After the 2007-2008 financial crisis, the Federal Reserve flooded the financial system with money to create a “wealth effect.” Your house isn’t worth more, but if it has a higher dollar value (because dollars are worth less), you’ll feel richer and spend more. That’s the theory behind “wealth effect.” I think you can see it’s somewhat of a scam. It worked for a while, i.e. propped up consumer spending in a weak economy, to keep the economy from getting weaker, but this couldn’t last forever. That day of reckoning is now upon us.
Then came the pandemic, an unforeseen “Black Swan” event, but I’ll skip over that. It didn’t really change much. Let’s now move to discussing stocks. Since about 2009, the Fed’s policies also have inflated stock prices. Owning stock is a claim on a company’s earnings, so stocks are deemed “expensive” or “cheap” by how much an investor has to pay for a dollar of earnings (this is called the P/E or “price-earnings” ratio). Historically, the S&P 500 companies’ aggregate P/E has averaged about 16 times earnings. But with the Fed inflating stock values, the market P/E shot up into the 20s. Over the last dozen years, the S&P 500’s P/E has been roughly 30% to 40% higher than normal, making the half of U.S. households who own stocks in some form (often in retirement funds) feel richer than they actually were.
Next came inflation, which forced the Fed to do a policy U-turn. With the Fed no longer able to inflate home and stock values, the prices of those assets are now coming down to something closer to “normal,” although we’re not completely there yet. For example, Redfin’s estimate of my Seattle home’s value has declined about 4.5% over the last couple months. The decline has been even more dramatic in stocks; the S&P 500 index is down about 32% from its January 5 peak, and the S&P 500’s P/E is now about 18.5, which suggests the stock market hasn’t quite bottomed yet. And, of course, if there’s a recession and earnings decline, stock prices would have to fall further just to maintain the same P/E. This is more or less why investors are dumping stocks now, although it’s also because bonds pay better now, and for some other reasons.
Many people knew the game was rigged, but couldn’t do anything about it. They’ve paid inflated prices for homes (or inflated rents) because they need somewhere to live. And with bonds, money market accounts, and savings accounts not paying interest, investors bought stocks at inflated prices, because stocks paid dividends and were going up (for a while). And they knew stock prices wouldn’t come down as long as the Fed kept propping them up. Now that the Fed isn’t doing that anymore, in order to shift its focus to bringing down inflation, stock prices are coming down closer to where they “should” be.
All of this is good in a way, because home prices will become more affordable, although borrowers face higher mortgage costs. And stocks will earn more, because they’ll be cheaper; and it’ll also be easier to invest, because you’ll be able to calculate a stock’s appropriate value from its earnings, instead of trying to guess what the Fed will do next. For the last dozen years, the Fed was the 900-lb. gorilla on Wall Street driving up stock prices, and not much else affected the market. That influence is still there for now, but will fade as stock prices normalize.
We’re not poorer because of all this. Our homes and investments are still intrinsically worth what they always were. We’re simply not being lured into spending beyond our means by deliberate cooking of the books anymore. Is that a bad thing?
Related story: See how much illusionary paper wealth has evaporated from the stock market here.