Why Is the Stock Market Hitting New Highs?


One would think that things were just ducky in the economy, judging from the rise in the stock market.  Indeed, the S&P500 keeps hitting new highs, as do the rest of the major indexes.  Even housing seems to be on a recovery, with prices in depressed areas such as Phoenix rising 20% year-over-year.  Obviously wages must be rising as businesses expand and try to lure talent away from other companies.  College seniors must be coming out of school, excited by all of the job opportunities they have in front of them.  Unemployment must be at multi-year lows and products must be flying off the shelf.

Unfortunately, this is not so much the case.  Unemployment is still well above 7%, and the real unemployment numbers are somewhere in the teens if you include the people who have quit looking for work and have gone from the unemployment roles to the disability roles or are working part-time jobs.  With layoffs and hours being cut as employers try to come in under the 50 employee limit at which Obamacare kicks in, there will be more and more people working less than 30 hours per week or not working at all.

Businesses are managing to get along without hiring a lot or new workers, and recent college grads have moved into their old rooms and settled in for the long haul.  At least their parents will have someone to water the plants and walk the dogs when they start to travel in their retirement.

So why is the stock market doing so well?   The reasons, as they often do, lie with the Federal Reserve.

The Federal Reserve control interest rates by controlling the supply of money and also by making loans directly to the banks.  If the Fed wants to take money out of the system, they simply tell the banks that they need to buy some federal reserve notes from them, which the Fed creates out of thin air.  If they want to add money, they buy the notes back or tell the banks they don’t need to keep as much in reserve in their vaults.  Lately they have even been creating money out of thin air by creating money and then using that cash to buy US Treasury debt when no one else will.  They also set the rate at which they loan money to banks, which in turn sets the interest rates for everything else.

The Fed does not have control over inflation, at least not directly and not with any precision.  If they add a lot of money and productivity does not increase (meaning there is no good place to put all of the extra cash), inflation spikes.  They can quell inflation by raising rates and causing the economy to crash, but this is obviously very crude.  It can also backfire, resulting in stagflation as Japan has dealt with for about 30 years where prices rise while the economy sits.

Equities (stocks) are things of value like anything else.  As inflation builds since the Fed has been pumping all sorts of money into the economy trying to make it recover from the housing bubble, the price of stocks goes up along with everything else.  If a slab of beef costs $20 instead of $10, the price of a share of XYZ might also go from $10 per share to $20 per share.  That doesn’t mean you can then buy more steak dinners with the value of your shares.  The value of both things remains the same relative to each other.

The other reason that stocks have been going up is that people are looking for a way to earn some income on their holdings.  Savings accounts have been paying nothing for a long time.  Retirees need some way to generate income to pay for things, and they just can’t cut it with a $1 M bank CD paying $10,000 per year.  They have therefore started to put money into stocks to increase their returns.  The trouble is this means they are taking on more risk, which may not end well.

So, enjoy the rise, but realize that some of the rise is just inflation, meaning you really aren’t making money.  The rest of the rise is due to interest rates, which could all disappear if the Fed raised rates again (or the market forces rates up because inflation starts to accelerate) and savers rushed back into traditional money markets and bond funds.  The real gain for stock investors will come as people create value and businesses grow.  Sadly, this is not happening yet to any meaningful extent.

Please contact me via vtsioriginal@yahoo.com or leave a comment.

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Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

3 comments

  1. i guess the nuance lies in whether the stock in question pays dividend or not. If it does, then the inverse of the P/E ratio can be considered like the yield. if inflation is high, generally, central banks spike up rates making yield on fixed income higher than the earnings yield on stocks. so the stocks’ prices would naturally fall down to being the E/P ratio to be nearly in line with the market yield for treasuries. if the stock is a non-dividend paying one, then yes, its price would rise in step with inflation.

  2. on second thoughts, i guess i am wrong in my prev comment. if you look at the basics, stock prices represent the present value of the future earnings of the company they represent. if inflation rises and ergo the interest rates inch up (short end of the yield curve) which means that the new discount rate would be higher. therefore the present value of the future earnings would come down and the p/e needs to be adjusted downwards affecting a fall in stock prices.

    Now, one more nuance in this is that the future earnings themselves may rise with inflation. so i guess the core question then is would inflation raise the future earnings more than it would affect the general discount rate. if so, then stock prices would rise, if not, then the stock prices will fall with inflation. which means that there would be a stock specific or industry specific reaction to inflation. companies that can pass on price increases (typically defensives like the fmcg bunch) would gain while the capital soaking ones or the ones that do not enjoy pricing power would be hammered down by the increased discount rate and not have any leg room to pass on the price increases to their customers.

    • Stock prices would actually do both. They would fall initially as investors discounted the future earnings to account for the effective reduction in return due to inflation. Over time, however, the earnings would increase since people would have more dollars, and the price of the stock would also increase, also because people had more dollars. The price of intellectual property, real estate, equipment, and market share would also increase in dollar terms.

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