1776 is an important historical number. It’s also my working target for the S&P 500.
The level signifies independence; independence from artificial distortion created by fiscal and monetary interference…i.e. The Fed. In fact, 1776 is the valuation that would prevail in a market actually forced to act on its own–without the staggering intervention of the Fed nor the torrential downpour of deficit spending.
In other words, an independent market that goes it alone.
Cheap Money Is Making the Markets Too Expensive
The S&P currently sits at just over 3,800. This means the S&P is trading about 30 times earnings, more or less twice the historical average.
Why is it so expensive? Cheap money. Essentially, government handouts in both the fiscal and monetary arenas.
I’m not just talking about the most rapid increase in debt in our history, the lowest rates in our history and, Central Bank asset purchases that have bloated the Fed’s balance sheet to unprecedented levels….
I am also talking about moral hazard.
You see, regulatory authorities have turned a blind eye on risk and other behavior that would traditionally invite scrutiny in normal periods.
This explains the why of where we currently trading at such expensive levels.
Why 1776? Fair Value Based on Real Math
My price target is based on basic math–which is based on traditional market price behavior.
In the long run, fundamentals tend to prevail and markets always tend to converge to fair value.
Unfortunately, when enormous deviations occur, even if driven by fundamental factors, the unwinding of the excess invariably leads to similar extremes at the opposite end.
We have seen these events many times over the years: 1929, 1987, Y2K, 2007, tulips, bitcoin and the like.
We have also seen market unwarranted collapses in prices as well. The market bottom in 1987 was a pretty good example.
Now for the painful part: the trip, or rather FALL, down the mountainside.
Major Fall Ahead
At current price levels of 3,800, a return to more normal metrics puts the market at 1,900. But, as I said, normal is not enough. Overshoots are inevitable, so why not 1776, or to be honest, even more?
The revaluation will come from almost every direction:
1. Federal deficits are staggering, but this is only the beginning.
I know there is discussion of “new economic theory” which basically says “liabilities are irrelevant.” I don’t buy it and, you shouldn’t either. There is no such thing as pixie dust or the tooth fairy. We have been drawing on the future and there will invariably be a reckoning.
2. Government deficits and ever rising demand for capital crowds out private participants and distorts normal allocation of capital.
Efficient allocation of capital and investment grows more and more difficult and, as a result, the economy becomes less and less efficient. In that regard, at current levels, every percentage point rise in average treasury yield will cost the federal government about $300 Billion per annum. I think that number will be at least $500 Billion by the end of the decade. And this does not include the avalanche of deficits at state and local levels.
3. Every dollar of return on equity will be harder to generate and, most likely, will result in less return.
4. Federal Reserve policy
Short term rates established by the central bank are zero; and longer rates are artificially capped by intervention and threats of more intervention.
In a freely functioning marketplace, with exponentially rising deficits and massive stimulus, the yield curve would look like the trajectory of a SpaceX rocket. That structure would be based on normal supply and demand dynamics as well as risk to price stability.
The consequences of normal behavior are now too painful to contemplate, or allow.
So, the Fed no longer tries to set rates and manage money supply, instead, it is now trying to manipulate our “MINDS”. (You should read that with the stress and exaggeration intended).
Don’t dare to think or act on your own, independently. Don’t worry about how bad your decisions may be, we have your back. And, by the way, the costs of you being wrong will be heaped on anyone who tries to behave rationally.
Think of it this way. A P/E of 30 means you are basically investing $30 to get $1 of return of after-tax corporate profits. That is modest return on risk free assets, like treasuries, but absurd on assets that basically entail significant risk and volatility.
So, how does the Fed bend your mind to their purposes?
By convincing you there is NO OTHER CHOICE.
Investors Are Being Forced Into Equities – How is That Good?
As bad as the return on equites sounds, the return on government securities is zero at the short end of the yield curve, and not much more as you extend to the longest maturities.
That means you have to spend almost three times as much to get the same return you get on equities.
The problem is that this is relative thinking. Expected returns on both asset classes are probably negative; and those losses will be highly correlated, driven by any number of factors that will force the removal of the artificial supports propping up markets.
Better to let your profits ride, and continue to take ever-increasing risk than leave money in return free assets like cash or short-term government securities. Better not to find a way to hedge yourself.
But that can’t end well. Unless, of course, it’s healthy for the markets to get to 1776.
The Markets Cannot Survive on Monetary Heroin
Please note, my price target is not based entirely just on removing government stimulus. In fact, over time I think 1776 will occur regardless of what the government does or what the Fed does. Remember:
Heroin addicts only survive on larger and larger doses; but sooner or later the narcotic is lethal. I believe the same to be true for monetary heroin.
The process is clearly evident in markets as successive intervention has required ever more stimulus with less and less economic effect. The only real impact has been on asset prices which have become a more and more important part of the monetary equation.
The next crisis, when it comes, will find the Fed begging for the authority to buy equities. It is easy to see the justification. Too many parts of the economic and capital structure are too tied to the level of equities. The consequences of severe market corrections will be too daunting to contemplate. They will be too painful to allow. And, in the first instance, it might extend the period of overvaluation.
But ultimately, gravity is a force with we should not trifle.
