Feldstein: Stocks are headed for a fall …

“The Fed’s easy monetary policy has led to overvalued equities”

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Let’s start by taking a stroll down memory lane ….

Over 40 years ago, an economist-wannabe co-authored a study in the Journal of Finance titled “The Supply of Money and Common Stock Prices”.

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The article summarized an econometric study (think: big, hairy financial model) that demonstrated a tight link between the amount of money floating around and, on a slightly time-delayed basis, the price of stocks.

That is, when the Fed adds liquidity into the market (think: “quantitative easing”), much of money flows into the stock market – rocket-boosting stock prices.

And the opposite is true. When the Fed tightens, stock prices fall back into earth orbit.

OK, fast forward to today.

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In a WSJ column, famed economist Martin Feldstein sounded some warnings about the soaring stock market:

Year after year, the stock market has roared ahead, driven by the Federal Reserve’s excessively easy monetary policy.

To deal with the Great Recession, the Fed cut interest rates to a historic low.

Fed Chairman Ben Bernanke explained that this “unconventional” monetary policy was designed to encourage an “asset-substitution effect” with investors pouring the added liquidity into equities and real estate.

The resulting rise in household wealth was expected to push up consumer spending and strengthen the economic recovery.

The strategy eventually worked as Mr. Bernanke had predicted.

The value of equities owned by households increased 47% between 2011 and 2013, and overall household net worth rose nearly $10 trillion in 2013 alone.

When interest rates rise back to normal levels, share prices are also likely to revert to previous norms.

In short, an excessively easy monetary policy has led to overvalued equities and a precarious financial situation.

The result is a fragile financial situation—and potentially a steep drop somewhere up ahead.

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I hate Prof. Feldstein’s conclusion, but have to pay attention since it’s rooted on some rock-solid (albeit dated) econometrics work done a few decades ago.

But, of course, there wasn’t a “Trump Effect” plugged into my model … so, there may still be hope of continued market euphoria.

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One Response to “Feldstein: Stocks are headed for a fall …”

  1. Coop Sr. Says:

    However, interest rates are still at rock-bottom levels from a historical perspective (10Y at 2.6% today, relative to typically 5-5.25% over the long-term) PLUS the global interest rate environment is also super low PLUS the yield curve is in a healthy upward slope (although flatter than 24 months ago)… all of which indicates, to me, that investors will continue to chase yield in equities. I wouldn’t get concerned until either (1) the 10Y trends north of 4% or (2) the yield curve becomes inverted, which as we all know has preceded every major correction.

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