The Inherent Fragility of the “Wealth Effect”

You probably thought the boom/bust cycle experiment that started with Alan Greenspan was over when Ben Bernanke came to the Fed.  Or maybe you weren’t that naive to begin with. Either way, Bernanke is implementing very similar and in my opinion, dangerous economic policy.

When Greenspan was head of the Fed, he made it well known that the stock market was a favorite target of his.  This became known as the “Greenspan Put”.  This was the levitating effect of stock prices that placed a “put” or floor under the equity market.  Greenspan was even more explicit a few weeks ago when he said:

“the stock market is the key player in the game of economic growth.”

I believe this is an incredibly misguided view of what the stock market is.  The stock market is a secondary market where SAVERS exchange shares of stock in what is nothing more than an allocation of their savings. The price of those shares reflect the GUESSES of future expected cash flows.  And as we all know, what you have in stock market gains is not real until you cash out of the game and exchange your shares with someone else.  Of course, everyone can’t cash out of the game at the same time since all shares issued are always held by SOMEONE.  So there’s an inevitable bagholder if the you-know-what hits the fan.  There is no escaping that simple fact.

The risk of course, is that a stock market has the inconvenient truth of both a “poverty effect” as well as a “wealth effect”.  Owners might feel better off if shares increase in value.  But owners feel just as poor when they decline.  Of course, if you can keep it going in one direction it’s like a good ponzi scheme.  But if the shares deviate from their underlying fundamentals and a disequilibrium occurs you’re asking for big time trouble from an inevitable “poverty effect”.  It ripples through the economy as stocks take the stairs up and the elevator down when panic sets in.  Anyone whose been awake during the last 15 years knows how that feels.

The danger here is the illusion of real wealth where there is only nominal wealth.  And that illusion appears to have at least some impact on spending.  As you can see in the following chart (figure 1 via Orcam Financial Group), the personal savings rate is inversely correlated to stock prices.  So, the increased wealth makes savers feel better off temporarily and then when the air comes out of the market those savers suddenly realize that their stock portfolio is just an allocation of their savings and they stop spending as the poverty effect kicks in.

There doesn’t appear to be any question that such a strategy can work in brief periods of time.  But the question is whether we should be designing policy around such an inherently fragile part of the economy (stock prices).  More importantly, we should ask ourselves whether a policy of targeting stock prices will create a disequilibrium where stock prices become detached from their fundamentals and create the illusion of a saver who is wealthier than he/she really is.

Me, I prefer to let prices float as they will and implement policy that actually helps the underlying corporations.  If I were running a public company I wouldn’t waste my time talking up my stock price.  I would run the corporation to maximmize earnings per share.  Global central banks obviously think this is nonsense.  And so the whole stock price targeting theory reeks of ponzi finance and putting the cart before the horse.  Of course, no one can know when the boom turns into the bust, but it appears as though this sort of policy substantially contributes to the bust when it does occur.   And that’s where we are.  We are in the boom phase.  The bust will come (just as it always does) and when it does we’ll likely all turn to the same institution who helped the boom get out of control in the first place.

(Figure 1 – Personal Savings Rate vs SP 500)

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  • SS

    It’s a great big chess game Cullen. And we’re the chess pieces on the board being told to move from space to space. Except this game ends with everyone losing.

  • Guillermo Izard

    Excellent post Cullen, are you turning Austrian? :-)

  • SS

    I don’t think he’s turning Austrian. I think he’s seeing the potential risks in what is obviously an extremely misguided policy approach. This idea has already failed for 20 year running. Why are we still steering people into stocks and real estate as if bidding up those prices makes us all better off in the long run? It’s insane.

  • http://sbinzagr@gmail.com SMOB

    Should companies be run with the goal of ‘maximizing profits’ or increasing shareholder wealth? How much of a culprit to the instability of the financial structure is single currency bank debt notes deficit sending? What if the system was interest free? In other words does it really matter as long as the finically system is built the way it is? It seems we are using an industrialized financial system in a post industrialized world.

  • frederick

    I think Cullen is saying stock price rises are good when driven by fundamentaals and bad when driven by Fed speculation.

  • Indignado

    Cullen, nice article. Yesterday Jacob Lew came out and basically said equities are not in a bubble. I found that an interesting comment from the new U.S. Treasury Secretary after U.S. stocks are up about 250% since 2009. It seems reminiscent of 2006 and 2007 talk from government officials about the sustainablity of a parabolic housing market. Shame on them I say.

  • Guillermo Izard

    My question was a bit tongue in cheek, but that kind of misguided policy approach is heavily criticised by Austrian economists and is a core principle of their economic cycle analysis.
    And honestly I don’t see anything bad about mixing ideas from different economic schools as long as they help us to understand our economic environment, economists ought to be truth seekers, not religious zealots.

  • William Bedloe

    Cullen said: “The bust will come (just as it always does) and when it does we’ll likely all turn to the same institution who helped the boom get out of control in the first place”…So wait – is government spending feeding the beast or preventing deeper recession? Government seemingly provides a backstop in case of failure, but is this allowing the behavior to continue unabated in the first place – creating a ponzi like effect?

  • Boston Larry

    The S&P 500 is up a bit over 130% from March 2009 up to yesterday, not 250%. I agree with you that a US Treasury Secretary should not say anything one way or the other about the level of equities. He should be focused on the overall economy, not on the wealth effect. That said, he is saying it is not a bubble just when it seems to be getting bubbly.

  • Bill Smith

    Aren’t the gains/losses in the stock market incorporated into the Savings Rate?

  • Joe in Accounting

    I don’t believe he is talking about government spending. I believe he is referring to the Federal Reserve’s QE policies, which don’t add any new net financial assets to the economy. QE is swapping a risk free asset with a coupon for a risk free asset with no coupon, which the Fed is doing to keep interest rates low in hopes of spurring more investment and consumption. The problem is the private sector isn’t really interested in adding more debt to their balance sheets at this point and the reduction of interest income may push them into potentially higher yielding financial assets, causing the prices of these assets to rise.

  • But What Do I Know?

    Excellent points about the wealth effect being problematic because using the money requires selling the asset. I would just add that if the equity holder is willing to leverage his/her position, then no sale need occur. One of the reasons the stock bubble in 1999-2000 and the housing bubble in 2005-06 were so effective at pumping up economic activity was that people were willing to take on leverage because they had the belief that prices would not fall. I don’t think this is so much the case anymore.

    To me, the essential question to ask is whether or not we have reached a point where cash flows out of the “asset markets” are greater than the cash flows in, for demographic reasons primarily, but others as well. Because the current investment choices produce less cash flow than before (pre-2008), this day has been accelerated.

    It will be interesting to see what happens when/if the NIKKEI reaches the 13,000 target set by the new finance minister by the end of March. What happens then? The cash flows from holding Japanese stocks certainly don’t justify sitting around if the market isn’t going to keep going higher. Will the MOF set a new target, say, 10% higher for March of 2014? At that point, why not just have a government savings account with a guaranteed x% return?

  • http://www.orcamgroup.com Cullen Roche

    Monetary and fiscal policy are two separate things here. The Fed is not an enabler of govt spending via QE. QE is pure monetary policy. While fiscal policy can be distortive, I don’t think its causing distortions in stock prices. I think its QE and its desired wealth effect that is essentially a repeat of Greenspan style policies….

  • http://www.conventionalwisdumb.com Conventional Wisdumb

    Greenspan’s interview on CNBC this morning was a joke. He says stocks are very undervalued based upon their historical risk premia.

    Seriously when did it become the FED’s job to inflate stock prices and housing?

    This is scary s**t.

  • knucklehead

    The equities portion of my portfolio isn’t giving me that wealth effect feeling. More like here today, gone tomorrow. Frothy markets are a little like riding motor cycles. Nervous experience for some, exhilarating for others.

  • Geoff

    There are two separate issues here. The first is whether the Fed should be manipulating stock prices (probably not). The second is related to the “fragility” of the wealth effect. The stock market is more than just a secondary exchange used to allocate savings. It is also a primary exchange where companies raise capital. The higher the stock price, the more capital a company can raise, which hopefully will be spent into the real economy. Also, the higher the stock price, the stronger the company balance sheet (debt/equity ratio), and in turn the more capacity a company has to borrow. As MR has proven, our whole monetary system is based on the capacity of the private sector to borrow.

    As George Soros likes to say, the stock market is reflexive. It is not only driven by fundamentals, but it also DRIVES fundamentals in a sort of feedback loop.

  • INDIGNADO

    Actually, I believe is about 250%. The low in the S&P was 666 and today it is around 1560. 666 X 2.5 = 1665.. So if we are going to get specific it is closer to a 235% rise.

    On the other point about Jacob Lew´s comments, I think it goes beyond inappropriate and border lines on immoral. They are coaxing people to buy into the market today. Even Greenspan has joined the party saying that there is no irrational exuberance in the stock market today! These commentaries are reckless in my opinion.

  • INDIGNADO

    My apologies.. You are correct on the 135% rise. I had a mind fart. :-)

  • Effem

    The market has actually followed corporate profits pretty closely…I don’t think that what you are seeing is ephemeral necessarily. New highs in corporate profits = new highs in the stock market. The bigger issue it seems is that corporate profits are not translating into meaningful gains for 80% of the population (the top 20% is having a great time on the other hand).

  • http://www.nowandfutures.com bart

    No

  • Andrea Malagoli

    The problem is that it is difficult to separate the two. If the Fed actions provide for cheap credit growth and some of it turns into increased spending, company fundamentals will look good, but still for the wrong reason, i.e. credit expansion as opposed to personal income expansion. There is a bit of an Austrian element here, but the most accurate interpretation is Minskyan.

  • KB

    Cullen,

    You are absolutely correct, but to really understand what’s going on and why all this blabbing happening, we need to distinguish between different groups of equity and debt holders, and to look at marginal flows.
    Obviously, if a equity holder rides his depressed assets all the way up to the current top, and then unloads them to somebody else, he would fully realize so-called wealth effect. You only need to answer who is this, and to whom he is unloading/will unload.
    Also, if an undercapitalized corporation uses this ride to “wealth” to issue shares and improve capitalization, or negate asset deficiency, this obviously would be a clear beneficiary of the “wealth effect”.
    Thus, some people/groups are winning. And, regarding them, all the fed talk about “wealth effect” is perfectly correct.

  • Andrea Malagoli

    Why are we even still listening to Greenspan?

  • Johnny Evers

    The wealth effect is real. When the Fed propped up and reinflated Fannie Mae and various other banks and bondholders, that provided real wealth to shareholders.
    So if the Fed can keep the market propped up by adding $35 billion a month, yes, that will do the same for stock shareholders.

  • Andrea Malagoli

    The “wealth effect” that the Fed is aiming for is the effect on consumer spending. In their naive view, people should be encouraged to spend more if they see their stocks rise in their 401k (where most 99%-ers people hold stocks) or their home value increase to the point where they can leverage through a HELOC. This has been very weak in relation to the size of the stimulus. In the end, “normal” people need job stability and increased wages to keep the musing playing.

  • Steve W

    Good post, Cullen. Your statement ” And as we all know, what you have in stock market gains is not real until you cash out of the game and exchange your shares with someone else.” got me thinking about securites based lending. Years ago, when I worked at Merrill Lynch, we were encouraged to sign up our wealthy clients for a “loan management account”. The idea was to borrow against the portfolio and buy that new boat, car, etc. rather than pay cash or use conventional boat financing or auto financing (for example). Of course, the program was intended for larger portfolios using fairly conservative borrowing limits. We didn’t want to worry about margin calls. I bring this up because this seems credit expansion. I’m work in the independent channel now and (happily) just focus on helping clients with their portfolios, so I don’t know if the wirehouses are still pushing the securities based lending programs. What are you thoughts about this sort of lending? Perhaps it’s too small of a factor to really impact credit expansion.

  • Geoff

    I recently used my margin account to fund a purchase in the real economy. The funds were obtained with the click of a button. Much less hassle than dealing with the bank. I could have actually sold some stock but was bullish at the time.

  • Kristian Blom

    What Cullen is outlining is spot on. This is in some ways all that anyone needs to know about the current environment; instead of picking it apart, we should digest the implications.

    Very little lucid thinking is taking place in the financial industry (purposely)or on the web.It is almost all noise and attempting to explain things by piling fact on top of fact, creating logjams of information and zero UNDERSTANDING.

  • Michael C

    Quantitative easing and zero interest rates push money into the banks and the market but the same time it reduces the amount of money the American public receives on their savings. It may be close to a zero sum game. The real wealth effect is the money you have in your bank account. The value of your stocks is variable and can never be truly depended upon in the long run in the way that a savings account or a CD. In my opinion all that has happened zero interest rates is ripping off the hard-working savers who truly make a consumer consumption the benefit of the top 10% don’t need the money for consumption. Truly disgustedly horrible policy

  • http://brown-blog-5.blogspot.com/ Tom Brown

    Not to argue with your conclusions, but just keep in mind that QE may distort financial asset prices, but it doesn’t actually change anybody’s equity (to a 1st order approximation anyway). Here’s a simple example illustrating what I mean:

    http://brown-blog-5.blogspot.com/2013/03/banking-example-4-quantitative-easing.html

    In other words, it’s not free money just handed out to banks or anybody else.

  • http://brown-blog-5.blogspot.com/ Tom Brown

    Also, Cullen has made the point that money put in stocks by your average Joe is actually savings. You put it there to hedge against other risk like inflation risk (that’s one reason anyway).

    John Bogle has done some analysis of stock and bond returns going back to the 1800′s. If you look at the inflation adjusted returns of owning the stock market as a whole (the S&P 500 is a good approximation, at least for the US), I think it came out something like 5% a year return on average. Bonds are a little lower (again, assuming you own a representative slice of the whole bond market). Bank accounts have got to be one of the worst performers. I’m not saying that can’t change… but that’s quite a lot of data and history and includes some pretty glum times (Great Depression, etc.).

    Plus the zero-interest rates… well there’s good and bad in that. Like you say it ruins return on some of the safest of savings (bank accounts, CDs, short to mid term treas bonds), but it also makes (re)financing a house easier.

    I’ve noticed that people in my Dad’s generation (he’s 95… WWII vet… still going strong!) don’t seem to really trust the stock market that much. I don’t know if he’s ever invested (in anything except CDs)… although he’s curious about it… he lived through the Great Depression … and probably read about the stock and banking fraud in the 20′s and 30′s in the papers… which lead to all that landmark legislation that we’re now undoing. He also volunteered to be on the supervisory committee of a credit union for more than 20 years. He came from the age of pensions, and is now a quadruple dipper (SS, Civilian retirement from the DoD, Retired Air Force Reservist, and whatever he gets for working 13 years as a contractor after retiring). He says he makes more money now than when he worked! But he could read the writing on the wall and encouraged me to use my 401k when I first started working… which worked out reasonably well.

    So I hear what you’re saying… and can sympathize with that view somewhat… but not completely.

  • Tim

    I think you mean “reeks” not “wreaks.” If it’s a typo, sorry; I don’t mean to nitpick. But maybe you honestly didn’t realize the difference.

  • http://brown-blog-5.blogspot.com/ Tom Brown

    I guess you could say:

    “And so the whole stock price targeting theory wreaks ponzi financing and cart-before-the-horse putting upon the devastated economic landscape.” … Ha!

  • Johnny Evers

    Two questions:
    1. After QE, Person X has an extra 200 deposit, which he will most likely use to buy an asset like a stock or another bond. Person X is most likely an institution of wealthy individual. Agreed? Or maybe he spends it. In either case, isn’t that putting money into the economy?
    2. When the Fed acquires the bond, why does the bank’s reserves grow by $200? When the Fed holds a bond, why does it create a reserve? Is that just an accounting method to remind us that the Fed has bought the bond by borrowing money?

  • http://www.orcamgroup.com Cullen Roche

    Thanks. My grammar is bad, but that’s just a brain fart.

  • Geoff

    Double entry accounting, man. T-bonds on the left, reserves on the right.

  • http://wellsfargomustdie.blogspot.com Wells Fargo Must Die

    I’m glad the Feds are finally admitting that they view their primary role as ginning up the stock market. This has been obvious for some time but they have been hesitant to admit it. Now, they are rather honest and even overt about it. When you have very little economy left, financial engineering is imperative.

  • Johnny Evers

    OK, I see. No double entry needed when I hold the bond, but when the Fed acquires the money, it has to ‘borrow’ to do so.
    It borrows from the banking system?
    So when it’s reported that the Fed is creating reserves, it is creating a loan to itself?
    When it sells the bond back to Investor X, it will take that money and use it to erase the reserve?

  • MH

    Your chart just shows that stock prices and spending are positively correlated, and there are cycles.

    But I don’t see how it backs your assertion of Fed policy creating ‘a disequilibrium where stock prices become detached from their fundamentals’.

  • http://www.orcamgroup.com Cullen Roche

    I am not saying that it NECESSARILY creates a disequilibrium. I actually think there’s a huge amount of fundamental improvement driving stock prices and that’s why I’ve been a non-recessionista for a long time now. But if you overlaid the Buffett Wilshire:GNP chart over this you’d get a pretty good idea of what I mean. I am by no means saying the stock market is a bubble, but I do worry about the risk of a boom/bust cycle becoming exacerbated.

  • http://brown-blog-5.blogspot.com/ Tom Brown

    1.: yes, but as Cullen argues, Person x was most likely planning to sell that bond anyway and probably already had plans for what to do with the proceeds as well. x doesn’t care who the buyer ultimately is. The Fed hasn’t forced him to sell. Even if it did, this doesn’t really affect Cullen’s argument. I have to admit I’m a little unsure that there aren’t at least SOME effects that the MMer’s talk about… that perhaps QE raises the prices on some of these assets, and thus it changes the minds of people who were wavering on the edge, to decide in favor of selling. In fact I’m not sure Cullen would disagree with that part, given that he talks about QE causing “distortions” in asset prices.

    2. I think Geoff covered that pretty well. But to be more pedantic about it (that’s how I roll), I’d say take a look at this example:

    http://brown-blog-5.blogspot.com/2013/03/banking-example-11.html

    It’s the same thing! When x buys y’s services, x’s deposit is transferred from bank A to B (and it becomes y’s deposit at B), but also reserves move from A to B. That’s how ALL purchases made with bank deposits work. That movement of reserves is the “clearing” of the transaction people talk about. If x and y both bank at A this clearing can take place w/o any reserves moving. So in the QE example, when the fed creates reserves out of thin air to make a purchase, it doesn’t offer x a reserve deposit at the Fed (that’s not how the system works), it instead credits x’s bank (A) with reserves with the proviso that A in turn create a deposit for x. A is in effect simply an intermediary for this transaction. Make sense?

  • Johnny Evers

    1. Yes, but…
    In the QE example, the public had a 200 bond, but now it has 200 deposit. Cullen says a deposit has more ‘moneyness’. For lack of a better word, the public is now more liquid.
    If Investor X sells his bond to investor Y, then the public still has the same amound of deposits and bonds.
    2. I guess I understand the bank is the intermediary.

    Fwiw, I don’t subscribe to the idea that the bondholder would have sold the bond anyway. If the bondholder does that, the amount of money and bonds in the system stays the same. Not to mention the Fed is setting a price by entering the market.
    If the Fed came out tomorrow and said it would buy every used car at blue book value, then every used car would sell at blue book value, even if the Fed only bought a few.
    Oh, another thing — QE allows Investor X to take his 200 deposit and buy a new bond. So maybe the Fed is using QE to make sure it has a market for new borrowing.

  • http://brown-blog-5.blogspot.com/ Tom Brown

    “No double entry needed when I hold the bond,” — Actually there is… the “Equity” of x shows up on the other side of the BS.

    “but when the Fed acquires the money, it has to ‘borrow’ to do so.” — Actually it doesn’t. I just creates money (reserves) out of thin air as a liability in exchange for the bond.

    “So when it’s reported that the Fed is creating reserves, it is creating a loan to itself?” — It’s not really doing anything different than a normal bank does. Think of bank A just making a loan to x. You could say the bank “buys” an agreement from x to pay back principal and interest (the loan papers) with an IOU (x’s deposit) that it creates out of thin air. In this case the Fed is buying an agreement from the gov to pay back principal and interest (the bond) with reserves it creates out of thin air.

    “When it sells the bond back to Investor X, it will take that money and use it to erase the reserve?” — yes, if x were to purchase the bond back during a Fed OMS (open market sale), then he’d get the bond, and the reserves would cease to exist.

  • http://brown-blog-5.blogspot.com/ Tom Brown

    “and the reserves would cease to exist.” … also x’s deposit would cease to exist.

  • ftm

    Stock market transactions are more than just exchanges of shares for cash. Buyers can be more or less levered than sellers. Typically as stock markets rise, buyers are more levered than sellers so aggregate wealth is being extracted from the stock market and shifted either to other assets or current spending.

    The net effect is wealth(savings) being liquified and made available for current spending( consumption or investment). It is not necessarily spent. It could also be left in a bank account to wait for lower stock prices. If the liquified wealth is used to buy other existing assets, then the ultimate macroeconomic effect will depend on the relative leverage used in the subsequent transactions and what spending vs saving choices are made by those on the liquid end of the transaction chain. Holding the stock sale proceeds as bank deposits would be the worst outcome for the economy. Since banks are awash in deposits, additional deposits have no impact on bank lending to consumers or producers. So the wealth effect could work, depending on stock buyers relative desire to take on leverage, and sellers allocations of the net sliver of liquified wealth between current spending vs holding other assets.

    But increasing leverage in the stock market is no free lunch. Levered investors are much more sensitive to stock price changes and if prices fall enough may be forced to sell to maintain margin. In a big crash, levered owners lose all their wealth invested in stock and bring their creditors along for the ride. The losses ripple out through the financial sector beyond the stock market and likely to the real economy.

    Boosting stock prices through QE, is a bit like a stock market cashout refi, it makes you liquid for a while but as the post points out it may end badly.

  • Anonymous

    Starting to make sense.
    Somehow I had gotten the impression in here that the Fed was exchanging ‘existing’ reserves for the bonds. But the Fed is creating reserves to buy these bonds, right?

    Is there a limit to how much of this the Fed can do? Do you think it unwinds this position sometime?

  • http://brown-blog-5.blogspot.com/ Tom Brown

    Yep, they create reserves to buy bonds, and there’s no limit to it except that they’re not supposed to destroy the economy! That’s not part of their charter. ;)

    I don’t think they have the authority to buy anything they want though… but I’m not sure about that. Obviously its not inconceivable that they could acquire that authority or set that precedent (as the case may be). They have also purchased MBSs (in addition to Treasuries). The Market Monetarists (MMers) think they should be able to threaten to buy as much of whatever they want in order to hit their NGDP target (which they don’t have now, but which the MMers wish they had). In fact if I read the MMers right, the Fed should stop targeting interest rates and target NGDP growth instead… letting the interest rate do what it will. Of course w/ all these excess reserves (ERs) on bank balance sheets (BSs) (due to QE), the only way the Fed has to set interest rates now is by paying interest on reserves (IOR) — because their traditional method of using open market operations (OMOs): buying (OMPs) and selling (OMSs), to set the (typically > 0.25%) overnight interest rate doesn’t work with so many ERs in the system.

    I don’t know if the Fed unwinds its position or not. I don’t think it’s necessary that it does but perhaps it generally does. I looked at the Fed keeping T-bonds to maturity here in this somewhat long example set of BSs:

    http://brown-blog-5.blogspot.com/2013/03/banking-example-6-cb-holds-gov-debt-to.html

    I was just trying to work through what that would look like… and trying to “close the circle” by having the various entities pay back loans when they could… getting ready for the next round of gov revenue raising / deficit spending through bond sales. You might want to just skip the intermediate steps if you take a look.

  • Geoff

    Fiscal policy affects corporate profits, and thus the stock market.

  • http://highgreely.com John Daschbach

    Cullen, I must admit I find your recent Austrian tendencies disturbing because they seem to reflect a divergence from your historical rational thinking. Here are a couple thoughts based upon the following data sets, S&P 500, adjusted close from Yahoo ‘^GSPC’, and the St. Louis Fed data series on urban cost of living ‘CPIAUCSL’, and constant dollar GDP ‘GDPC1’. (Using linear interpolation on the Fed data to match all dates in the GSPC).

    The S&P 500 (GSPC) divided by the CPI is a reasonable estimate of the real price. By this measure the GSPC/CPI is at about 65% of it’s high (around year 2000). It dropped below 50% of this in the post tech-crash, and reached around 80% of prior to the housing crash, and then dropped to almost 30% of it’s all time high. Although the swings have been large, it’s now at the average of 1994-2013 (but still only 65% of it’s high).

    But the market might be expected to reflect a share of GDP. If we take the constant dollar GSPC and divide it by the constant dollar GDP ((GSPC/CPI)/GDPC1) we get a very different picture. This might more closely approximate the real value of the market (constant dollar market/constant dollar GDP).

    Now we are at around 55% of the high, which was reached around 1962. It was on average above 80% from around 1955 to 1970. It dropped to a little over 20% by 1982, recovered to 35% by 1995, and then went on it’s longest, steepest rise in this whole period (1947-2013) to almost 100% around 2000. The tech crash took it down to 45%, the housing bubble took it up to around 70%, the housing crash took it down to 30%, and now it’s recovered to 55%. The mean and median of these data (almost 70 years) are 59% and 55% (relative to high) so we are right there today.

    This is a slightly different but similar take on the Buffet Wilshire 5000/GNP approach. But the data suggest the market is not highly overvalued or frothy on a long term basis. Given that desire for nearly risk free assets has increased over the past 30+ years with a concomitant decrease in real risk free yields, one might expect the risk premium to have increased from it’s very evident 1970 − 1995 lows.

  • http://www.orcamgroup.com Cullen Roche

    I am not saying the market is “frothy”. I am saying that this asset based approach to monetary policy is dangerous and could lead to inflation in inherently unstable parts of the system. This isn’t a new position for me. I wrote similar comments to clients in 2006 during the housing bubble….I think the odds of a disequilibrium are growing. I won’t call this environment a “bubble”, but I think we’d be naive to totally ignore the potential risk in the coming years of this asset based policy approach….

    Plus, I don’t see how this is consistent with Austrian economics. Austrians hate govt and the Fed. I don’t like QE, but that doesn’t mean I think the Fed should be scrapped as Austrians do. I think the Fed system and its public/private hybrid system is rather brilliant by design. I think an Austrian would stick a knife in my ear for saying that….

  • Johnny Evers

    What is the Fed doing to drive stock prices higher?
    Some observers believe QE means the Fed is providing money for banks to buy stocks — I am pretty sure you don’t interpret QE that way.
    So I’m curious as to what mechanism you believe the Fed is using here.

  • Geoff

    I think Austrians prefer guns. Agreed the market doesn’t appear frothy. There is still a ton of negatived sentiment out there. Most people I talk with are still scared sh-tless that the US is going bankrupt. And yes, the Buffet indicator has provided some decent timing signals in the past, but probably more due to luck than anything else.

  • http://brown-blog-5.blogspot.com/ Tom Brown

    Well here’s one possible mechanism: bond prices rise and yields go down (due to QE and low interest rates). Investors are desperate for a better yield on safe assets as those assets continue to rise in price and continue to offer lower yields, so they start putting money in riskier assets like corporate bonds and eventually stocks, which raises their prices too.

  • http://brown-blog-5.blogspot.com/ Tom Brown

    I thought this was a pretty funny page on how to debate an Austrian:

    http://rationalwiki.org/wiki/Fun:Austrian_school

    Here’s a more serious article on the same site on MMers, with this surprising sentence (to me):

    “You might think that this Weimar Republic route to economic recovery wouldn’t be terribly appealing to Austrian school economists, but in fact two of them have come out for it.”

    http://rationalwiki.org/wiki/Market_monetarism

    I wonder which two those were??

  • Geoff

    Good finds, Tom. The one on the Austrians was hilarious :)

  • Andrew P

    Policy makers don’t have an infinite time horizon. They see out to the end of their term(s) or the next election. If Bernanke declines (or is refused) a third term, that could be as bad an omen for the stock market as Greenspan’s retirement was for the Housing bubble. And that is especially true if Bernanke quits the Fed completely (his term as a governor will still have 6 more years even if he is no longer Chairman)

  • Andrew P

    The stock market also has a third function – CEO and insider compensation. Insiders get “free” stock as part of their pay, and the company borrows money to buy back stock as the insiders are selling. This is done instead of just writing larger paychecks for tax advantages.

  • Andrew P

    This is exactly as Bernanke described the wealth effect in his testimony. The essence is by boosting the value of collateral, more credit is pumped into the economy. Financial institutions are the biggest users of inflated collateral for borrowing.

  • Andrew P

    Pushing up asset prices also boosts the amount of collateral in the economy and boosts borrowing. This could be where the real stimulus effect comes from, and is according to Bernanke, the intended effect.

  • Andrew P

    What is the Fed going to do when the Bernanke Bubble runs out of gas? What tools do they have left? QE is already at max levels. I guess they could declare a national emergency, ignore the law, and buy stocks directly.

  • Dennis

    When I (#5) helped start our company my CEO said we need to “add value”. There was nothing we could do about the stock price (after we went public), there was little we could do about profits (at that time), all we can do is create value that overtime we could benefit from (we = us employees). I think that’s what Greenspan actually means here “the stock market is the key player in the game of economic growth.” He means the companies that make up the market, not “the stock market” itself. If those companies can add value to themselves (whether or not these are translated to profits or stock price at that moment), then that is the key player in … economic growth. It’s no “game”. This is serious for all of us. Our company was bought out in the depths of early 2009 for $100 billion in stock value and now commands sales or royalties from 5 of the eleven highest revenue generating drugs in the world. Unlike what Cullen says above, if I ran a company I would strive to add value and continue to invest in our own business (at the expense of profits). If we can keep doing that then the stock price should come up in time along with cash generation. Although I’m not a Greenspan fan, I think you’re taking his words a bit to literal.

  • Geoff

    Exactly. MRists should appreciate this point more than anyone. Depending on how that new money is spent, it can have very positive effects on the real economy.

  • jt26

    It doesn’t really matter whether the wealth effect is real or not. I don’t think the Fed is targeting wealth as much as preventing declining wealth (a side effect of targeting positive inflation). The problem is they need to make sure that money/credit is not created to create more money (speculating on houses). Monetary policy was meant to mediate spending/saving desires, keeping aggregate demand constant and with “maximum” employment. I think this is where the moneyness concept is important: we should not be creating money/credit for the sole purpose of creating money. E.g. housing adjusting CPI. Of course we can argue on what the moneyness of the house is in calculating HA-CPI, but it is nonetheless large, i.e. the government can get regulatory stats on equity withdrawls, lines of credit (tapped and untapped) etc. One can also look at the moneyness change in all sorts of assets: for financial assets, some have used haircuts, trading volume etc. There is no perfect measure, but we can’t ignore it either.

  • Kent

    Lowering the discount rate on assets to incentivize consumption and investment is simply a redistributive tactic employed in hopes of raising aggregate demand. Most people can understand the basic implications of when the government raises taxes or increases welfare payments but the redistributive tactics of monetary policy are more abstract and not seemingly as “fair” or intuitive. Right now the Fed feels compelled to tax risk aversion in order to prevent disinflation and to keep the consumption game running. I am certainly in the skeptic regarding this gigantic game of whack-a-mole. This short post on the Interfluidity blog tells you everything you need to know about our political economy: http://bit.ly/WWj1zM.

  • Johnny Evers

    That’s what happened in the housing bubble. Housing prices rose, individuals and banks borrowed against those assets, the economy grew.
    Of course once the asset prices fall, the consequences were severe.
    A housing correction of 10 percent caused 100 percent losses for some.

  • Geoff

    Very true. House prices rose too far, lending practices became too lax, and we paid the consequences. But that doesn’t appear to be the case now. We’ve had a pretty decent correction, in case you haven’t noticed. The current up cycle appears to be growing on much firmer foundations, at least for the moment.

  • Johnny Evers

    It ‘appears’ to be on firmer ground. That’s my point, well two points — we simply don’t know if we are on firmer ground and we can’t put ourselves in a position in which if we’re a bit wrong, we’re dead wrong.
    The banks do it, because they are playing with make-believe money and can always get themselves bailed out, but the rest of us can’t.

  • Geoff

    JE, I don’t mean to sound like an apologist for the current system. I fully agree that it isn’t ideal, especially the household borrowing part. I’d much rather see a system more focused on corporations, where the money is used for more productive purposes.

  • Geoff

    But we’re not here to discuss what might be. The system is what it is. IMO, the economy looks relatively healthy. In fact, it may be about to get a little too strong. As Cullen has stated, inflation is beginning to perk up.

  • LVG

    The stock market does not perfectly represent corporate America. It represents what private investors think of corporate America. Running economic policy through the stock market is like trying to understand how to create better athletes by encouraging the junkies at a casino to gamble on sports.

  • Geoff

    Then things will get very interesting for the Fed.

  • LVG

    I wonder what Cullen think there. With private investment jumping, real estate firing on all cylinders AND a huge government budget deficit this economy might really start humming.

  • http://highgreely.com John Daschbach

    The Austrian reference was related to the argument that all holdings of stock assets should be financed by savings and that credit (in this case somehow working it’s way into the market (since it can’t directly) from the Fed and QE).

    Targeting nominal wealth does likely introduce instabilities into the system. But one also has to look at the situation in light of the options available to the Fed. Given that employment and inflation are the two mandates of the Fed what is the alternative to QE? Deflation and higher unemployment seem possible. Fiscal efforts are so much more direct but we seem unable to engage that thinking at the moment.

    Converting nominal wealth into real wealth would result in an increase in moneyness measures like the M2. I think the Fed has been pretty clear that it keeps a close eye on the M2. I suspect that a large increase in the M2 would be noticed (and be inflationary) but at some level the Fed can counteract this through the discount rate, which should raise consumer credit costs, damping the economy (although targeting a different group of people than the wealth effect).

  • http://brown-blog-5.blogspot.com/ Tom Brown

    That’s an interesting point. In other words lets be realistic about the House, the Senate, and the White House: we have divided government. What’s in it for a Republican who agrees to higher tax rates or agrees with anything Obama proposes? What’s in it for a Democrat who agrees to benefit cuts? Perhaps the sequester is the best we can do… which is pretty sad, but basically congress and the WH are stuck. Realistically they won’t do anything, nor have they done anything for years now (thus in my opinion, their pay and benes should be cut to $0, but that’s another matter). Given that, what is the Fed supposed to do? It really has to go it alone, right? Perhaps they’re not doing the right thing, but the political reality has to be factored into our criticism.

  • Nils

    How many of all the publicly traded companies raised capital last year?

  • Nils

    There needs to be demand for loans though. Pushing rates down by 50 basis points is not going to make someone decide to take out a loan.

  • Geoff

    How many issued bonds? I think you’ll find it was a record.

  • Shannon Laing

    I agree, the economy is driven by real wealth (products and innovation). Dumping piles of cheap cash on it will not make it better. There needs to be stimulation in the mechanics of real wealth generation of a sustainable nature. Means shouldn’t be provided to inflate balance sheets temporarily and therefore miss-price the stock market.

  • Nino

    Corporate profits have been actually falling now for two quarters in a row on a year-on-year basis. The same two quarters when the stock market took off.

  • ReturnFreeRisk

    Late to this post. Good work.
    There is a lot of people, including economists, who have not learnt anything from the experience of the last two bubbles and are hell bent on blowing another one. Amazing but true. Want evidence? GO read Mark Thoma’s blog.