There’s no question that persistently deranged and activist Federal Reserve policy has required investors to adapt. But the form of that adaptation is crucial. The thing that 'holds the stock market up' isn’t zero-interest liquidity, at least not in any mechanical way. It’s a particularly warped form of speculative psychology that rules out the possibility of loss, regardless of how extreme valuations have become.
A remarkable feature of extended bull markets is that investors come to believe that steep market losses are impossible. None has so thoroughly nurtured that illusion than the bubble we find ourselves in today.
When the time comes to ask the question – 'What triggered the crash?' – remember that this is the least important question. The important question to ask is 'What drove the bubble?' That's where the lessons are. The most egregious role will - or should be - assigned to the Federal Reserve.
Equilibrium is like conservation of mass – every purchase is also a sale; every security that’s created must be held by someone until it is retired; the shortfall of one sector must be the surplus of another. Once you insist on thinking in terms of equilibrium, it becomes obvious how many discussions in economics and finance are incoherent.
Investors seem to be vastly underestimating the extent to which a likely economic rebound will replace rather than augment the effect of trillions of dollars in pandemic relief programs, amounting to close to 20% of GDP, which preserved corporate revenues while subsidizing labor costs.
When a good market valuation measure rises, the extra return you celebrate has simply been removed from the future. When a good market valuation measure collapses, the shortfall of return that you suffer has also been added to the future. It’s important to know where you stand in that cycle.
What defines a bubble is that investors drive valuations higher without simultaneously adjusting expectations for returns lower. That is, investors extrapolate past returns based on price behavior, even though those expectations are inconsistent with the returns that would equate price with discounted cash flows.
The present constellation of market conditions creates the potential for the sort of “trap door” situation we observed in March. Still, an improvement in our measures of market internals would ease this risk, and could even create a constructive opportunity if improved market internals are first preceded by a material retreat in market valuations.