Obviously, we’re worried. Based on trailing earnings, the current P/E ratio for the S&P 500 is about 40. This number is the third-highest level surpassed only by the P/E levels leading into the bursting of the dot-com bubble. At a Shiller P/E of 35, the market is paying a whopping 5.45 times above its trailing 12-month average.
We don’t have to go further than some tech-stock favorites to see that things are getting out of whack. These companies are trading at enterprise values to sales multiples that would give most reasonable people pause for concern. To name a few: Snowflake (146), Crowdstrike (62), Datadog (49), Shopify (53) and Zoom (57).
The E/P Ratio
Those who have followed our pronouncements regarding stock market fundamentals know of our penchant for focusing on the reciprocal of the P/E ratio, namely the E/P ratio minus the 10-year U.S. government bond rate, to gauge the premium of stock market returns over fixed-income securities. That premium or spread has narrowed from 3.5% in March of last year to a recent 1%. If the 10-year bond rate continues increasing at its pace over the last few months, the spread will drop below 1%, hardly the kind of premium that justifies the risk of investing in a market with a trailing multiple of 40.
In 2020, retail investors doubled their share of total equity trading volume to 30% and increased the utilization of margin and options to 43% of their investments. This kind of hyper-retail investor activity is yet one more sign of an overheated market.
Pumping more and more air into what we perceive as a stock market bubble is an extremely accommodative Federal Reserve (Fed) at the ready to buy up a steady supply of bonds being sold by the Treasury to fund its record-breaking deficit. Since the beginning of 2020, the Fed has acquired more assets than during the six-year period of quantitative easing from 2008 to 2014. Most startling, year-to-year growth in the money supply as measured by M2 hit 20% in May of last year and more recently surpassed 25%. M2 is a calculation of the money supply that includes cash, checking deposits, and other assets that can quickly be converted into cash, such as certificates of deposits (Chart 1).
M2 Gone Wild
Based on the research conducted at the A. Gary Anderson Center for Economic Research, we’ve shown that during the three periods since 1940 when M2 growth exceeded 13%, sharp increases in inflation followed.
Our growing apprehension of a stock market bubble is based on more recent research findings that go one step farther than examining the impact of rapid money growth on inflation. That next step involved examining the impact of inflation on the stock market during three periods of hyper M2 growth.
The first of those three periods occurred at the end of WWII. Fearing the prospects of a post-war recession, the Fed increased M2 at annual rates in excess of 20%. That was followed by a surge in inflation from 2.2% in the first quarter of 1946 to 18.9% only one year later. During that same year-long period of sharply higher inflation, the stock market swooned from annual appreciation rates of 32% to annual losses of 18% (Chart 2).
In the early 1970s, after M2 growth grew at annual rates approaching 14%, inflation increased from 4% in early 1973 to 10.5% by the end of 1974. Similar to the pattern following WWII, this spike in inflation was accompanied by a sharp decline in stock market appreciation from an annual increase of almost 20% in mid-1972 to a steady decline to negative 33% by late 1974 (Chart 3).
A mirror image of this stock market correction in the early ’70s was followed a few years later when M2 growth again surged to 14%. This time, inflation only increased from 5% in late 1976 to 6.6% one year later. That uptick in inflation, however, was still accompanied by a sharp fall in the stock market, a decline of 10% (Chart 4).
Inflation is Quiescent
And now, almost 30 years later, we are experiencing M2 growth higher than any of these three previous periods. Similar to the early stages of those three periods, inflation is quiescent.
And as usual during those early stages, the Fed seems unconcerned. That’s not surprising since the Fed usually waits until it sees the white of the eye of inflation before doing anything about it.
We believe, though, that the historical record documented here already shows that rapid M2 growth inevitably leads to higher inflation. We shouldn’t be surprised, therefore, that when inflation begins to rear its head, the stock market bubble will burst.
In light of our inflationary concerns, the first step we took was to decrease our equity positions in our portfolios to 60% and increase our holdings of cash (money markets and other short-term financial instruments).
The fact that we still have 60% in U.S. equities means that we still have skin in the game. We’ll reduce our equity allocation even further if our expectations of higher inflation are supported by early signs of pricing pressure.
The fact that the price index for all primary commodities has increased by 25% over the last three months to its highest level since 2014 is the kind of evidence that suggests to us that our recent pivot from U.S. equities is prudent. n
Editor’s Note: James L. Doti, Ph.D., president emeritus at Chapman University, is one of the nation’s most prescient economic forecasters. He’s also on the board of directors of Whittier Trust, which has $14.7 billion in assets under management. Fadel N. Lawandy is director of Chapman’s Hoag Center for Real Estate and Finance and was a portfolio manager at Morgan Stanley. The pair wrote this article before the recent downturn in the market.
