The Real Diehl is a weekly column by former United States Mint Director Philip N. Diehl, exclusively for CoinWeek ………..
Has tax, monetary, and regulatory policy set in motion another stock market bubble?
Robert Shiller, a Noble prize-winning economist, is among the market analysts and economists whose work I follow and admire. I discovered Shiller several years ago when I was arguing that stocks were becoming over-valued. People who disagreed with me kept pointing to price/earning ratios (the current price of a company’s stock divided by the company’s annual earnings), which at the time were inline with historical averages.
I believed that stock prices were inflated (they’re even higher today, of course), but price/earnings ratios are followed so religiously that I couldn’t make a persuasive case. Then I discovered Shiller’s work.
Shiller’s analysis is based on price/long-term earnings (rather than annual earnings). He shows that a year isn’t enough time to determine whether a company’s stock price is too high or too low. This makes perfect sense. Short-term effects, such as the state of the economy, one-time accounting adjustments, and the success or failure of a new product, distort P/E ratios.
Price/long-term earnings [P/(l-t)E] ratios correct for this distortion and, today, warn us that that stock prices are very high. In fact, the only times P/(l-t)E ratios have been this high was leading up to the 1929 crash, just before the dot-com bubble burst in 2000, and on the eve of the 2008 financial crisis.
Multiple economic forces are driving stock prices to these unsustainable heights. The most widely recognized are very low interest rates, low commodity price and labor cost inflation, and increasing efficiency from technological innovation. All of these forces increase corporate profits and stock prices. And they are unlikely to be sustained indefinitely.
But another powerful force, commonly overlooked, is artificially driving higher stock prices: the Federal Reserve’s easy money policies, especially its five and a half years of quantitative easing (QE).
The threat of high inflation is what worries most gold advocates about QE. I don’t worry so much about inflation. For five years, we’ve heard repeated warnings that QE will inevitably spark a sharp rise in inflation but, today, there’s no sign of it. The Fed’s QE policy is unprecedented, so maybe it will lead to higher inflation some years down the road. But inflation is the least of our problems, today.
What worries me is the huge amount of money QE has driven into stocks by driving interest rates so low that investors have rushed into stocks and accepted ever-higher levels of risk in search of higher returns.
Moreover, rapidly rising after-tax incomes of investors, higher returns to institutional investors, and increasing leverage have added to the storm surge of money into stock markets. Lower capital gains taxes have added tidal flows to the market. The gutting of financial market regulation over the past 20 years and the failure to hold anyone accountable for rampant abuses in the financial sector have eroded the flood walls that protected us for 70 years.
At the risk of torturing the metaphor, we have allowed Wall Street, and the rest of us as collateral damage, to become vulnerable to a financial Hurricane Sandy.
As I’ve written previously, gold, as wealth insurance, protects you in hard times by offsetting losses elsewhere in your portfolio. Gold has consistently outperformed other asset classes in the seven periods of significant economic or political turmoil of the past 25 years, most dramatically in the 2008-2009 financial crisis. I believe we are creating conditions that will lead to an economic crisis more severe than the Great Recession of 2008-2009. Of course, the Great Recession was the worst economic crisis since the Great Depression.
Philip N. Diehl was the 35th Director of the United States Mint and a former chief of staff of the U.S. Treasury. He has written about gold markets for The Wall Street Journal and Institutional Investor and currently serves on the boards of the Industry Council for Tangible Assets, the Coalition for Equitable Regulation and Taxation, and the Gold and Silver PAC. He was recently named president of U.S. Money Reserve. Be sure to check out Philip’s blog.