Watch out for a looming stock market turn that could hit the economy

John Maynard Keynes, the great English economist, was highly critical of the casino behavior of the stock market in his day.

He compared investors to those who participate in a journalistic contest to choose the six photographs out of a hundred that popular opinion considers the most beautiful. Instead of spending energy figuring out which photos were actually the prettiest, the contestants spent their time guessing which photos the other contestants thought were the prettiest.

Keynes thought that in the stock market, similarly, investors don’t bother to find out how much a company is really worth, but instead try to guess what other people think it is worth.

What would Keynes have done with the current behavior of the stock market? It’s not just that stock valuations have reached stratospheric levels. They also appear to be impervious to interest rate developments and rising downside risks to the economic recovery.

One reason to suspect irrational exuberance in today’s market is the all-time highs that stock valuations have reached. According to Shiller’s Measure of Cyclically Adjusted Prices (CAPE), at the end of last year, US stock valuations were around double their long-term average. That was a level experienced only once before in the last 100 years.

One could argue that last year’s historically high stock valuations were justified by rock-bottom interest rates on risk-free US government bonds. With the 10-year US Treasury rate below 1% for an extended period, investors seemed to have no choice but to take more risk in the stock market if they hoped to earn a reasonable return on their investments. And any expected future earnings stream is worth more if discounted at a low interest rate rather than a high interest rate

Federal Reserve Chairman Jerome Powell appears on a monitor in the foreign exchange trading room at KEB Hana Bank headquarters in Seoul, South Korea.
Federal Reserve Chairman Jerome Powell appears on a monitor in the foreign exchange trading room at KEB Hana Bank headquarters in Seoul, South Korea.
Ahn Young-joon/AP

But that leaves the question: Why do stock prices today seem essentially indifferent to the prospect of a higher interest rate environment?

Federal Reserve Chairman Jerome Powell recently signaled that the bank may soon raise interest rates in 50-basis-point increments to tackle a rate of inflation that has now hit a 40-year high. And the 10-year US Treasury rate has already more than doubled to its current level of 2.5%. And yet, the stock market has barely budged.

Equally disconcerting is the stock market’s apparent indifference to mounting downside risks to the recovery that could have clear implications for corporate earnings.

From Russia ukrainian invasion is shipping oil, food and metal sky-high prices. from China closure of major cities as Shanghai in response to a new COVID surge threatens to keep global supply chains disrupted and shipping costs high. As if that wasn’t enough, the Fed is in the process of removing the punch bowl to deal with inflation by starting a cycle of raising interest rates.

Interestingly, the bond market does not share the stock market’s complacency about the economic outlook. For the first time since 2006, the 5-year Treasury rate has risen above the 30-year rate. The stock market might want to note that in the past, this so-called yield curve inversion, where short-term rates exceed long-term rates, has been one of the most reliable. indicators of a recession on the horizon

Stocks spill out of the entrance of a supermarket in Shanghai, China, on Tuesday, March 29, 2022.
A supermarket in Shanghai, China, which has just started a two-phase COVID lockdown.
Chen Si / AP
Jerome Powell, Chairman of the Federal Reserve
Fed Chairman Powell has admitted to investors that the central bank has an inflation problem.
Tom Brenner/REUTERS

All of this is not to say that we should necessarily prepare for an imminent big stock market crash. After all, as Keynes himself pointed out, markets can stay irrational longer than you can stay solvent. Former Fed chief Alan Greenspan also saw a long lag between his famous 1996 “irrational exuberance” remark and the eventual bear market.

But we must understand that, having fueled stock speculation with years of ultra-loose monetary policy, the Fed has likely set us up for a hard landing in the stock market in the future. That eventual correction could have important indirect effects on the rest of the economy, especially if it coincides with the bursting of the housing market bubble.

As in the past, if households felt less wealthy and less financially secure, they would tighten their belts and cut spending, which could send the economy into a nasty recession. All thanks to the Federal Reserve.

Desmond Lachman is a senior fellow at the American Enterprise Institute. Previously, he was deputy director of the International Monetary Fund’s Development and Policy Review Department and chief emerging market economics strategist at Salomon Smith Barney.

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