The S&P 500 has fallen 7.37 percent so far this year. What to make of it? Naturally, some people find falling stock prices to be unpleasant. Others find them distressing. Another way to look at falling stock prices, however, is like a high-fiber diet. The effect is necessary to a healthy functioning system.
The simple fact is that stock prices, fueled by speculative liquidity, have long since outrun the real economy. The disconnect between the two has been widely observable. The economy’s lagged, incomes have stagnated, yet stocks have soared.
Wilshire Total Market Index vs. GDP since 2009 (01/01/2009 = 100). The market’s capitalization vs. GDP has been soaring ever since the adoption of the full-fledged fiat money system – and the gap between the two has never been wider than at the 2015 stock market peak – click to enlarge.
Thus the present, ever so slight reduction in liquidity, and the subsequent lowering of stock prices, has a cleansing influence. For it will serve to eliminate marginal businesses, and trim the fat from larger businesses. Consequently, business owners, managers, and workers of marginal undertakings will have to redirect their efforts into something new…something that’s of greater value.
For example, Walmart recently announced it would be closing 269 stores and laying off 16,000 workers. Obviously, we don’t wish any harm to hard working Walmart employees. But we’re also confident many of these 16,000 people will now find a new, more meaningful, and more prosperous purpose in life.
Though it can be painful at times, eliminating and minimizing wasteful activities is how the world becomes more affluent. On the other hand, propping up negligible endeavors with cheap credit ultimately subtracts wealth from the world.
How much more stocks will fall, no one really knows for sure. Perhaps they’ve already fallen as far as they will. But we wouldn’t bet our life savings on it.
This is merely conjecture, of course. But we do recognize that even with the 7.37 percent drop year-to-date, the S&P 500’s Cyclically Adjusted Price Earning (CAPE) Ratio is 23.97. We also recognize that the CAPE Ratio’s mean, going back to 1881, is 16.65.
In terms of the P/10, this is one of the most overvalued markets since 1880 (in fact, it is in the 92nd percentile of the entire data series – only the peaks of 2007, 1929 and the tech bubble were even more overvalued) – click to enlarge.
On top of that, we understand that valuations always revert back to their mean eventually. Similarly, we know that when reverting back to their mean, valuations often overshoot not only to the upside; but to the downside too. This is how an average is formed.
Certainly, there are countless ways for valuations to come down. One obvious way is for corporate earnings to increase. Another way is for share prices to decrease.
From what we gather, fourth-quarter earnings for S&P 500 companies are expected to fall 6 percent year over year. What’s more, this is the third consecutive quarter that earnings have fallen on an annual basis. Thus, it seems likely, that for stock valuations to get anywhere near their historical average, share prices will need to go down much, much more.
These are some simple facts regarding stock valuations as we understand them. Don’t listen to us, if you don’t agree with them. For there’s plenty out there that we don’t agree with.
Something’s Gone Horribly Awry
For instance, we don’t agree with the illusion and degradation of prosperity that’s readily visible to us as we make our way through our daily rotes in downtown Los Angeles. There are tall shiny buildings, sleek new cars, and chic restaurant fronts up 5th Street and Grand Avenue.
Then, several blocks down 5th Street, at San Pedro Street in Skid Row, there are sidewalk tents, concrete ruble, and multitudes of empty stomachs outside the collection of of rescue missions.
A part of skid row in downtown LA
Photo credit: Lawrence K. Ho
Clearly, something’s gone horribly awry. Hard work, perseverance, and ingenuity likely have something to do with the shiny streets. Conversely, sloth, drug abuse, and mental defectives likely have something to do with the blighted streets. But we also have an inkling that 20 years of activist Fed policy has left its marks all over both.
No doubt, the collection of shiny skyscrapers has sprouted up over the years thanks to the fertilizer of cheap credit. At the moment, Korean Air / Hanjin Group is financing construction of The Wilshire Grand Tower. When it opens its doors in 2017, it will be the new tallest building in Los Angeles and the tallest building west of the Mississippi.
Our friend Pater Tenebrarum of Acting Man, recently explained how the construction of marque skyscrapers coincides with the late stages of an artificial, central bank induced, boom. The Wilshire Grand Tower will forever be a monument to ZIRP.
At the other extreme, it may be unclear upon first glance how the Fed’s artificially cheap credit has wrought abject poverty. Ironically, John Maynard Keynes, the godfather of modern day economic intervention by governments, provided one of the better, succinct explanations of this hidden and insidious relationship. Thus we’ll close with an excerpt of Keynes from The Economic Consequences of the Peace, written in 1919.
Before Keynes became a Keynesian, he wrote this….
“Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the equity of the existing distribution of wealth.
“Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become “profiteers,” who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat. As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery.
“Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”
Charts by St. Louis Fed, Doug Short/Advisorperspectives
Chart and image captions by PT
M N. Gordon is the editor and publisher of the Economic Prism.
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