As Stock Market Rises, Instability Grows

Is the surging stock market its own worst enemy?
January 17, 2020 Updated: January 19, 2020
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Commentary

We’re living in amazing times. That’s not just a cliché; it’s absolutely true.

It’s no secret that the stock market’s performance continues to amaze. But as the market continues its fantastic, record-breaking rise in value, a couple of simple but unavoidable truths might be worth keeping in mind.

First of all, yes, it’s a great thing to be making money in the market. People’s investment and retirement plans are doing better than ever. And, the market’s growth is attracting more capital investment from all over the world. It’s all good, as the saying goes.

The market’s high-flying performance is also helping the real estate market, as is the fact that wages are finally improving. Plus, more people are working in this economy than ever before, earning more, with lower personal tax rates to boot. That means more Americans are seeing their standard of living rise.

All of these things are great for families and businesses. After all, the more money in people’s pockets, the more they’ll spend in the economy, and everyone does better. All of that is great news and drives both consumer and business confidence, which are critical factors for sustained economic growth.

But now to those unavoidable truths I was talking about …

Unhealthy Growth

One truth that must be understood is that even as market valuation skyrockets, not all growth is healthy growth. By that, I mean that not all of the gains in stock valuations are organic. Under normal circumstances, the valuation of a company expressed in its stock price is a function of rising profits and its earnings compared to the current price. That’s what’s known as the price-to-earnings (PE) ratio of a stock.

As a stock’s PE ratio widens, there’s less support for the price, because the price goes up faster than earnings. Eventually, the support, or rationality, of a stock’s high price becomes irrational. People become “irrationally exuberant,” meaning that the buying public believes that the market will continue to rise, even though it’s no longer tied to the fundamentals of value.

That’s likely where we are today. Does that mean that we’ll see a market correction this week or next? Perhaps, but it’s not likely.

How can that be?

Didn’t I just use the same term that former Federal Reserve Chairman Allen Greenspan used to describe market conditions just before the “dotcom” crash in 2000?

A Federal Reserve Economy

Yes, I did.

But the difference is that today, irrational values can go higher, and stay there longer, because the Federal Reserve again is pumping money into the U.S. financial system. It’s doing so by the hundreds of billions of dollars per month, and will continue to do so for the foreseeable future.

And where does that money go?

The money flows into large Wall Street banks, and eventually into the stock market, either directly, through investments in futures, exchange-traded funds (ETFs), or single name stocks, or indirectly through low-priced credit to public companies, which may then buy back its stock, which is happening a lot these days.

And keep in mind that as the Fed prints more money, there aren’t that many more assets, e.g., stocks, in which to invest. As a result, asset prices rise to accommodate the greater number of dollars chasing the same number of stocks. Suffice it to say that, today, the stock market is way beyond organic growth.

Growth Imbalance—An Inverted Pyramid

That brings us to another unavoidable truth. Not all stocks are benefiting equally from the Federal Reserve’s quantitative easing. In fact, most of the benefit is going to just 18 stocks at the top of the Standard & Poor’s 500 (S&P 500).

This is a very big problem because these top 18 S&P 500 stocks—the top 1 percent of listed companies—represent 20 percent of the valuation of the entire stock market. This distortion of the normal growth distribution has several undesirable effects.

For one, a gross imbalance of value makes a market correction much more likely, and likely to be more severe when it does happen. This isn’t rocket science, either. With a narrow distribution range, any negative event or report affecting one of the top 18 companies will have a much greater impact than it otherwise would.

Markets are much more stable when value is distributed across a greater number of large-cap companies as well as mid-cap and small-cap companies. Value concentration in a small number of companies simply makes it more susceptible to corrections.

This concentration of value also attracts growth capital away from small-cap companies that really need it. Many promising small companies don’t have the money to afford rising cyber security and regulatory costs. Nor can they access low-cost capital that the big companies can and do.

That means less capital to fund research and development. It also results in fewer small companies surviving and growing into medium- and large-cap companies, which would employ more people over time. The upshot is that less innovation reaches the marketplace and that, over time, our economy becomes less competitive than it should be or could be. It should come as no surprise that new business formation, the biggest driver of employment, still hasn’t reached pre-2008 levels.

Party Like It’s 1999

Even in 1999, just prior to the dotcom market meltdown in 2000, the valuation imbalance was high, but didn’t approach what it is now. Of course, there are significant differences in today’s economy from back then. It’s a much more liquidity-driven market than it is an earnings-driven one—at least for the time being.

But as discussed above, an imbalanced market isn’t a good thing. It stifles smaller companies, sucks up investment capital, fuels further unjustified valuation hikes, reduces innovation, and, eventually, lowers employment as well.

What’s more, from a stability standpoint, regardless of how much liquidity the Fed pumps into our financial system, the current market imbalance is simply unsustainable. At some point, earnings will come to matter again, and liquidity levels will cease to be effective, especially when it’s in the form of unsupported debt from the Federal Reserve.

James Gorrie is a writer and speaker based in Southern California. He is the author of “The China Crisis.”

Views expressed in this article are the opinions of the author and do not necessarily reflect the views of The Epoch Times.