Stocks declined last week as I anticipated they might. Last week I wrote this:
That is precisely what happened as the Dow and the S&P 500 declined. More decline from here to move stock prices closer to their longer-term moving average of price would not be surprising.
“Barron’s” reported that stocks experienced their worst weeks since August. (Source: https://www.barrons.com/articles/stocks-catch-a-cold-after-fed-stops-expanding-its-balance-sheet-51579916069). Here is an excerpt from the article (emphasis added):
Interest rates remain the primary underpinning for stocks, as equity valuations look stretched, except when compared with the paltry returns offered by the debt market. Much of the credit for that is owed to the world’s central banks, notably the Federal Reserve. In addition to last year’s three one-quarter percentage-point short-term rate cuts, the central bank has expanded its balance sheet by over $300 billion since September, when ructions in the repurchase-agreement market led it to inject liquidity. Since then, U.S. stocks’ value has jumped by more than $3 trillion.
The Fed prints and stocks rally. It’s a predictable pattern. More from the Barron’s article (emphasis again added):
The Fed insists that its operations don’t constitute quantitative easing, as it calls its purchases of long-term securities intended to boost stock and bond prices. Its recent operations consist of adding liquidity to the money markets through repurchase agreements and by buying short-term bills. Others call this a distinction without a difference, given the impact on stock and bond prices.
Interestingly, the Fed’s balance sheet contracted by $25 billion for the week that ended last Wednesday, and stocks declined.
Coincidence?
Probably not in my view.
Money creation and stock rallies occur in tandem.
Since September, the Federal Reserve has been ‘injecting liquidity’ into the repo market. What does that mean exactly?
Simply put, the repo market is the overnight or short-term lending market between banks. In September, for some reason that has not yet been disclosed, some banks refused to lend to other banks or financial institutions on an overnight basis.
In our view, there is only one reason for this – the lending banks were concerned that the borrowing banks could not pay them back. In other words, it’s a red flag of trouble that may be brewing in the banking sector.
To ensure that the banks could get the short-term loans that they needed to meet reserve requirements, the Fed stepped up and provided the loans that the borrowing banks and financial institutions couldn’t get from other banks.
Where does the Federal Reserve get the money to loan to these borrowing banks?
They print it.
Of course, it’s not reported as straightforwardly as that in the news. As the “Barron’s” article above states, “the central bank (the Fed) has expanded its balance sheet by over $300 billion since September”.
“Expanded its balance sheet” means printed money.
A visit to the Fed’s website illustrates where the balance sheet was at the beginning of September and where it is presently. At the beginning of September, prior to ‘injecting liquidity’ into the repo market, the Fed’s balance sheet was just over $3.7 trillion.
Presently, it’s approaching $4.2 trillion.
Over that same time frame, the S&P 500 has increased from about 2,850 to about 3,350.
I’ve long suggested that Fed policy is driving stocks and while this relationship between stocks and the Fed’s balance sheet level does not prove anything conclusively, it is, at the very least, interesting.
The bottom line is this.
Money creation to price inflation.
Price inflation occurs in stocks and in consumer goods.
John Mauldin, best-selling author and publisher of an excellent weekly newsletter “Thoughts from the Frontline” had this to say on the topic of inflation in his newsletter this week (I’ve pulled excerpts) (emphasis added):
Wonks tell us, with all sincerity, things like “the US cost of living rose 2.1% last year.” Really? To an actual numerical decimal place? On something as vague and as complex as inflation? Now, to give them credit, they are looking at the total national inflation rate and it is extraordinarily complex. They do the best they can.
But the inflation you and I experience? They don’t know that. They can’t know it, at least not with any precision because the cost of living is so individualized. Everyone spends their money differently, and the things they spend it on vary in price for many reasons.
I believe the analysts try to be fair and scientific. They have to work within boundaries that don’t always make sense. So, we get crazy things like “hedonic adjustment.” That’s where they modify the price change because the product you buy today is of higher quality than the one they measured in the past.
According to Consumer Price Index data, a television set that cost $1,000 in 1996 is now $22. You can’t buy any such product today, but the fact you can spend the same amount of money and get a better TV depresses the inflation rate.
They do the same thing for cars, as Peter Boockvar noted earlier this month.
Last week Edmonds.com said the average price of a new vehicle sold in 2019 was $37,183, a new record high and up 30% from where it was 10 years ago. Within today’s CPI, the price of a new car reflected a 2% increase in TOTAL since 2009. This is magically done via hedonic adjustments which discount the value of new add-ons with each subsequent iteration of cars.
The Fed relies on hedonically-adjusted data points and not the price that people are actually paying out of pocket.
Hedonically-adjusted prices exist only in theory. They don’t reflect what people actually have a choice of spending.
The Chapwood Index might be a better measure of the actual inflation rate.
This index compares the retail price of 500 consumer items that consumers most frequently purchase over different time frames.
Using this arguably more practical measure of inflation, one finds that the average annual inflation rate over the past five years ranges from 8% annually in Dallas, Texas to 13% annually in San Jose, California. Mesa, AZ on the low end of the metro areas tracked, had an average annual inflation rate over five years of 6.6%. On the high end was Oakland, CA with an average annual inflation rate over five years of 13.1%.
The dollars used to purchase consumer items are the same dollars used to purchase stocks.
I believe the driving force behind higher consumer prices and higher stock prices is largely Federal Reserve policy.
The changes in the way the official inflation rate is calculated has masked this reality.
Given higher debt levels at the government level and trillion-dollar-plus deficits as far as the eye can see, this money creation will have to continue in our view.
To protect yourself, I’d urge you to consider ‘going tangible’ with some of your assets. Tangible assets have physical characteristics and intrinsic value.