Fed Bubble Trouble

 I have tried to explain to friends and family why I think there is a real risk of the stock market dropping by a factor of 4 or more.   It is hard to explain in conversation and it is easy for them to dismiss me.   I decided to put down my thoughts here and see if I can make a more plausible case in writing.  

First I will explain a very simplified model to evaluate a reasonable price of major asset classes.  Then show how interest rates and inflation impact these prices.  Then explain how the Fed can blow bubbles and why they eventually pop.   Then how far down things can go after a pop.

The 3 main investment categories,  bonds, real-estate, and stocks can all be viewed as a future stream of income that you are trying to put a current price on.  The bonds pay interest, the real-estate pays rent, and the stocks will eventually pay dividends (or buy back shares, but lets simplify that out for this).   The bonds state what the payments should be, so the question is just will the issuer of the bonds really pay or will they default.  With real-estate you have to have some idea of what future rents will be, what operating costs will be,  and what percentage of the time it will be rented.  With stocks to have to figure out what the profits for the company will be in the future (and the odds of it surviving) and what that comes to per share.  Fundamentally in each case you are putting a price on a stream of payments.  

There is a "net present value" calculation for what a future stream of payments is worth today.  This depends on the interest rate.   So changes in interest rates change the "net present value" of all 3 of the main investment types.  

By changing the interest rate, the Fed can change the present value of things.  If the Fed lowers the interest rate, the current price of these investments goes up.   This makes people feel richer and they also pay more taxes on profits and such, so it is good for the government too.   

The problem is that by making the interest rates artificially low, the Fed is making the prices of investments artificially high.   The right way to think about this is, "The Fed can blow bubbles".

 The reader may be thinking that they don't do a "net present value" calculation, and that is fine.  But even if you are just using your intuition to decide where to put your money, the interest rates change how good the yields, rents, company earnings of your potential investment seem to be.  For simplification, lets pretend that the neural network in your head does some sort of "net present value" evaluation and interest rates are really important.  This fits with what we see experimentally.  

Many investors will think that these artificially low interest rates can last for the next 30 years, but they can't really.   So the "net present value" calculations are all in error.   They assume some low interest rate for the next 30 years to get the high current price of the investment.   But that was a wrong assumption,  the interest rate won't be low for the next 30 years.  There is a saying, garbage in, garbage out.   The calculation is only as good as the input.   At some point investors realize they need to use a different interest rate and reevaluate what the "net present value" is.   When they calculate with a higher interest rate, the current price calculates lower.  If the interest rate is assumed to go up by a lot, the resulting current price can be far lower.   This is when "the bubble pops".

The Fed was created in 1914 and made lots of new money in the 1920s and kept interest rates down and caused the Roaring 20s where stock prices went up.  Then we got the 1929 stock market crash.  Eventually stocks were down by something like a factor of 8.

In the 1970s when interest rates were high the P/E on stocks was low, like 5.  Today the P/E on stocks is high, like 43 because interest rates are really low.   If people realized that interest rates were going back up to 1970s levels then stocks could go down by a factor of 8.

Because the reader was not investing in stocks in the 1920s and 1930s, and probably not even in the 1970s, this seems too far fetched to be a real concern.   But I think the reader should be concerned. 

You may think, why can't the Fed just keep interest rates artificially low forever?  The reason is inflation.   If they are loaning money at 2% and you can buy copper (or anything) and watch it go up at 6% then so many people would do it that it would go up at 20%.   If they keep printing money once the inflation starts, they can get hyperinflation.  

Recently the inflation index graph is curving up.   The last CPI report was 4.2% for the last 12 months.    People will say there are "base effects" because of the dip in the previous graph.  But that dip means that the next report will be even higher.   It does not imply that future reports are lower though.   If the last few months the CPI index was steady, then after we got past the dip we would have lower inflation (12 month change in index).  But the last few months the CPI index has been going up as fast as it was coming out of the dip.  So the "base effects" argument does not really work. 

It seems we are getting the start of inflation.  If we do get inflation, the stock market could come down by a factor of 4 or more.   There huge trouble is a real possibility.

In The Great Crash 1929 by Galbraith on page 108 it has:

"A common feature of all these earlier troubles [previous panics] was that having happened they were over. The worst was reasonably recognizable as such. The singular feature of the great crash of 1929 was that the worst continued to worsen. What looked one day like the end proved on the next day to have been only the beginning. Nothing could have been more ingeniously designed to maximize the suffering, and also to insure that as few as possible escaped the common misfortune." 

I fear this crash will be like the 1929 one and would like to warn my friends that although every previous crash in their investing experience was over after a 30% or 50% drop, this one really may not be.   Do not be eager to jump in.   The bottom can be far further down than you think.

The following graph comes from an interesting paper with many other graphs.  The yield is the Earnings divided by price for the stock market (inverse of P/E ratio).   So if you subtract the CPI and plot it you are showing how much above inflation the stock yields should be.  On average it is 4.9% above inflation.   When it gets too low you get the shaded areas that are bear markets.   The inflation rate has gone up since the end of this graph so the current plot would be even lower.   It really seems a bear market should follow.  Just understanding this graph means that as inflation goes up the P/E for stocks will go down.