Editor’s Note: Sven Henrich is founder and lead market strategist at NorthmanTrader. The views expressed in this commentary are his own.
Last month US markets once again hit a little-known but highly relevant ceiling which has spelled market trouble numerous times in the recent past, most famously during the major market bubble bursts in 2000 and 2007. Investors should recall what happened then, take note and brace themselves for the possible implications.
What is that ceiling? It’s when overall stock market capitalization vs. GDP reaches a point historically disconnected from the underlying size of the economy. We are in such a period again, having recently reached a ratio of stock values to GDP of 145%.
The biggest bubbles in most of our lifetimes were the 2000 tech bubble, the 2007 real estate bubble and the monstrosity we are witnessing now: the cheap money bubble. This new bubble has been induced by central banks’ artificially low interest rates which are creating the TINA effect, which stands for “there is no alternative.” This effect is found in markets where hungry investors are forced to buy high risk assets like stocks because other assets offer worse returns.
Bubbles occur when excess optimism about the future pushes the value of asset prices beyond what the underlying economy actually produces. They are a result of unrealistic future growth and valuation expectations.
All three bubbles have done something unique. They have vastly accelerated asset prices above their historical mean. In 2000 and 2007, these bubbles reached extreme ratio peaks of 146% and 137% in the US, respectively, before they burst, correcting into bear markets.
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Today’s cheap money bubble has arrived with full vengeance on the heels of $20 trillion in global central bank intervention through quantitative easing and a historic collapse in bond yields, which has forced money into equities.
The bull case for the market to continue its rise has been presented like this: When the Fed cuts interest rates, you must buy stocks. That’s it. It’s not earnings. It’s not growth. Indeed, Goldman Sachs recently raised its target price for the S&P 500 while simultaneously cutting earnings and growth forecasts, primarily based on multiple expansion expectations due to the Fed cutting interest rates.
But look closely at what has happened over the past 18 months. We have kept hitting that 140% to 150% ceiling. In January 2018, US markets reached nearly 150% market cap to GDP and stocks got punished with a 10% correction. From last September to October, US markets hit 147% market cap to GDP and stocks got hit with a 20% correction. And last month, we hit 145% market cap to GDP and stocks have since begun selling off again.
How far and for how long can stock markets stay this far disconnected from the underlying size of the economy? History says not for very long.
A similar valuation wall can be observed across the globe.
Each time global market capitalizations cross the 110% mark, markets get volatile. Global market cap to GDP peaked in in January 2018 just north of 110% again before reverting.
There is no market history that supports stock market capitalizations above 145% of GDP for an extended period of time.
There is also no history that suggests unemployment can stay this low (near a 50-year low) for an extended period of time.
And there certainly is no history that suggests that both can be maintained for an extended period of time concurrently.
I don’t know what fair value is in this financially distorted world, but the historic mean is significantly lower. It’s only truthful to acknowledge that central banks have contributed to an artificial excess in the market cap to GDP ratio.
This is a central bank bubble. To be buying stocks here based on the Fed rate cut is to believe central banks can maintain asset values above the underlying size of the economy and can do so at a historically unsustainable level in a period of slowing growth.