By Roman Chuyan, CFA
- I show (again) that the stock market valuation is at its highest in at least 150 years.
- However, reason doesn’t apply in a bubble; instead, crowd mentality is in charge.
- What might trigger a turn in the market? I think inflation and rising rates are inevitable.
Stocks have continued to rise in April, taking the market to an even more-extreme valuation. While the S&P 500 reached an all-time high, corporate earnings haven’t rebounded from their early-2020 plunge, and in fact continued to decline through Q4-2020 (the latest final EPS available). These trends have brought valuation ratios to an extreme. In its 150-year history, Shiller’s cyclically adjusted P/E ratio, at 37, has been higher only in 1999-2000:
The “regular” P/E ratio is also extreme at 42. It exceeded this level only in 2001 and in 2008 when earnings plunged during recessions. So, it’s now at its highest non-recession level in at least 150 years:
As I wrote before, this is a bubble, plain and simple. Let’s keep in mind that reason doesn’t apply in a bubble. Presenting facts and analysis won’t change anything. Instead of rational decision-making, crowd dynamics is in charge – it will continue until it ends. But make no mistake, it will end as all bubbles do, in a crash. In today’s article, I speculate on what might trigger a turn in the market.
What might serve as a trigger? While it’s hard to predict – it could be almost anything – a few negative developments are already in the works:
- Rising inflation and interest rates: Both have begun to rise, and will likely continue – see below.
- Rising taxes: The plan to raise corporate tax from 21% to 28% hasn’t done any damage, but it still can when corporations and analysts project lower after-tax earnings. Personal income taxes will also rise, and possibly the capital gains tax.
- A geopolitical conflict: Tensions with Russia around Ukraine have escalated in recent weeks, and China appears to be emboldened regarding Taiwan and Hong Kong.
Among the three potential triggers, in my view inflation is the most inevitable. The rally in commodities in the past year pushed the producer price index (PPI) to 4.2%, its highest in 10 years. This began to filter into consumer (CPI) inflation, at 2.6%. You can see the progression, from commodities to PPI to core CPI, on this chart. Core CPI inflation (which excludes food and energy) is still low at 1.6%, but is likely to rise as economic growth and rising wages add to price pressure from high commodity prices.
Some of the rise in inflation rates (12-month rate of change) is due to the “base effect,” the drop in price indexes in early 2020. The base effect is temporary – it will go away by May-June. The chart below shows the price indexes over three years. You can see that inflation has accelerated in recent months, with PPI leading the way followed by CPI. This short-term acceleration means that inflation is rising beyond the base effect.
Inflation is rising due in large part to the Fed’s money-creation, which I wrote about in my recent commentaries. Someone noted to us the jump in money supply. Money supply measures jumped in May of 2020 coinciding with the stimulus at the time, and continued to rise this year. Specifically, the M1 measure (cash and checking accounts) inexplicably skyrocketed in that month to $16 trillion – a three-fold jump in the entire US money supply – and continued to rise to $18 trillion this year.
Such many-fold increase in money supply is unprecedented, and I can’t make sense of it yet. The St. Louis Fed’s economists attempt to explain it by a change in banking regulations. The data appears to be discontinued in February, adding to the mystery.
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