2 Classic Bear Arguments That Are False


It was another difficult day for U.S. stocks, as the S&P 500 and the narrower, price-weighted Dow Jones Industrial Average both fell 0.84%.

Consistent with those losses, the VIX Index , Wall Street's fear gauge, shot up another 8.9% today (on top of yesterday's 10.6% increase), to close at 18.59 -- its highest closing value since Feb. 25 and the second-highest this year. (The VIX is calculated from S&P 500 option prices and reflects investor expectations for stock market volatility over the coming 30 days.)

As market declines bolster the bears' conviction, I thought it useful to separate the wheat from the chaff by debunking two bearish falsehoods I have come across (I have nothing against bears per se, but one should be bearish for the right reasons only):

In March, the S&P 500 set a new all-time high. Stocks were overvalued when they set their previous high, in Oct. 2007, so they must be overvalued now.
First, it doesn't make sense to compare nominal values belonging to two periods separated by more than five-and-a-half years. Inflation matters! You may be surprised to learn that, adjusted to inflation, the S&P 500 has yet to break its Oct. 2007 closing high of 1,565.15, which corresponds to roughly 1,740 in today's dollars.

Second, a comparison between two index values, without any reference to underlying fundamentals, is pretty meaningless. Stocks may well be overvalued today, but not because the index has surpassed a previous bull market high. Here's a sensible fundamental comparison: On Oct. 9, 2007, the S&P 500 was valued at 27.8 times average real earnings per share over the trailing-10-year period. At today's close, that multiple stood at 23.2, which suggests that, while stocks are expensive today, they're significantly cheaper than they were then.

With the Fed printing money with abandon, inflation (or even hyperinflation) is inevitable (and will ravage asset values, purchasing power, etc.).
According to Milton Friedman, "Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output." If that is correct, then surely the Fed's money printing (bond buying) must spur an inflationary episode?

The Fed's repeated rounds of quantitative easing have led to an explosion in the size of the Fed's balance sheet. That's a fact, which is reflected in the graph of the monetary base aggregate (the red line in the graph below.) That expansion has not led to an explosion in the money supply (blue line) -- this is also a fact. Instead, the difference is largely explained by the growth of excess reserves that banks have sitting in accounts at the Federal Reserve (green line).

Inflation is a latent risk, but it is not inevitable, neither today, tomorrow, nor even in the long term, as Martin Wolf, the Financial Times' chief economics commentator, explains in an excellent article (subscription required) in yesterday's newspaper on this very topic. Although he focuses on the U.K., his argument is applicable to the U.S.:

They [inflationistas] assume banks will lend more against these reserves, meaning that the current high level of reserves at the central bank is an indicator of future monetary expansion.

But a solvent bank can obtain the reserves it needs from the central bank. Moreover, the central bank will make sure that such a bank never falls short of reserves... So the equity capital of the bank is, accordingly, a far more important determinant of its ability to create money than its reserves. Moreover, should the central bank wish to lower excess bank reserves, it can either sell government debt to the public or raise their reserve requirements. Thus, the idea that a high level of reserves guarantees a future surge in broad money is false.

Agree? Disagree? Let me know in the comments section below.

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