As you’re acutely aware, we live in extraordinary times, especially from the standpoint of financial markets. Rather than diving into one of our normal financial planning topics, this week, I instead wanted to bring you a current market situation report. I’m writing this in advance of the Fed’s FMOC (Federal Open Market Committee) report that will be released on June 16th.
Depending upon the source, today’s markets are either the greatest ever and will never, ever go down again or they are poised on the brink of a biblical apocalypse. But what do the numbers have to tell us? And more importantly, what can we do to prepare ourselves for these possible outcomes?
Before we get into the details, let me be clear: there is no perfect metric or indicator that will tell us what will happen next. Markets are among the most complicated of human inventions ever conceived. There’s nothing linear about them. There are thousands of variables that factor into their movement, including second and third-order variables such as financial derivatives.
With that said, let’s review a few key market indicators to gain some idea of where we are and where we could go from here.
The Buffett Indicator
The first metric we want to examine is the value of the U.S. stock market vs. the U.S. GDP. This is known as the “Buffett Indicator” since Warren Buffet considers this the best of the market valuation indicators, acknowledging that all of them are flawed.
Here, we simply divide the value of U.S. stocks by the value of all of the goods and services produced (GDP). We see that markets are historically overvalued according to this indicator. In fact, we could see a market correction – a drop of 10% – and markets would still be more overvalued than they were at the top of the tech bubble.
The Buffett Indicator is over two standard deviations above its historical norm. For those of you who are not statistically inclined, this means that these kinds of high valuations should occur no more than 2% of the time.
This tells us one of two things. First, that the numerator in this equation could be much higher than its historical average. Second, the denominator in this equation could be lower than its historical average. Of course, both could be true.
Where stock market valuations tend to be forward-looking, GDP numbers take some time to compile based upon data that rolls in after the fact. The argument against the Buffett Indicator is that these “old” GDP numbers don’t reflect the trajectory of the economy. Indeed, we do expect GDP growth as the world begins to open up again. Should GDP grow, then this indicator could descend from geosynchronous orbit.
Market Valuation vs. Interest Rates
Another metric that we want to review in this week’s market situation report is the value of the stock market vs. interest rates. Why is this important? If interest rates are low (as they are today), then otherwise conservative investors seeking higher returns are forced into riskier investments. This drives market prices higher as these investors take on more risk than they normally would.
Given the extraordinary suppression of interest rates by the Federal Reserve since the Great Financial Crisis, investors have been continually forced into riskier assets in order to find returns. This creates an interesting dynamic.
On one hand, keeping interest rates low allows the government to minimize its debt service costs. This is fantastic for the U.S. since it is now the greatest debtor in the history of mankind. Uncle Sam is barely making the interest payments on his credit cards each year. If his interest rate jumps much higher than 0%, he’d immediately default on all his debt.
While that’s great for Uncle Sam, it creates some less-than-ideal consequences for the rest of us.
The current market valuation to interest rate indicator is showing us that, while the S&P 500 is currently overvalued relative to its historical norms, the lower-than-historical interest rates balance that out. In other words, higher market valuations are normal due to what’s happening with interest rates.
It’s also important to note in the graph that this indicator has been creeping up toward the “overvalued” line. If interest rates rise much at all, then we could see this indicator move into overvalued territory. However, it’s doubtful that the Fed will allow rates to rise significantly.
The next metric we want to examine is margin debt. Margin debt is simply the amount that people have borrowed in order to invest. The total amount of margin debt gives us a good indication of how much speculation exists in the market today. Generally, the more people borrow in order to invest, the greater the chances that markets are overvalued.
As you can see from this graph, margin debt levels well exceed the Tech and Housing Bubbles, even adjusted for inflation. Also, note the significant acceleration in margin debt over the pandemic. Again, none of these indicators are perfect; these are just data points. As we discussed earlier, low interest rates drive investors into riskier assets, which drive up the markets.
What we’re witnessing is a positive feedback loop: lower interest rates drive up market prices, which fuels speculation, which increases margin speculation, which drives up market prices further.
Euphoric speculation is considered a classic hallmark of an asset bubble. We’ve certainly seen that over the last year with the rise of Robinhood, meme stocks, cryptocurrencies, and NFTs.
Money Supply and Velocity
Now, as part of this week’s market situation report, we turn our attention to money supply and money velocity. Combined, these numbers can give us some indication of what inflation we might expect.
First, let’s look at the M1 money supply, which is simply the total amount of cash (including near-cash instruments such as travelers’ checks) in existence.
Yikes. Remember the good ol’ days of the Great Financial Crisis when everyone thought that a billion dollars was a lot of money?
Next, let’s look at money velocity. Money velocity is simply the speed at which dollars are circulated in the economy. Money velocity is important because it is viewed as a general indicator of the health of the economy. More economic activity means a higher circulation of money.
As you can see, money velocity fell off a cliff during the pandemic – and continues to remain lower than any point displayed on the graph, which goes back to the 1960s. This is in spite of stimmy checks and money printing machines going into hyperdrive.
So how does this happen? Consumers may, on the whole, be saving more and paying down debt. The interplay between these two variables is complex. In spite of the efforts of the Treasury and Federal Reserve, stimulus money has not been absorbed into the system yet.
While inflation is typically thought of as an increase in the price of goods and services, it’s actually the increase of money in circulation. The Treasury and Fed are trying to counteract the drop in money velocity by increasing the M1 money supply. When the M1 money supply and money velocity start to move in lockstep, then we will be in an inflationary environment. However, as of today, deflation is still on the table.
Current Market Situation Report
When viewed together, these data points indicate a highly overvalued market environment in my opinion. If we look back through history, markets can remain overvalued for extended periods. So, at face value, over-valued markets aren’t something to be afraid of. That being said, the current yield of the S&P 500 is lower than the yield of the 10-Year Treasury. If stocks’ values are supposed to be the present value of their future cash flows, what does that tell you about the expected future growth expectations of the stock market?
I believe that now is the time for caution. There are two quotes that come to mind for me in this environment. First is from Warren Buffet: “Be fearful when others are greedy and greedy only when others are fearful.” Given prices, margin levels, and the zeitgeist of meme investments, we seem to be living in a time of extraordinary greed.
The second quote is from JP Morgan: “I made a fortune getting out too soon.” As sure as the tides turn, we will have another correction at some point. Being early is okay. Being late is not. Avoiding the big drop is better than having big returns in any given year. If you drop by 50%, you’ll need 100% returns the following year just to get back to where you were.
I hope you enjoyed this week’s market situation report. If you’d like help protecting your wealth from a potential mean-reversion event, then click here to set up a quick, complimentary introduction call to see if Prana Wealth is a good fit. We do still have the capacity to take on new clients.
As a fee-only financial advisor in Atlanta, we can (and do) work virtually with clients all across the U.S. and we’re here to help you when you’re ready.