Wednesday, December 4, 2013

Is this bull market for real (part II)?

In a previous post, I discuss the dramatic rise in money demand spurred by the financial crisis.  The Federal Reserve obliged investors' appetite for cash with an unprecedented infusion of money dubbed Quantitative Easing (QE).  At this point, it is too early to tell if cash allocation has reached a peak; however, one thing is clear.  The Fed has successfully neutralized the deflationary pressures on asset prices exerted by the scramble for cash.

Now, let's look at high-level market fundamentals to try to make sense of current stock prices.  I prefer to look at 10 year trends.  If you recall from part I, asset booms and busts are the side effects of an active Fed.  Looking at 10 year price trends will hopefully mitigate the distorting influence of monetary policy.

Chart 1 Source: St. Louis Fed

Chart 1 shows the S&P 500 Index aggregated quarterly and its 10yr average.  It also overlays the 10 yr average of an index representing GDP and corporate after-tax profits as a percent of GDP.  There is a fairly good correlation between the 10yr averages as demonstrated by the dashed line.  As a point of simple reference, both GDP and corporate profits as a percent of GDP have roughly doubled since 1995.  It is not unreasonable to expect that stock prices today would be 4 times higher compared to 1995.

A cautionary note here - all projections need to be taken with a grain of salt, because they simply take past relationships and project them into the future.  Human society is so dynamic - it simply does not behave according to fixed laws.  People adjust their behavior to new conditions and external influences.  Past relationships are not guaranteed to hold true in the future.  Just consider the different reactions to government economic policy as I observed in part I.  People responded to active fiscal policy in the 1960's and 70's by increasing inflation expectations.  When monetary policy took center stage in the 1980's, inflation was defeated; however, active monetary policy prompted asset booms and busts.

That being said, I will continue to monitor this time series in order to better assess its predictive capacity.  Also, it is helpful to take a more granular look at the individual drivers - GDP and profits.

Chart 2 Source: St. Louis Fed

Chart 3 Source: St. Louis Fed

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