US Stock Markets: what goes up must come down

As the US-fed signals it wants to start tapering soon markets are rattled. After 7 months of non-stop rallying and market extremes (surging 100% since March) the Fed wants to phase out the $120bn-a-month bond-buying.

Price-to-equity ratios are in their 90th percentiles on most metrics, inflated due to stimulus checks, QE and record levels of saving during COVID. “The S&P 500 has essentially turned into a 36-year, zero-coupon bond,” says Savita Subramanian head of U.S. equity and quantitative strategy at Bank of America.

Historically these levels are high (above), sitting around 15 over the past 140 years.

But many believe this is too early. The US economy is 'soft' and recovery is expected to slowdown in September-November as retrospective data updates and an uptick infections squeeze supply chains. Job creation in August was a meagre 235,000 compare June and July's roughly 1 million. "Top Fed official pushes for quick ‘taper’ despite weak US jobs growth" states the Financial times.

Job demand and vacancy rates are high: signalling strong routes for growth. But Job immobility and poor worker confidence has kept labour market in doldrums. It is hoped the ending 7.5 million Americans enhanced unemployment relief may increase job occupation.

James Bullard, president of the Federal Reserve Bank of St.Louis and inflation hawk, expects the labour market to be strong with job growth about 500,000 a month for rest of the year. He is also wary of rising inflation and an insurgent house bubble which is concerning other central banks (see below). Other central banks have also signalled worry at growing wealth inequality caused by market highs propped up by expansionary policies.

Bullard wishes to maintain the Fed's policy flexibility and return to pursuing the price stability trade-off of 2%. Concerns are also raised about future trade-offs: cheap money today means savers lose out whilst debt continues to rise. Who will be the spenders of tomorrow? He suggests tapering now and possibly raising interest rates in the Spring.

As seen before P/E did not recover since last crisis because central banks weren’t able to clean their balance sheets - remaining bloated for years; each crisis is becoming more taxing than the last.

With all this in mind, Deutsche Bank equity strategists wrote "the risk that the correction is hard is growing,” a sentiment echoed by other investment banks including Goldman Sachs, Morgan Stanley, Citigroup and Bank of America. In other words, they expect stock market to fall to more usual levels once tapering takes effect - and it may be hard and markets are poised.

Signs of market exuberance have caused with large mis-allocations of capital and developing bubbles have attracted speculators. Central banks can't let the market rally get out of control else more harm may be done.

Cheap money won't last forever; as ever, Newton was right: what goes up must come down.