop Stock Market Bubble, The Two Pins That Will Pop The Stock Market Bubble

The Interest Rate Pin

As noted, the problem with inflation is that if economists do get their wish for higher prices, such also corresponds historically with higher interest rates.

Pop Stock Market Bubble, The Two Pins That Will Pop The Stock Market Bubble

However, as you will note, each time that interest rate has moved up correspondingly with inflation, such never remained the case for long. While much of the media is currently suggesting that interest rates are about to surge higher due to economic growth and inflationary pressure, I disagree.

Economic growth is “governed” by the level of debt and deficits. However, it isn’t just the heavily leveraged government – it is every single facet of the economy.

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