The Case for the Bears

Following yesterday’s case for a continuing bull market, here’s a case for the bears from Martin Feldstein, chairman of the Council of Economic Advisors under President Reagan.

Feldstein wrote in The Wall Street Journal that, “Stocks Are Headed for a Fall,” based on his belief that the Federal Reserve Board will be unable to raise interest rates to normal levels without having a negative impact on the stock market. Just as the lowering of interest rates caused asset prices to rise, the raising of rates, he believes, must cause prices to fall.

“Year after year,” he wrote, “the stock market has roared ahead, driven by the Federal Reserve’s excessively easy monetary policy. The result is a fragile financial situation—and potentially a steep drop somewhere up ahead.”

To deal with the financial crisis, the Fed began its quantitative easing program in 2008, buying long-term bonds and mortgage-backed securities until its balance sheet grew from less than $900 billion to nearly $4.5 trillion.

This unconventional monetary policy encouraged investors to shift out of bonds and into equities and real estate, resulting in an increase in household wealth to push consumer spending higher and strengthen the economic recovery.

As a result, the S&P 500 stock index gained more than 300% from 2009 to today.

Because stock prices rose faster than profits, the P/E ratio for the S&P 500 skyrocketed to 26.8, which is 70% above its historical average and is higher than it was at any time in the century before 1998.

“Although some of the market’s recent surge reflects improved expectations since the 2016 election,” Feldstein wrote, “the P/E ratio just before the election was already 49% higher than its historical average.”

While the stock market soared, the 2.5% yield on 10-year Treasury bonds is about equal to expected inflation over the next decade, meaning the real yield is zero. Historically, the real yield on 10-year Treasurys has been about 2%.

“When interest rates rise back to normal levels, share prices are also likely to revert to previous norms,” according to Feldstein. “If the P/E ratio declines to its historical average, the implied fall in the market would reduce the value of household equities held directly and through mutual funds by $10 trillion. If every dollar of decline in household wealth reduces annual consumer spending by 4 cents, as experience suggests, spending would fall by $400 billion, or more than 2% of gross domestic product. The drop in equity prices would also raise the cost of equity capital, reducing business investment and further depressing GDP.”

Feldstein sees four reasons for a sharp decrease in stock prices and an increase in bond yields:

  • The Fed has said it will continue to raise short-term interest rates. Higher short-term rates will result in higher long-term rates, even if the slope of the yield curve does not increase.
  • The Fed, which built its portfolio to $4.5 trillion through its bond-buying program, is now reducing its holdings of Treasury bonds. Interest rates will need to rise to get the market to absorb the greater supply of securities.
  • With a federal deficit of 3.5% of gross domestic product, Washington will need to borrow about $700 billion this year. According to the Congressional Budget Office (which is frequently wrong), the deficit will grow under current law to more than 5% of GDP, which would boost the debt-to-GDP ratio from its current 77% to 97% in 2027.“This is probably too optimistic,” according to Feldstein. “Spending on defense and discretionary programs is shrinking as a share of GDP, and the need to reverse this trend means the deficits and debt will be even greater than current law suggests. Buyers of this increased U.S. debt will require a higher interest rate.”
  • The consumer price index rose 2.1% over the past year, which is a tad over the Fed’s goal of 2% inflation. It’s taken the Fed years to achieve its inflation goal, but what happens if inflation continues to grow? Given the growing economy and the tight labor market, that’s likely to happen. Feldstein says the expectation of rapidly rising inflation will cause long-term rates to rise even before higher inflation occurs.

“The Fed should have started raising the fed-funds rate several years ago,” he concludes, “reducing the incentive for investors to reach for yield and drive up equity prices. Since it didn’t do so, the Fed now faces the difficult challenge of trying simultaneously to contain inflation and reduce the excess asset prices—without pushing the economy into recession.”

Good luck with that.

Considering both the case for a bull market and the case for a bear market, consider diversifying your investments, so that you can take advantage of rising stock prices in case Luskin is right and protect yourself from falling stock prices in case Feldstein is right.

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