The United States stock market valuations are in a Danger Zone. A formula of stock market valuations around the world indicates that United States markets are the second most overvalued in the world (after India). Frankly our model forecasts negative one and two year S&P 500 returns if considering only market valuations. However the Federal Reserve’s actions in March 2020 temper this bearish outlook.
In March the Federal Reserve (Fed) lowered the Federal Funds rate - the rate at which money is loaned to banks - to its present rate near 0% in order to fuel a stalling economy. Lowering the Federal Fund rate fuels the economy because it lowers borrowing costs. For example, 30-year mortgage rates recently reached all-time lows around 2.88%. Lowering the Federal Funds rate also fuels the stock market because low interest rates produce bonds with unattractive yields. This drives investors to bid up stocks.
Today’s investing environment is similar to the 1930s (Great Depression). The Federal Reserve is limited in its options should the economy (markets) stall again (they did in 1929 and 1937). One proposed option to fuel the economy is reducing the Federal Funds Rate below zero to negative, an agreement (seemingly out of the Twilight Zone) where the government promises to repay less money than borrowed. Central Banks in Japan, Denmark, Sweden, and Switzerland have implemented negative interest rates. Fortunately the Federal Reserve appears reluctant to adopt negative interest rates at this time.
At the recent Annual Economic Symposium, Federal Reserve Chair Jerome Powell pledged to not target inflation as tightly as in the past. High inflation is harmful because it raises prices and diminishes the value of wealth. Post-WWI the German Mark declined a trillion-fold in value. A loaf of bread costing 160 Marks in 1922 cost 200,000,000,000 Marks by the end of 1923. Inflation rendered the Mark so worthless some used it as fire kindling.
In the U.S. the Fed traditionally acts to prevent too much inflation by raising the Federal Funds Rate. Inflation reached 14.5% in 1980 requiring the Fed to raise the Federal Funds Rate to an astounding 19% to fight inflation. This caused 30-year mortgage rates to reach 18.5% in 1981 and precipitated a bear market from 1980 to 1982. The Fed's recent pledge to not target inflation as tightly effectively guarantees that the Federal Funds rate will remain near zero for the next several years (even in the face of inflation).
If Afterburner sounds hyperbolic for a pledge, note that the Federal Reserve likely does not have much fuel left to burn after already lowering the Federal Fund rate to near 0%. With U.S. market valuations in a Danger Zone, readers are wise for being less bullish this month than in recent months (and kind for permitting my Top Gun 2 references).
Addendum: The Report was written earlier in the week before the S&P 500 dropped 4% on Thursday and Friday (9/4/2020). We do not see indications that we are currently in a bear market; instead we are Very Bullish for the upcoming month.
This report reflects the current opinion of the author. The report is based upon sources believed to be accurate and reliable. Opinions and statements about the future expressed in the report are subject to change without notice. The report is not a solicitation or an offer to buy or sell any security.