Dear John (#9)... why the stock market means nothing today

Dear John,

The other day you said in defense of Obama:  “but where is the DOW? Where was it when he took over? This at least has to be considered.”

No it doesn’t.  what we really need to consider is why stocks are so high despite Obama’s self-destructive interventionist policy program.    The reason is simple. 

Low interest rates thanks to the Fed. 

Thanks to QE1, QE2 and now QE3 (also being called QE infinity) plus various other interventions, e.g. TARP and 2 massive rounds of Fed govt stimulus,the Feds (including Fed Reserve and US Federal govt) have “successfully” replaced a historic global real estate bubble, private credit bubble, stock market bubble, commodity and a global bond/US Treasury bubble it created in 2001 to 2008 with another real estate bubble (smaller), another stock bubble, another global commodity bubble and another even bigger Treasury bubble while replacing the private debt bubble with a public debt one.

Some day we will all pay the piper.

There is no such thing as financial markets anymore. The Federal government uses a combination of regulation, GSEs (Fannie and Freddie) and the Federal Reserve to manipulate (at least for the moment) the major stock, bond and asset markets in the US and to a large extent, the world.  This can’t last. 

In one of the great intellectual debates in modern history called "the socialist calculation debate" (also called  "the economic calculation problem"), Ludwig von Mises and FA Hayek turned upside down Carl Marx's dialectical argument about why capitalsim sows the seeds of its own self destruction. 

see wikipedia:  http://en.wikipedia.org/wiki/Economic_calculation_problem

  

Mises and Hayek together provided a compelling (and i would say definitive) argument why central planning / socialist systems (eg USSR) -- and NOT capitalist free market economies -- sow the seeds of their own destruction.  Hayek elaborated on his ideas in his book the Road to Serfdom and showed why even well intended "third-way" systems (like Europes Social welfare democracy or America's Special Interest / Crony Capitalism system) are also ultimately self destructive.  Enlighted Third Way systems slowly, but surely distort and eliminate market signals and replace them with central planning institutions.  This occurs because each round of enlightened intervention aimed at solving some identified "market failure" ends up creating and introducing new "artificial" distortions that lead ineluctably to new "market failures" that are then the focus of additional rounds of enlightened public policy.  And this continues until the government's reach extends further and further into the market crowding out market players and distorting market price signals.

This is exactly where America is today.  The stock market (S&P and the Dow’s) excellent performance since Obama came to office in 2009 has NOTHING to do with Obama or his policies.  One of the huge problems we have today is that the stock market isn’t allowed to discount any policy news no matter how bad its been and is likely to be going forward under Obama because the Fed is flooding the market with easy money and keeping the short term rate at zero percent. 

There is no such thing as zero percent interest rates in a real market.  This is a completely artificial and irrational and unsustainable situation that will only lead to a worse outcome down the road.

As i already said above:  We will pay the piper eventually.  There are no free lunches in life and surely none the Federal government or the Federal Reserve (thanks to money printing) can offer. 

Progressives and conservatives – Dems and GOPers -- are blinded by wishful thinking when they assume their ideas can work because their ideas only work in a fantasy world of free lunches and central bank printing presses facilitating debt accumulation to the moon and back!!!    Both sides pretend they are the fiscally responsible side.  We know the GOP is full of it because it has a history of big deficits.  but we also know the Dems are full of it, even though Clinton succeeded in reducing public debt because the Dems like to ignore the enormous contingent liabilities of the government entailed in entitlement programs that are clearly unsustainable. 

Bottom line:  America is broke any way you slice it thanks to bipartisan overreaching and over spending -- all facilitated by the Fed and bipartisan support for the Fed.   The options we have are bad and worse.  Either we default directly on our public debt or we default indirectly by debasing the dollar.   it looks like we are headed for option #2.

America is a house divided where each mainstream political party argues the other side is going to drive our country over the cliff.  Each sides' increasingly die hard supporters believes they own "the truth."  The fact of the matter is that neither side has the answer or "the truth."  Both sides are driving us off the cliff with lies and wishful thinking.  The progressive Dems pretend they have science on their side giving them a claim to the truth, and conservatives pretend they have a deep understanding of free markets on their side as their claim to the truth. 

The free market has its own logic and truth that isn't owned by either progressive or conservatives.   we think of progressives and conservaties as opposite sides of the political spectrum, but along one fundamentally important dimension they are identical:  both need and embrace an artificial central bank money printing press to implement their vision.

Whatever looks rosy today will  look like a nightmare when interest rates “normalize” some day in the future.  We are kicking the can down the road for ourselves and our children.  Consider this article i copied below arguing why stocks are over-valued: stock prices today have everything to do with low rates.

The Fed replaced a massive unprecedented credit and real estate bubble with an EPIC unprecedented Treasury bond market bubble plus another big stock market bubble and another real estate bubble.   this doesn’t end well.

John, you’ve often argued that my ideas are too abstract, ideological and impractical to be of any use in the "real" world. 

Someday, we will see that the exact opposite is true.  Ideas have consequences.  And some day we will see the destructive consequences of bipartisan political support for the Federal Reserve printing press.  Defenders of the Fed claim that a market can’t work without a central bank as proven by the harsh volatility of econmoic business cycles (called panics) in the 1800’s.   Such "conventional wisdom" is revisionist history and it is plain wrong.  What history has taught us if we would open our eyes for a minute or two is that the establishment of the Fed has facilitated a century of unprecedented war and economic destruction like we’ve never seen in the history of the world. 

We had panics in the 1800s and we had a few wars.  But, we also had the most peaceful and productive and wealth creating period in the history of the world in the 19th century.  all with small government and no Federal Reserve.   

In the 20^th century we had 2 world wars, a Great Depression, the Vietnam War, the Iraq War 1 and 2, the war in Afghanistan, the Great inflation of the 1970s and now the Great global credit crunch and Recession of 2009 – which ain’t over yet!  by any stretch of the imagination. 

The market will continue to be under attack going forward as it inevtiably “fails” again thanks to additional rounds of well intended government interventions implemented in the wake of the 2008 Lehman collapse.  This is the Road to Serfdom that FA Hayek warned about.

We are failing the market.  

Nature entails great natural disasters resulting in human suffering, like earthquakes and hurricanes and droughts.  The economy also entails similar "natural disasters" like temporary booms and busts, business cycles, bankruptcy, income inequality, industrial accidents, etc. 

But, such economic natural disasters never resulted in what we now call systemic risk until the Federal Reserve was established in 1913. 

Only humans when they are organized in powerful government central planning organizations have the capacity to destroy the world.  we pretend that only government can solve market failures when in fact the truth is the opposite:  government cannot solve market failures without also triggering a cascading of unintended consequences that end up causing more social harm than good.  On the other hand, a powerful central govenrment can inject systemic risk into the economy and/or financial markets that couldn't otherwise develop in a "free economy."    Free market doesn't mean anything goes or selfishness rules.  it means that we understand a central govenrmetn cannot guarantee certain social outcomes without undermining the natural ability of markets to improve social welfare.    Free markets channel self interested behavior into socially productive ends.  Selfishness is NOT a natural feature of markets.  Self interest is NOT selfishness.  Selfishness and greed and other anti-social behaviors manifest most when the government intervenes to try to make markets better, such as when the central bank prints money.  money printing is what drives self interest into the abnormal behavior range of selfishness and greed.  When the central bank prints money, (like it is doing now as reflected in ultra low interest rates) this turns savers into suckers!!

Central government intervention tends to crowd out natural local cooperation in times of need and crisis.  By trying to fix so called market failures, the government prevents us from learning how to adjust to and adapt to what are really just natural features of markets.   

the government creates the necessary conditions for systemic failure in society and then it claims it is the only entity that can save society from the very horrors it created in the first place.  this is the history of the Federal Reserve Bank.

Democracy is a false god.  we need rule by law and equal treatment under the law.  we do not need rule by special interests and money politics and/or tyranny of the 51% over the 49%.

we need a system that accomodates people's right and freedom to agree to disagree.  we don't need a system where there is an assumption that society can come to agreement over what is the truth or what is fair or what is equal or what is decided to be social justice.  Implementing progressive ideals like equality, justice, fairness, level playing fields, equal opportunity necessarily requires and results in an inherently self destructive process of ends-justifies-the-means logic.  Progressives say they want to eliminate might makes right from society and they want to eliminate cynical ends justify the means behavior.  they pretend that these sins are a result of the so called "free market."  in fact, the opposite is true.

the free market requires mutual acceptance which is the opposite of might makes right.  the market requires if a company gets big and enjoys market dominance, it won't stay that way for long if it doesn't keep offering a good deal to its customers.  progressives worry about evil monopolies taking advantage of consumers in the market.  in reality, large firms can only get large or stay large if they meet the needs of customers who are able to pick and choose between other suppliers.  

ironically, the only truly sustainable monopoly is a government monopoly enforced by brute force of the state and financed by the bottomless pockets of tax payers.  private sector monopolies can't survive without the assistance of the state as enforcer because there is always an entrepreneur ready, willing and able to offer a better deal for consumers than offered by the entity attempting to enjoy so called monopoly power in the market. 

too big to fail banks were not a natural creation of the so called "market."  too big to fail banks were created, like Frankenstein, by Federal Reserve bailouts and its lender of last resort function which resulted in the opposite of natural selection of the most adaptive and successful banks surviving and the weakest banks being weeded out.  instead, the Fed and Federal govt have promoted policies that have resulted in "adverse selection" where the most aggressive and least risk averse banks got bigger and bigger. 
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ironically, it is through anti-trust laws that many private companies win an advantage over a business rival that they wouldn't otherwise be able to achieve without state intervention.  anti trust doesn't promote competition and level playing fields, it promotes special interest politics aimed at creating market advantage for politically connected companies.  

why are progressives afraid of monopolies in the market -- where they cannot survive except with a powerful state protector-- yet they promote and support monopolies when they are controlled by the state for example in monetary policy, primary education, regular mail, infrastructure building and soon in health care.  if we look at the record of government monopolies, the record is one of failure, low quality/productivity and eventually of bankruptcy and/or chronic deficits.  

Wake up America!     

Not Under-Valued

September 20, 2012  | 7 commentsby: John Early  |  about: SPY

Have you noticed that, over the last four years, Treasury yields have tended to go up when the stock market goes up? For most of the last 50 years interest rates and stock prices moved in opposite directions. Those who claim that the stock market is cheap because Treasury yields are so low may not have caught on to this change and thus don't realize the market (SPY) may be 73% over-valued and headed for a fall.
From 1965 to mid 2008 the 10-year Treasury yielded more than 5.5% and had an inverse correlation with stock market valuation, i.e. higher yields meant lower valuation. However, looking at a broader history the correlation flips to positive when the yield has been below 5.5%. The highest stock market valuation tends to come with a yield of about 5.5%. History suggests the near record low yields should come with near record low valuation. In other words, the risk premium for stocks declines as the 10-year Treasury yield falls toward 5.5%, but then rises as the yield falls below 5.5%. With the 10-year yield down around 1.8% the risk premium should be near an all time high.




chart1
to see chart go to original article:  http://seekingalpha.com/article/877791-low-interest-rates-mean-stocks-are-over-valued-not-under-valued?source=email_macro_view&ifp=0

In the scatterplot above, each dot represents a month and shows the month's PEses on the horizontal scale and what the 10-year Treasury yield was on the vertical scale. The current PEses is 37.4. The best fit line (red) suggests a 10-year Treasury yield of 1.78 should have a PEses of 10 - thus suggesting the stock market is 73% over-valued.
For more info on PEse, see here.
If you use Shiller's PE10 the best fit line suggests the PE10 should be at 10 rather than 21.9, representing a 54% over-valuation.


chart2
to see chart go to original article:  http://seekingalpha.com/article/877791-low-interest-rates-mean-stocks-are-over-valued-not-under-valued?source=email_macro_view&ifp=0

If you use a standard PE with the last 12 months of available "as reported" earnings, the PE is 16.4 while the best fit line suggests it should be 11 - thus indicating the market is over-valued by a third.


chart3
to see chart go to original article:  http://seekingalpha.com/article/877791-low-interest-rates-mean-stocks-are-over-valued-not-under-valued?source=email_macro_view&ifp=0

There is not enough "operating" earnings history to estimate a best fit line.
In the three charts above the more accurate the historical correlation, the greater the suggested over-valuation. The best fit line between the PEses and the 10 year yield has an R-squared of 0.57. The best fit line for the PE10 has a respectable R-squared of 0.46. The R-squared for the PE is a poor 0.08, so the degree of overvaluation is likely closer to the 73%.
Just because the stock market is over-valued does not mean it could not go up and become more over-valued in the next few days or weeks, but it does suggest that the risk is great and the downside dwarfs the upside.

All the pundits I have heard who claim the stock market is dramatically under-valued base the claim on low interest rates. The charts above suggest these claims are a bit like Wylie Coyote running off the cliff, and not falling until he reaches down and finds there is no support. The stock market has run off the cliff and thinks interest rates are right under its feet. Sometime soon it will look down to see they are actually way down in the valley.