Beware of the bull

The post-Covid stock market boom will be brought to an end by rising inflation

Tim Congdon

This article is taken from the October 2021 issue of The Critic. To get the full magazine why not subscribe? Right now we’re offering five issue for just £10.

On what basis is the soaring American stock market to be explained? The gains since the Great Recession have been astonishing. By early February last year, after almost eleven years of virtually uninterrupted advances, the S&P 500 index — representative of share prices as a whole — was nearly five times higher than it had been at the previous major trough in March 2009. 

Investors were then suddenly devastated by the realisation that Covid-19 would change everything. The S&P 500 index plunged over 30 per cent in a matter of weeks. In March last year every major forecasting organization expected the pandemic to depress business activity for years to come, leading to projections of the persistent disinflation and comparisons with the Great Depression of the early 1930s.

The projections and comparisons were far from silly. Covid-19 implied protracted setbacks in hospitality, tourism and travel, with knock-on effects to aviation and the demand for oil. Might not indebted companies in these sectors go bust and heavy loan losses ricochet around the banking system, creating the same kind of contractionary pressures seen in both the Great Depression and the Great Recession? Sure enough, hospitality, tourism and travel have had a rough time in the last eighteen months. The doomsters were right about that. 

But the wider macroeconomic pessimism has been wrong, and curiously so. By September last year American share prices had moved back to where they had been at the February highs, a recovery perhaps attributable to the understanding that eventually vaccines would restore a more or less normal world. The real puzzle is what has happened subsequently. The American stock market has not just gone back to where it was before Covid-19, but instead risen far ahead of those levels. 

The S&P 500 index is about a third up from pre-Covid, but the tech-heavy Nasdaq stocks are 60 per cent higher. How does that make sense? As expected, the coronavirus pandemic has had vicious adverse effects on certain sectors and caused disruption of some kind to practically every industry. By what argument can that have been good for the economy and so for the stock market?

At present the stocks in the Nasdaq index are valued at about 38 times last year’s earnings, whereas for much of the last decade they have been priced more cautiously, at under 20 times earnings.

What are the benign properties of the Covid-19 virus, and humanity’s reaction to it, that can account for the leap in valuation? Yes, Covid-19 has been followed by a miracle: it has demonstrated our ability to create chemical compounds that master nature at its most callous and malevolent. That is certainly relevant to the valuation of companies that make vaccines. But there are only a handful of such businesses. Why should the entire stock market be sky-high?

The S&P 500 index is a third up from pre-Covid levels. Nasdaq is 60 per cent up. How does this make sense?

Is there something about the larger American scene that justifies investor enthusiasm? One explanation for why share prices are so elevated is that the Federal Reserve responded to Covid-19 with large-scale asset purchases that boosted the quantity of money. In the one month of April 2020 the quantity of money — on the broadly-defined measure that includes all bank deposits — jumped by 7 per cent, more than it had done in any full year in the 2010s; in the year to June it went up by 26 per cent, the largest increase since 1943; in the two years to mid-2020 it advanced by 35 per cent, ahead of any other two-year period since the Second World War. 

The weird behaviour of US share prices — of seeming to celebrate Covid-19 and to salute the Biden presidency — becomes logical. Fund management companies can hold either money or non-money assets, like stocks and shares. If the quantity of money bounds ahead by over a third in a short period, the value of non-money assets has to be affected. If a self-feeding euphoria has also been at work, the bull market is to be interpreted as a by-product of excessive money growth. 

Simply, too much money is chasing too few assets. But history shows that a condition of “too much money chasing too few assets” early in the business cycle evolves into another condition — of too much money chasing too few goods and services — later on. 

People spend their stock market winnings on larger houses, more cars and so on, and shortages and bottlenecks push up consumer inflation. Sooner or later the American pattern is for the Federal Reserve then to halt money growth, and the bull market in stocks becomes a bear market. Indeed, the higher the stock market goes, the stronger the positive effect on consumption and the worse the general inflation consequences. 

In this sense, every period of extreme stock market valuation suffers from a self-destructive tendency and an inherent contradiction. The Covid-19 bull market — what else might it be called? — has been an amazing phenomenon, but rising inflation in the rest of 2021 and 2022 will bring it to an end. 

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