THE MARKET´S OPTIMISM IS BUILT ON A FOOLISH PROPOSITION / MONEY TRENDS

The Market’s Optimism Is Built on a Foolish Proposition

By Andy Krieger, Editor, Money Trends



The U.S. hasn’t seen unrest like this since the assassination of Dr. Martin Luther King Jr. in 1968.

We’ve had widespread violent protests, riots, and looting across dozens of major cities, with thousands of arrests.

Yet the impact on the markets has been negligible. Stocks continue to rally. They’ve surpassed the highs of the market when the first several Covid-19 deaths in the U.S. were announced.

However, I believe that won’t last. Let me explain…

A Foolish Proposition

The only thing that seems to be relevant to the markets is the de facto put option from the Fed.

The 40% economic collapse in the second quarter is irrelevant. So are the 110,000 U.S. deaths from the coronavirus.

In the minds of stock buyers, the Fed is going to continue providing support and economic stimulus.

In reality, the economy is a mess, and the civil unrest is only going to hinder the recovery. Damage to property and extensive curfews are not helpful to economic growth, to say the least.

Not to mention, the mass riots and protests provide a perfect breeding ground for the virus to spread, as tens of thousands of shouting people are bunched together for many hours.

The likelihood of a second wave of Covid-19 infections is growing stronger by the day. Yet none of these things seem to matter to the markets.

People are relying on the assurances of Jerome Powell, the Chairman of the Federal Reserve, that the Fed is not going to run out of ammunition… and that the Fed will provide essentially unlimited lending to support the economy.

But counting on the Fed to keep up the stimulus indefinitely is a very foolish proposition that is doomed to fail. Here’s why…

Even the Fed Has Limits

The system is not seizing up right now. The banks are working efficiently. No, they are not lending easily, but they always prefer to lend to companies and people who don’t need the money.

Companies that are weak can realistically be expected to go out of business, not get bailed out by taxpayers. That is not the function of government in a capitalistic, democratic society.

That is why stocks are theoretically considered “risky” assets. Companies can go out of business and fail. They aren’t supposed to get propped up and supported due to some sort of shady cronyism.

But today’s system has been distorted by funny money.

The Fed just keeps blowing out its balance sheet, pumping ever more money into a weak economy to trick people into thinking that things are alright.

In 2019, the Fed’s balance sheet stood at $3.76 trillion. Since the onset of the coronavirus, the Fed has grown the assets in its balance sheet to $7.1 trillion. Yes, $7.1 trillion!

That sounds a bit scary. If I just keep borrowing money so that my balance sheet is getting bigger and bigger, am I getting wealthier?

Of course not. That is not a creation of true wealth. It is a creation of true debt.

Bad Environment for Risky Assets

This is what I’m referring to when I talk about funny money.

The huge injections of borrowed funds simply pushed up the value of assets like stocks, without the underlying economic growth that should really be driving the stock market.

That’s why the market’s valuations today are truly extraordinary. The P/E ratios – which measure how much investors are paying for each dollar of a company’s earnings – point to fantastic growth rates and an economy that is humming on all cylinders.

They are not discounting an economy that just needed over $5 trillion of emergency bailout spending.

However, the Fed and the Treasury do have limits, as much as they may not want to admit it. At some point borrowers will resist any further debt issuance by the Treasury.

Federal borrowing will start to crowd out money that would otherwise go towards investment.

The Fed will finally have to restrain its balance sheet and start to reduce its size. And the trajectory of long-term economic growth will be more modest.

This is not a great environment for risky assets.

We don’t know which catalyst will propel the markets in a direction that matches the fundamentals.

But that time is coming.

At a minimum, we will see a correction of 10% from current levels in the S&P 500. Potentially, we will see a second wave of violent selling that will melt down to new lows.