Will the Fed crash the party in stocks?

The party in global stocks continues to rage, driven by a powerful combination of generous government spending and an ocean of liquidity by central banks. However, with the Fed thinking about taking its foot off the accelerator and the G7 nations agreeing on a minimum tax rate for big multinationals, the rally could come under fire. Even so, it's difficult to envision anything more than a correction. Equities are still the only game in town.

Stock market train keeps rolling

Global equities have been in an ecstatic mood for over a year now, staging one of the most legendary comebacks in history. Central banks injected a tremendous amount of liquidity into the financial system and governments rolled out unprecedented fiscal packages to fight the crisis. Add the vaccines into this mix, and it's a recipe for a market party.

When central banks start buying bonds in force through their quantitative easing programs, that simply pushes yields down and drives investors away from safe assets - into riskier ones. Why buy a low-yield government bond that's guaranteed to lose you money once inflation is factored in, when you can buy stocks that still offer a real return?

In other words, when bonds become return-free assets, everything else instantly becomes more attractive. Think of bond yields as the price of money. If that price goes to zero or negative, then investors will borrow for absurdly cheap rates and use that money to earn real returns elsewhere. It just encourages risk-taking.

Rise of small investors

Beyond all this, small investors have also joined the frenzy. This new generation of day traders has discovered new sophisticated ways to game the market – by weaponizing call options.

Purchasing a call option allows traders to command more buying power than simply buying the stock. It also forces the dealers that sold those options to hedge their price exposure, by buying the stock too. This can spark a bullish price loop, where retail buying forces more dealer hedging. The price rises and short-sellers run to close their positions to avoid massive losses, adding more fuel to the upward spiral.

This is the famous short squeeze. It has been happening left and right lately, particularly in small-cap stocks, but not exclusively. Remember how Tesla shares rose 10x last year? Or how several 'meme stocks' like Gamestop, AMC, Clover Health, and many others skyrocketed lately?

Is the market in a bubble?

That's a tricky question. Looking at the classic valuation metrics, then yes this market is quite 'expensive'. The forward price-to-earnings (PE) ratio for the S&P 500 is currently at 21.2x, which is very high by historical standards.

It's a similar story with every valuation measure, like price-to-sales or price-to-book value. Even the famous 'Buffett indicator' is at an all-time peak, far higher than any previous bubble. This is the ratio of the entire stock market capitalization relative to the US economy.

So the market looks overpriced, but perhaps not entirely in a bubble. Fiscal and monetary policy are extremely loose simultaneously, which has never happened in recent history. Indeed, comparing valuation metrics to anything before the era of quantitative easing started in 2009 may be pointless. That's when central banks really went all-out. In the age of endless money printing, stock valuations may be permanently higher.

The other shift that perhaps justifies higher valuations is the rise of big tech. Many of these tech giants have completely different models to traditional businesses. They can scale their operations without any additional costs and can reach a global audience almost instantly, which allows for explosive growth. Valuation measures weren't developed with these businesses in mind.

The next phase

Looking ahead, this 'sweet spot' for markets could persist over the summer, but around the autumn is when things look difficult. The developed economies are healing quickly thanks to vaccinations and monster spending packages, leading several central banks to consider an exit strategy from their emergency money-printing programs.

From the Bank of England to the Bank of Canada to the Reserve Bank of New Zealand, policymakers have started to outline a path towards less QE and ultimately higher interest rates. The Fed could join this club soon. Vice Chairman Clarida said that a discussion about scaling back asset purchases could begin at the coming meetings, so September may be a realistic time for an actual decision.

That could spark a sharp correction. The Fed will make the whole process as slow as possible to avoid any market panic, but even so, the signal that cheap money will start being withdrawn will likely send shock waves. In combination with higher taxes for big multinationals that the G7 powers are about to agree on, it could get ugly for a while.

Ultimately, there is no alternative

In the big picture, even if there is a decent correction later this year, it is difficult to argue with the positive trend. In the end, equity markets follow the economy, which is doing better and better.

Investors might kick and scream at first when the Fed takes the punchbowl away, but as the 2015-2019 period showed, stock markets can keep rising even without cheap money.

After all, what else is there? Bonds are a dead asset class, commodity markets are too small, and crypto is too risky. Equities are the only game in town.

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