MAY 11, 2021 — The stock market is, or should be, mostly a big yawn. It goes up, down, back up, down again, etc. ad. infinitum. The best way to manage your portfolio is pay little to no attention to it. Study after study has shown that trying to manage around market swings reduces long-term returns.
Counterintuitively, stocks exploded upward after a brief — very brief — crash in March 2020 as deep uncertainty hung over the economy. That happened largely because Federal Reserve monetary policies and Congress’ fiscal response — the twin pillars of stimulus — pumped newly minted cash into the economy and some of that river of money flowed into stocks.
There are other reasons why stocks are now expensive relative to historical norms. Principally among them, the Fed has held interest rates artificially low for a dozen years and counting now, with no end in sight, although one may be coming into sight soon. The Fed raises interest rates to cool inflation, and the economy suddenly is seeing a burst of inflation. For now, the Fed believes the jump in prices is temporary, and is standing pat on its low-rate policies. (Which are coupled with aggressive bond buying.) But a growing number of investors are skeptical, and inflation worries are beginning to take hold in the exchanges.
Another reason is a shrinking supply of shares. Over the past decade, companies have been aggressively buying back shares. (They prefer this over paying dividends, because it’s easier to cut buybacks than dividends, and more importantly, by artificially boosting earnings per share — by spreading the same amount of profits over fewer shares — buybacks artificially inflate executives’ stock-based compensation.) In addition, some companies have merged, been acquired, or taken private, taking their shares off the market. There are far fewer publicly traded companies today, and more money chasing a smaller number of shares. It’s simple supply-and-demand economics; more money + fewer shares = higher prices.
And then there’s TINA — there is no alternative to stocks, because places for savings — bank and money market accounts, bonds, etc. — pay virtually nothing. Actually less than nothing, because with long-term inflation running about 2%, you need to make 2% interest on your savings just to break even, but no savings accounts pay close to that. For over a decade, the stock market has been virtually the only place investors could get above-inflation returns. So money has flocked there.
The U.S. stock market is especially attractive to foreign investors, because it’s the most stable market in the world. Whatever our economic problems are, the rest of the world is worse and more unstable.
Why does any of this matter to anyone but the wealthy, who own most of the stock?
Actually, about half of adult Americans own stock, although some may not realize it. (Most people, though, are pretty aware of things financially.) With the disappearance of traditional pensions, and most people having to provide for retirement themselves, far more people are investors these days. However, many do so through IRAs and 401(k)s, ETFs, and mutual funds, and the number who own individual stocks — and follow specific companies and stocks — is considerably smaller; although with online trading platforms, elimination of broker fees, and trading in small lots, individual stock ownership is now available to everyone and far more common than it used to be.
There’s a lot of background noise, all of it opinion, because no one knows what the market is going to do. There’s simply no way to predict the collective impact of millions of individual buying and selling decisions. Nor is the market entirely logical — if it was, it would be more predictable, although not entirely predictable because it’s still affected by unforeseeable events — but it’s not entirely illogical, either (even if it sometimes seems so). What it boils down to is if a particular investment makes sense, do it; and if it makes little or no sense, don’t do it. Because investors are buying future earnings, it’s that simple, and what the company earns will dictate how the market values its stock over the long run. So invest in good, well-managed, growing businesses, and you should do all right.
Today, stock prices have been inflated by artificially low interest rates and heavy fiscal spending by Congress in response to the pandemic. If those props go away, those inflated stock prices will become more vulnerable, so keep an eye on Fed policy and government spending. Stock prices also are high because investors expect a very strong economic recovery from the pandemic, and if pandemic effects linger longer than expected, or consumers don’t spend as much as expected, or the recovery trips over labor and supply shortages, then you can expect investors to pull back on their risk taking, and that’s when selling in the markets will begin. Maybe we’re already seeing some of that; it’s been going on in the technology sector for a while, and now appears to be spreading to other areas of the market.
Nearly everyone on Wall Street, and many outside and looking in, agree the 900-lb. gorilla is the Fed and interest rates. If the Fed raises rates, then bonds look more attractive, and money leaves stocks to go into the bond market. That would pull down stock prices, likely very quickly, and possibly by a lot.
But the simple fact that stocks are very expensive, relative to earnings, makes them vulnerable; and the higher stock prices go, the more vulnerable they become to a pullback. Many market watchers have been predicting a correction this spring. Regardless, summer typically is a weak time for stocks. There’s a general belief that the market is vulnerable, although analysts at most major banks and investment houses still expect stocks to gain overall during the remainder of this year. (Nobody knows if they’re right.)
The “wealth effect” is another reason stock prices matter, even for those who don’t have stock exposure. The theory is that if people feel richer, they’ll spend more, and because the U.S. economy depends on consumer spending, the stock market’s ups and downs have a material effect on the economy’s health. This idea was the bedrock of former Fed chair Ben Bernanke’s policy response to the financial crisis and Great Recession; he deliberately pursue policies that inflated financial assets in the belief it would stimulate consumer spending that would pull the economy out of the worst recession since the 1930s. Whether it actually did is for scholars to debate.
But “wealth effect” ideas are still around, and very much current, and behind much of the current policy thinking. The U.S. economy is rebounding from the pandemic slump at a very fast clip, and consumer spending is very strong right now — actually outrunning the supply of goods — but if stocks drop 10% or more, which definitely is a possibility, that could cool consumer spending to a degree, although in that scenario the economy would still be growing rapidly, just not as rapidly.
So, the stock market affects all of us, whether we’re investors or not, and that’s why I’m now talking about it on this blog. I’m not impressed by daily headlines; the fact the Dow Average dropped over 500 points today means almost nothing to me. It’s not a pointer to market direction; it could go up 350 points tomorrow. (That’s been the pattern lately, when we’ve seen these big daily swings.) I’m more interested in the undercurrents.
The undercurrents are that the twin props of monetary and fiscal spending are still in place, will continue to be for at least a while, consumers are sitting on piles of hoarded cash and stimulus money and are coming out of their bunkers eager to spend, so there’s massive pent-up demand, and neither the economy nor stock market are going to collapse at this point.
In fact, consumer spending on goods remained strong throughout the pandemic (tried to buy an appliance lately?). It was the services economy that the pandemic shut down, and it’s services jobs that are now coming back, although not all of them will come back. The pent-up demand is for things like haircuts, restaurant meals, travel and hotel stays, summer driving and vacations, and other things that can’t be delivered by Amazon or a food delivery service. This spending won’t depend on “wealth effect,” because consumers have cash burning holes in their pockets, and couple that with a strong sense of deprivation, I don’t think you see a stock market correction having much impact on the economy.
Mainly, stock prices are too darn high, and if there’s a correction, all that’s happened is a non-story for the news media to turn into a story. It’s nothing to worry about. If stocks skid, you should buy stock, if you can.