This post builds on the 4/21 Monday post -- just below.
The Fed's M-1 basic money supply (cash & checkables) stands at about $2.75 trillion. It has increased by roughly $1.2 trillion since the QE programs first began in late 2008 and I would
estimate about $700 billion of this increase reflects the flow of $ from QE into the transactional
part of the financial system with the bulk of the remainder of the $3 trillion + QE money sitting
in the excess reserve account the Fed holds for banks. Excess Reserves
Over the past half dozen years, M-1 in current $ has grown at a ripping 12%. That represents
10.3% growth when adjusted for inflation. Based on very long term relationships, the strong
basic money growth has been a powerful stimulant for the stock market. Since real M-1 may
benefit in a lagged way from QE even as it winds down, I plan to watch this indicator going
forward as well as the lazy way of just trying to match up market performance with the size
of the Fed's balance sheet. The velocity of M-1 seen against the economy has declined sharply
reflecting the modest US recovery from near depression conditions, but since companies have
been so successful in boosting profit margins, the stock market has benefited greatly from
the powerful monetary liquidity support despite the downshift in money velocity.
When broadly measured, if transactional financial liquidity grows faster than the economy,
excess liquidity is generated, and this can be a major support for stocks as well so long as the
economy is positive and investor confidence is reasonable. The monetary and economic
turmoil of the 1999 - 2012 period greatly disturbed the longstanding relationship between
stocks and surplus liquidity, but recent data suggest matters may finally be returning to normal.
One factor to keep in mind here is that more vigorous economic growth if accompanied
by a cyclical acceleration of inflation can sharply reduce liquidity available to the capital
markets. My excess liquidity indicator has declined from a moderate 3.0 level seen last year to
a slightly positive 1.0 currently as the economy has perked up.
Using mundane economic, profits and dividend growth assumptions, it is easy to make a
reasonable case for a 15 p/e ratio. To argue for the current 17.4 p/e, you have to assume
inflation and interest rates will remain non-threateningly low and that profits growth will
exceed the long term rate of 6.5% per annum. So a narrow focus of this sort can net you
a premium valuation so long as you waive off certain micro and macro risks. Steadily
rising profit margins reflect growing imbalances centered around seriously skewed income
distribution and under-investment in facilities and people that will make stable progress in
the US more difficult in the future. The transition away from QE remains a work in progress
and the ability to efficiently mange monetary policy in a post QE world is a question mark.
Moreover, major foreign economies -- the Eurozone and China -- are in the throes of change
which involve major challenges. These are all hard factors to ignore and do not fit easily
into the textbook concepts of stock market valuation.
- Peter Richardson
- Retired chief investment officer and former NYSE firm partner with 50 plus years experience in field as analyst / economist, portfolio manager / trader, and CIO who has superb track record with multi $billion equities and fixed income portfolios. Advanced degrees, CFA. Having done much professional writing as a young guy, I now have a cryptic style. 40 years down on and around The Street confirms: CAVEAT EMPTOR IN SPADES !!!