15 Nov Rational Exuberance

The obverse of “Rational Exuberance” is “Irrational Exuberance,” a phrase popularized in December 1996 by then-Federal Reserve Chairman Alan Greenspan when he warned investors that unjustified internet optimism had crept into stock market valuations.  As a consequence, he warned, soaring valuation assumptions based on rosy projections of future profitability inevitably would prove excessive.  Chairman Greenspan understood that disproportionate enthusiasm for the dot coms would end in disproportionate disappointment … with the absence of profits ultimately prevailing over the pursuit of pie-in-the-sky possibilities.  Greenspan’s 1996 warning was ignored …, rightly as it turned out.  It came too early in the cycle.  The market had more climbing to do before the inevitable triumph of reality over fantasy, which did not occur for three more years.  Stock market values continued to levitate until March 2000 …, when the dot com bubble burst and they fell back to earth … hard.

The late 1990s marked the internet bubble era when U.S. stock valuations grew exponentially – reflected in the technology-powered Nasdaq index that rose from under 1,000 in the early 1990s to more than 5,000 by March 2000 – grounded on fad-based investing that was fueled by an abundance of venture capital made available by a robust American economy.  That robust dot com bubble world of early 2000 is markedly different from today’s … where America’s and the world’s economies are hobbled by Covid-19, lockdowns, trade wars and political, social and economic disruption … a far-from-optimal economic environment.  Today’s markets also are not being driven by fads or excitingly new, but untested, technologies.  The technology leaders of 2020 are mature monopolists with enormous market power.  Their stock valuations are not driven by Irrational Exuberance but by market supremacy and ever-increasing profitability.  The warning that Chairman Greenspan gave in 1996 is inapt today when the market’s highfliers are firmly grounded multi-nationals with rock-solid, widely diversified businesses.  Although the S&P 500’s trailing 12-month price-to-earnings ratio is at a heightened elevation, it has reached its level for arguably valid economic reasons and still falls short of PE ratios in 2000 … and far short of those in 1996.  The U.S. stock market therefore is may be said to be enjoying a Rational Exuberance.  It has been posting appropriately enthusiastic gains with reasonable projections of higher prices to come.  It is doing so for reasons that, contrary to those in the 1990s, are appear to be reality-based.

The fact is that stock markets this past week reached new all-time highs following the announcement of favorable Covid-19 vaccine news, an apparently economically-bullish resolution of America’s election complications, upbeat third quarter corporate revenue and profits, a third quarter GDP increase of more than 30%, and a comforting presentation from the Federal Reserve.

Pfizer announced on Monday that in a trial of 44,000 volunteers its vaccine was “90% effective in preventing cases of Covid-19.”  Pfizer and its partner, BioNTech SE, indicated their strong belief that the vaccine would soon be approved by America’s FDA and that the vaccination process could begin as soon as December.  That news animated the stock market’s animal spirits!  The pall of Covid-19 that had been hanging over the American economy and, more importantly, over Americans, suddenly seemed to have lifted … and on Monday the Dow Jones Industrial Average exploded over 1,500 points (5.4%) and the S&P 500 Index rose by 3.8%!  Pfizer’s announcement followed hard on the heels of the welcome weekend news that America’s suspenseful election outcome had finally been resolved.  The media agreed that Joe Biden had become President-Elect Biden and that government would be divided between the Democrats – holding the Presidency and a reduced majority in the House of Representatives – and the Senate – which is likely to remain in the hands of Mitch McConnell the Republican Party.  A divided government is viewed by most analysts as ideal for stocks because it enables businesses to plan for a stable legal and regulatory environment.  Change, if there is to be any, is likely to be incremental.  A divided U.S. government reduces domestic and global risk and thereby makes the US Dollar less attractive as a safe-haven currency, decreasing its value and, consequently, increasing the attraction of U.S.-listed stocks (which has potential adverse consequences as well – see https://blog.thelonelyrealist.com/the-fracturing-us-dollar/).  The election outcome and the Pfizer news followed shortly after the Federal Reserve confirmed that it would continue into the very far distant future its $120 billion/month (over $1.4 trillion/yr.) of Quantitative Easing-bond buying … and would be amenable to increasing that amount should circumstances warrant – that is, the Federal Reserve confirmed that it will continue to serve as the fiscal backstop for economic weakness and Federal government laxity.  That, too, is bullish for stocks since the Fed’s QE actions inject liquidity into the U.S. economy, liquidity that boosts asset prices …, and especially the prices of stocks and bonds (see https://blog.thelonelyrealist.com/japans-economic-wormhole/ – as TLR noted, “We today are living in a world in which there is spiraling asset inflation in stock and bond prices”).  Although both Democrats and Republicans seem committed to enacting further Federal stimulus measures, disagreeing only over the amount, if Federal stimulus ultimately proves a bridge too far or inadequate, the Federal Reserve has vowed to over-fill the breach, which would provide just the type of economic stimulus that would power stock prices:  “Is monetary policy out of power or out of ammunition?” Fed Chairman Powell asked.  “The answer to that is no, I don’t think that.  I think that we’re strongly committed to using these powerful tools for as long as needed.”

The promise of “whatever it takes” Federal Reserve QE means that the stock market has an impenetrable safety net.  Rational Exuberance indeed!

A degree of economic, social and political stability also is likely to be created by the Biden Administration’s efforts to (1) create a national Covid-19 policy and (2) reduce trade tensions with both America’s European allies and China, which have caused economic disruptions without discernable benefit to America.  Domestic economic stability could be further enhanced should the Biden Administration find common cause with Senate Republicans in pursuing legislation to repair America’s crumbling infrastructure.  Both Political Parties agree that roads, bridges, airports, ports, mass transit, the electrical grid, etc., are in dire need of updating.  The Biden platform called for a $2 trillion infrastructure spending plan designed in part to overhaul roads, bridges, trains, the auto industry and the broadband system.  Those projects could create desperately-needed jobs and, together with expected Republican Party modifications, be just the sort of economic stimulus that could excite bipartisan agreement … and Rational Exuberance.

The Pfizer vaccine news, the election outcome, third quarter economic reports, the Fed’s money-printing, and bipartisan economic and medical stimulus all point in the direction of an improving American economy and higher stock market prices.  However, their success is far from guaranteed.

Insofar as a Covid-19 vaccine is concerned, the Pfizer product is costly, its components are unstable and require ultra-cold-chain transportation, it can only be produced in quantity over numbers of months, and it has a short shelf-life.  Pfizer has not released demographic data so that the age composition of its recipients is unknown, which means that it is not clear whether the vaccine will be efficacious for those in the most threatened age groups.  Pfizer also hasn’t released data on the severity of the Covid-19 infections suffered by those in its test groups, which could either make it more-than-90% effective … or less.  Moreover, it is unclear whether those people who enrolled in the study changed their behavior and thereby made the results look rosier than reality.  Perhaps most significantly, however, the Pfizer study necessarily was a short-term one.  Never before has a vaccine been tested and rolled out in a matter of months rather than over many years.  One consequence is that there is no data on how long-lasting the immunity will be.  Celebrating medical science and the end of the pandemic therefore may be premature … and portend continued suffering well into 2021 …, with negative health and economic consequences.  Viruses also have been known to mutate, sometimes in dangerously adverse ways.  There is no way of knowing whether the Pfizer vaccine will continue to be effective should such mutations occur.

The Federal Reserve undoubtedly will not let up on its QE money-printing because any reduction in the demand for fixed income securities would cause interest rates to rise, which would be disastrous for America’s fiscal health.  The hope expectation is that such money-printing will continue to positively power the American economy as it has done for the past decade … and, yet, there are questions of how long such limitless money creation can continue without creating fiscal fission.  For example, on January 20, 2017, President Trump’s inauguration day, U.S. debt stood at 19.6 trillion.  It now exceeds $27 trillion.  For the fiscal year ending September 30, 2020, the U.S. deficit was 3.1 trillion, which was the largest ever and more than 16% of GDP … when a 3% deficit ordinarily has been considered the limits of prudence.  The August trade deficit exceeded $67 billion, the highest since 2006 … and for good reason.  With U.S. production shut down and consumers no longer traveling or paying for entertainment, the government’s printing of Dollars was used to purchase foreign cars, TVs, electronics, etc.  The US Dollar Index peaked at 120 in 2015 and is now below 93.  A weaker Dollar may be good for stock prices, but it can become extremely unhealthy for America (as TLR first discussed in https://blog.thelonelyrealist.com/be-careful-what-you-wish-for-the-trade-war-with-china/).  It goes without saying that with global bonds worth over $17 trillion having negative interest rates – which means that they are guaranteed to make a loss if held to maturity –, investors have few options other than to continue piling into equities, creating a most Rational Exuberance for stock prices.  Yet these are not good statistics.  They tell a tale of economic weakness.

On the political front, although markets generally prefer a divided government because the presence of disparate goals means that there is little risk of radical changes that could cause significant damage to the economy, that predisposition works poorly when action is necessary.  Today’s economy is in desperate need of help.  The fact that the House and the Trump Administration were unable to reach agreement on an economic stimulus package prior to the election is not a hopeful sign.  If the Federal government continues its failure to act, there is no historical precedent for the Fed alone to carry the economy on its back.  The fact that President Trump will continue to wield real political power means that there is likely to be an obstructive opposition to all Biden Administration initiatives …, including stimulus spending.  Additional disruptions will include Republicans politicking to take control of the House at the 2022 mid-terms and Democrats jockeying for Party leadership roles, Senate seats, and to succeed President Biden in four years … all of which will be occurring while State legislatures are busy gerrymandering voting districts.  The political climate isn’t likely to be friendly to the sorts of fiscal and economic law-making that America is likely to need to recover from the pandemic and its resulting recession, yet alone repair the divisions that have created America’s partisan divide.  Oh, and let’s not overlook the possibilities for divisiveness that could be created by precedent-breaking Supreme Court decisions.

2020 has been a bad year from almost every perspective …, including economically, health-wise, weather-wise and politically.  One can only hope that the Rational Exuberance evident in today’s events will carry forward into 2021.

Finally (from a good friend)