There have been many recent references to US stock prices relative to earnings (P/Es) being uncomfortably high. Not in absolute terms, mind you, but relative to historic norms considering the lagging growth rate of the economy and earnings. This inconsistency is being taken as evidence, by some, that there is another “conspiracy” underway — this time by the government’s Plunge Protection Team to raise and then support those higher stock prices.
Well there is a mechanism by which the government’s Plunge Protection Team can support stock prices (see below), but today’s market action doesn’t meet the plunging prices criteria for their involvement. Actually, we have exactly the opposite: upward price drift with relatively low volatility.
This doesn’t mean there isn’t central bank support of stock prices and other risk assets — there is, and it’s epic. But this post is about why and how this support of asset prices, including risk assets, is occurring.
First off, it shouldn’t be news to anyone that we have a worldwide economic system that is plagued with very high debt levels. The concern is not in the absolute level of debt so much as in the debt relative to the income resources needed just to cover the interest. The global debt problem includes not just the developed countries (the US, Europe, and Japan) but also China, as well as most emerging nations.
This growth of debt relative to income creates troubled waters for which a bridge is needed to safely navigate the obstacles.
First, the existence of the debt pressures the debtors of the world, both public and private, to reduce spending so as not to add to their debt overload. This has an adverse effect on the demand side of an economy, emanating from either the public or private sectors or both. For example, we can see the pressures mounting as Congress comes to grips with the size of the Federal deficit, which is acting as a constraint on more spending, which in turn leads to less demand for goods.
Spending less in order to stop adding to debt works for individuals. But if a country were to spend less — let’s say by the government or the consumers in aggregate — it also reduces country income. That is, frugality or austerity (depending on how one views it) can work for the individual because it doesn’t really reduce one’s income.
But for a country it does, and this is the debt trap we are in now. These are the troubled waters of compromised economic growth.
The second problem arising out of excess debt is vulnerability to another financial crisis like the one from 2008. Generally speaking, when there are extreme quantities of anything, an over-supply means downward pressures on the market price of the over-supplied item. And that includes government and private debt.
So this puts into motion a process by which those who purchased and hold the debt become vulnerable to a deterioration in market value. To those owners of the debt, whoever they may be (banks, pension funds, etc.), the market debt instruments are their assets, and if there is too much of it, per se, there are downward pressures on the value of institutional assets.
For the institutions owning these assets, this is a major problem. It can cause the financiers of those institutions (depositors or repo lenders, for example) to give pause and not automatically roll over their funding to these institutions owning the vulnerable debt. Thus, even without a concern for asset quality, the over-supplied debt sitting on the institutions’ balance sheets is a red flag. (Think what happened to the institutions last time around in 2008 when they held oversupplied mortgages.)
As a result, those who fund the institutions’ asset purchases naturally become concerned and start to demure from requests by the institutions to roll over their funding for longer periods of time.
This over-indebtedness creates the fear of declining asset values, and it becomes self-actualizing even if there’s not an actual default on those assets. The trigger is when the nervous funders seek to cash out their funding and, hence, force the institutions to sell the over-supplied assets in order to be able to pay the funders who want out. And selling those assets depresses their price while the line to cash-out gets longer and longer.
The institutions in question include banks of all varieties: commercial, investment, and shadow. It also includes money market mutuals and all asset-backed securities that, by definition, hold the over-supplied debt whether it be government debt, student loans, auto loans, or corporate junk debt.
If you believe this is a matter for only to those in high finance and that you are not subject to this risk, think again. This is the description of a deposit run on commercial banks, savings banks, and credit unions in which the “man on the street” is the funder (otherwise known as a depositor), and that includes you and me.
The policy solution to this problem that visited us worldwide not 10 years ago was to keep asset values afloat, especially when a government has written a blank check to cover the losses to depositors (called deposit insurance) or other Federal asset guarantees such as on mortgage-backed securities or student loans.
So this is a motivation on the part of policymakers not to allow the over-supplied institutional asset values to decline a la the financial crisis of 2008 — particularly if the government has guaranteed the funding. In that case, the short fall becomes a government and taxpayer liability, otherwise known as deposit insurance or other government third party guarantees.
Central banks are the first, second, and third lines of defense against a financial meltdown, but now they have an incentive to foster an asset inflation lest one of its protected banks experiences a deposit run, which would create uncertainty for all banks.
Of course, this motivation for asset support is not expressed, because if the Fed’s concern for asset prices is reflected in a public statement, it triggers the very event they are attempting to prevent. Therefore, a cover-up is in order.
So, in a way, it’s a conspiracy.
As a result, the Fed’s rationale for being in financial asset support mode is couched in terms of helping the unemployed when the central banks of the globe buy, buy, and buy to create the demand equal to the bloated outstanding supply of debt — and in so doing provides support for their prices.
The chart below shows the assets of the major central banks over the last decade (and does not include China and the Emerging Market Countries). The major central banks’ balance sheets have been the ongoing solution to maintaining market values of debt, as their debt purchases have risen by $12 trillion from a base of $6 trillion in 2008. This compares to an issuance of US government debt over the same time period of approximately $10 trillion. So in round numbers, the added demand ($12 trillion) just from major central banks offsets the added supply ($10 trillion) of US government debt.
Now getting back to the “conspiracy” of how that affects equity pricing and things as the market P/E: It must be understood that central banks tend to purchase government debt but that “official” buying of “official” assets bleeds into market support for ALL assets, including risk assets such as stocks, real estate, etc.
The indirect market support for risk assets is a twostep processes. In the first step, central banks purchase “official” assets (government bonds) from private sellers (not the government).
In the second step, the private sellers of the government bonds now has the cash and is looking for a replacement asset that, for whatever reason, they deem to be more desirable than holding the “official” asset that it just sold to the central bank. So the new, at-the-margin financial buying power spreads out and elevates the price of risk assets across the board, including in foreign markets if the acquisition of assets wanders there.
All this is a long way of saying that under the cover story of providing jobs for the unemployed, the Federal Reserve and most other central banks around the globe are creating higher asset prices and providing private sellers of official assets with the cash in-hand to purchase risk assets and, therefore, are generating an elevated P/E ratio for stocks.
The same can be said for the market valuation of real estate. That is to say, risk assets are substitutes for official assets. Indeed, the private portfolio managers sell off official assets to the central banks because they think they found a “bigger fool” who will pay more for them.
But that’s not the end of the “official” buying of “official” assets because when some private managers direct some of their replacement buying to foreign financial markets as indicated above. This elevates risk asset prices abroad as well. It also drives foreign currency prices upward relative to the US dollar because the buying moves through the foreign exchange market to reach the foreign asset.
In turn, typically, the emerging market’s central banks then intervene in the currency market to lower its exchange rate to the US dollar to where it had been prior to the foreign financial inflow to its market. This re-setting of its currency allows them to continue enjoying a trade surplus against the developed countries.
This link to the foreign central bank reaction is sometimes called “The Currency War.” Their purchases of US dollars in the foreign exchange market, paid for with their own currency, resets export competitiveness. The US dollars purchased in this transaction are noted on their balance sheets as foreign exchange reserves, but there is no reason to hold US dollars that do not earn income. So it has become the standard for foreign central banks to turn around and purchase interest-bearing US dollar debt with newly purchased dollars. Some even purchase US risk assets with the dollar proceeds, including corporate stock.
This additional market support from emerging market official buying amounted to another $6 trillion over the same time period considered above. In essence, there is a “money supply multiplier” in that the developed countries’ monetary expansion causes export-reliant countries to also expand their central bank money and purchase US assets. So the developed world central banks expanded by $12 trillion, and the EM central banks expanded their US assets by an additional $6 trillion.
The bottom line is that excess country debt has become targeted by central banks because they have a vested interest not to allow their bond prices to decline in market value. This, in turn, supports risk asset prices because risk assets are substitutes among investors. These risk asset purchases create higher equity prices and relatively stable P/E ratios irrespective of the changing fortunes of the underlying corporate earnings and the growth of those earnings. When a company’s earnings disappoint, central banks do not panic and sell, sell, sell. If anything, they are motivated to disallow a price correction and intensify their buying.
In essence, central banks have been building bridges over the troubled waters of excess debt, slow economic growth, and the vulnerability to asset price meltdown.
Thus, those US stock market mavens have good reason to be wondering what in the world has happened to their understanding of market P/Es. They are no longer consistent with what one would historically expect from a slow growing economy.
It’s indeed difficult to relax as an investor when you know you’re crossing troubled waters. The government has built bridges for us to cross, but those bridges are producing high P/Es that are out of line with the underlying fundamentals as we used to know them.
Hence, an excess debt environment creates pressures for austerity and low growth and puts the central banks in the unseemly position of indirectly supporting all asset prices and using a smoke screen to do it (we are here to save the unemployed). So as the mavens suggest, there is a mechanism at work to support risk asset prices, but it’s not the Plunge Protection Team… though they will likely be called in if the bridge doesn’t hold.
*The Plunge Protection team is the name given by the Washington Post to the government group that first acted in l987’s flash crash. It now has authority to intervene in the stock market. There are four voting members to do so: the Federal Reserve Chairman, the Secretary of the Treasury, the Chairman of the SEC, and the Chairman of the Commodity Future Trading Commission. In order to intervene, it requires a vote of at least three members and the approval of the president. The method of doing so is typically for the Federal Reserve to lend or fund an investment bank asset purchase of stocks to be wound down at some future time when the prices have been re-established. This loan obligation is annulled to the extent that losses might occur.