Sunday, December 1, 2013

Are we in the midst of another stock bubble or is this bull market for real?

In a recent post, Paul Krugman rejected calls for monetary tightening as a way to deflate a supposed bubble in stock prices.  It will come as no surprise to anyone that asset bubbles are the side effect of an active Fed.  Understanding how Fed policy causes asset bubbles holds the key to the question at hand:  are we in a stock bubble with the S&P 500 Index hitting 1,800 or does this bull market have real legs?

Here is an interesting chart that compares the S&P 500 Index with changes in US money demand (Ma).
What is money demand?  This is the money people stuff in their mattresses or hoard as bank deposits and money market funds.  The demand for money is the most important macro-economic monetary variable because unlike the supply of money, it is not subject to direct manipulation by the Federal Reserve.  Rather, it is corporations and individuals who choose what to do with their money.

When times are good, people are comfortable taking on risk.  Accordingly, they attempt to allocate more of their wealth into riskier assets such as stocks, bonds and real estate.  This drives down the demand for money.  The opposite occurs during a downturn.  Investors scramble to sell risky assets and attempt to allocate a greater percentage of their wealth into cash, which raises the demand for money.

Since the nominal value of money is fixed, fluctuations in the demand for money affect the prices of other assets.  Suppose people hold 5% of their wealth in cash.  An economic downturn prompts investors to increase their cash allocation to 10%.  Assuming the supply of money stays constant, prices of all other assets will have to come down by 50%.  A simple change in the demand for money can wipe out half of the country's wealth, at least on paper! 

Here comes the active Fed.  In a downturn, the Fed would increase the supply of money in order to avoid the self-perpetuating deflationary spiral of an asset liquidation.  In the above example, the Fed would simply double the supply of money enabling investors to reach the desired cash allocation without precipitating a dramatic collapse in prices.

Of course, there is a catch.  The new reserves supplied by the Fed pack a tremendous punch.  As the real economy finds a bottom and fears of the future subside, the new money has the potential to fuel an asset bubble.  To illustrate, should investors attempt to allocate back to 5% cash, asset prices would have to double from their original level unless the Fed perfectly times the withdrawal of the extra money supply.  Based on the historical record over the last 25 years as illustrated in Chart 1, it seems the Fed has done quite poorly on that account.  It is this mistiming of Fed policy that is the root cause of asset booms and busts.

Now back to Chart 1.  Let me first explain how I derive changes in money demand (Ma).  I deconstruct M2 into its components – transaction money (Mt) that people use to accommodate spending and asset money (Ma) that people hold as part of their wealth portfolio, which is also a proxy for money demand.  We can solve for Ma by using the following identities:
M2 = Mt + Ma
Q * P = Mt * Vt
The second identity stands for the quantity of money equation.  Quantity times Price (Q * P) represents the real economy or GDP and Vt stands for the velocity of transaction money.  I assume Vt to be fairly constant since it is primarily driven by factors independent of money demand such as payment technology and purchase friction.  Based on data provided by the St. Lous Fed, the average velocity of money since  1959 is about 1.85.  By plugging that number in the above identities, I solve for Ma and construct the time series in Chart 1.

Chart 1 illustrates a strong correlation between changes in money demand (Ma) and the stock bubbles of the 1990’s and 2000’s.  Also, it is evident that the financial collapse of 2008 and the subsequent recession caused a dramatic rise in the demand for money to the tune of some $2 trillion.  However, the Fed under Chairman Ben Bernanke countered with a massive infusion of money dubbed quantitative easing (QE), which has kept excess reserve at a level sufficient to meet money demand.   Clearly, Ben Bernanke is the unsung hero of this crisis – he has single-handedly prevented a second Great Depression.  However, two questions remain.  First, why has the Fed done such a poor job in timing the withdrawal of Ma balances over the last 25 years, which enabled two big asset booms and busts?  Second, do we again find ourselves in the exuberance of another asset bubble?
To answer the first question, let’s explore the options people have to dispose of new Ma balances supplied by the Fed in response to an economic downturn.  At first individuals simply hold the extra money until the fear of the downward correction subsides.  By this point, the Fed has pushed down interest rates while also having pumped the money supply in order to build inflation expectations.  The hope of policy makers is that the negative real returns on cash balances will prompt individuals to divert money into the Mt category which leads to higher spending and economic growth.  However, individuals also have the option to buy existing assets, which sets the stage for a rapid increase in asset prices.  Ma balances begin to flow from asset buyers to sellers with little immediate impact on the real economy.
So which of those two options would individuals choose – would they spend the newly-printed money in the real economy or would they plow it in the asset bubble?  It is important to consider that Ma balances are not equally distributed among the population.  For the most part money balances reside with big corporations and wealthier individuals who have low marginal propensity to consume and invest.  Only as the wealth effect and the lower cost of borrowing trickle down to the general population will the newly created money find its way to the Mt category thus setting the stage for the real recovery.  Furthermore, none of the asset bubble indicators are on the Federal Reserve radar screen.  The Fed does not ponder the stock market to assess if it is overpriced.  Instead, the Fed will begin to tighten only when inflation and unemployment in the real economy move outside the acceptable range.  However, the churn of Ma balances between asset buyers and sellers takes place outside of the real economy, which gives the asset bubble plenty of time to run unabated.
It is interesting to look at the evolution of macro-economic policy.  After the massive government spending during World War II pulled the US out of the Great Depression, fiscal policy became the primary tool for managing the economic cycle.  However, active fiscal policy came with the permanent side effect of inflation, which culminated in the stagflation of the 1970’s.  After Paul Volker successfully fought off inflation, monetary policy took center stage as the primary tool for managing the economy, but it did come with its own side effects – asset booms and busts.
Now back to the second question – are we in an asset bubble today?  The hallmark of an asset bubble is an attempt by investors to allocate a greater portion of their wealth away from Ma balances.  Basically an asset bubble is marked by a declining cash allocation.  The next two charts show Ma balances as percent of total household wealth and the total value of US equities.

 Chart 2 (Source: St. Louis Fed)

Chart 3 (Source: St. Louis Fed)

The bars on the graph represent Ma balances as a percent of the respective asset group, which can be used as proxy for investors' allocation in cash.  There is no observable decline in cash allocation which would suggest that we are not in a bubble, at least not yet.  Early in 2011, it appeared as though cash allocation had reached a peak only to suffer a marked rise in Q3-2011 most likely as a result of the debt ceiling fight in Congress.

A sustained flattening or even a decline in cash allocation would suggest that investors' appetite for cash has finally been satisfied.  If the Fed continues to pump money after that point, any excess cash will be plowed into assets giving rise to another bubble.  To illustrate that point, the dashed line assumes that the peak in cash allocation occurred in Q4-2012 and shows asset levels without QE.  Of course, this all speculative.  At this point, it appears too early to tell whether we are past that point.  I will continue to update and share these charts as the Fed releases more data.

The important thing to take away is that the potential for another bubble is there, but nothing is assured.  We could be in an extended period of elevated demand for money; however, the risk remains that as soon as investors and corporations begin to allocate away from cash, asset prices will once again enter into bubble territory.  If history is any guide, the Fed will not tighten monetary policy timely out of fear of hurting the real economy.  The most important question still remains.  What will people do with the excess money printed by the Fed would they continue to sit on it, would they spend and invest in the real economy or are we in for another boom and bust cycle?

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