Are Stocks Headed for a Fall?
Today’s (1/17/18) Wall Street Journal featured an opinion piece by Martin Feldstein (Harvard professor and chairman of the Council of Economic Advisers under President Reagan) boldly entitled, “Stocks Are Headed for a Fall”. Ironically, The Dow Jones Industrial Average today turned in its best gain so far in 2018 (up 322 points) in what is starting to look like a “January Effect” on steroids. This, of course, is on top of a record-breaking nine-year winning streak beginning in 2009, with very little volatility, especially in the last few years. Indeed, it now seems that the question we ask is not, “Was the market up or down today?” but rather “How much was the market up today?”
As expected, Feldstein marshals some cogent arguments to support his case. He begins by explaining how we got here via extraordinary intervention by the Federal Reserve through its zero interest rate policy (on the short-term side) and Quantitative Easing (massive purchases of government bonds and mortgage-backed securities, tamping down long-term interest rates), making stocks and real estate far more attractive than bonds and cash. Feldstein cites the valuation measure of the price-to-earnings ratio to note that stocks are now priced 70% higher than their historical average and are higher than at any time in the last 100 years, except for the run-up to the dot-com crash of 2000. Since the 2016 election, the Dow is up 42.5% and the broader-based S&P 500 is up 31.0% (as of 1/17/18 close). A back-of-the-envelope calculation suggests that the highly anticipated and recently passed tax cut is responsible for about 21.5 percentage points of those increases.
Of course, both of the aforementioned Fed policies are now running in reverse along with increasing federal budget deficits and the threat of higher inflation resulting from overly tight labor markets prompting Feldstein to state, “When interest rates rise back to normal levels, share prices are also likely to revert to previous norms.” It would take about a 40% drop to return valuations to historical norms. This would mean a $10 trillion reduction in the value of equities owned by households, leading to an estimated $400 billion drop in consumer spending, or more than 2% of GDP.
From an efficient markets standpoint, the counter-argument to Feldstein is that all of these forces pushing up interest rates (and leading to an eventual sell-off of equities) are well-known to every serious participant in the market, yet rather than dropping like a lead balloon, prices have only gone up.
As for where we stand at Clarity Capital Advisors, investors with balanced portfolios who have not recently rebalanced should consider doing so, especially if their portfolio is now at a substantially higher risk level than when it was established. If you have any questions or concerns about your own portfolio, please call us at 800-345-4635 or email us at firstname.lastname@example.org.