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Stock Markets That Never Fall Are Up to No Good

Stock Markets That Never Fall Are Up to No Good

(Bloomberg Opinion) -- Unemployment is rising at a record rate. Businesses are vanishing in huge numbers. Much of the economy is on life support as fear of a pandemic keeps Americans at home. Global trade and investment are collapsing. The economy is looking at the possibility of a long-lasting depression.

So why is the stock market doing so well? The S&P 500 Index is down for the year, but it has recovered by half from its March low point:

Stock Markets That Never Fall Are Up to No Good

Meanwhile, the Shiller cyclically adjusted price-earnings, or CAPE, ratio, a common measure of stock-market valuation, is still at levels that prevailed in the mid-2000s before the financial crisis, suggesting that stocks are still expensive:

Stock Markets That Never Fall Are Up to No Good

It’s possible that stock market investors simply expect the economic recovery after the end of lockdowns to be swift and robust. But that’s looking increasingly unlikely. The U.S. has failed to suppress the epidemic, and lifting lockdowns is unlikely to bring people out of their houses as long as the threat of the virus remains. Meanwhile, business closures, mass unemployment and the collapse of global trade will weaken the economy for years to come.

A more disturbing possibility is that investors have decided that the U.S. government will prioritize preserving stock market valuations regardless of what happens to the rest of the economy.

This isn't a completely new idea. Ever since Federal Reserve Chair Alan Greenspan cut interest rates after the stock market crash of 1987, there has been talk of a so-called Greenspan Put — a commitment on behalf of the central bank to support asset prices. But the Greenspan Put was probably never just about the stock market. Although the correlation is very noisy, stocks are generally believed to be a leading indicator of recession. By cutting rates as soon as the market fell, Fed leaders were probably just attempting to get in front of a coming downturn.

The current situation might be different. President Donald Trump clearly views the stock market as a key barometer of his own success as a leader. It was only when the market plunged in March that Trump began to treat the pandemic with the seriousness it deserved. This might be because of his own stockholdings, or it might be the result of years of consuming conservative op-eds that treat the Dow Jones Industrial Average as the be-all and end-all of economic health.

But Trump isn’t the only one who’s personally invested in the markets. At the beginning of the 1990s, only about a third of Americans owned stocks; now,  more than half do. The rise of 401(k) retirement plans and shifts in allocation by pension funds seeking higher returns democratized equity ownership. Although wealthy Americans still own the bulk of stocks, the middle class has enough of a stake that propping up the stock market is probably a political winner. That could influence Congress, future presidents and even the Fed.

There is therefore now a possibility that the government — the Fed, Congress and the president — may all reliably act to buttress the stock market, independently of whether such action supports the economy. Call it the Golden Put.

One way the Golden Put could happen is if the Federal Reserve buys common stocks. This now is against the rules, but other central banks, such as the Bank of Japan, do it regularly. Already, coronavirus has prompted the Fed to bend the rules about buying corporate bonds, using off-balance-sheet vehicles. Some now are suggesting that the Fed do the same thing to buy stocks. This would support prices, but it probably wouldn't do much to support economic activity because debt financing is already so cheap.

Another way of implementing the Golden Put would be for Congress to use bailouts and other legislative action to support corporate profit margins. Ideally, emergency loans and grants should support both big and small businesses. But if the programs are structured so that small businesses lose out, it could mean that concentration grows in industries such as retail. That would preserve profit margins — and hence long-term stock market valuations — but it could hurt economic growth through higher prices and lower wages.

The Golden Put would change the fundamental nature of the stock market. Traditionally, equities have been a very risky investment, offering higher returns than bonds in exchange for forcing investors to endure regular declines and even crashes. When things go bad, stocks are supposed to be the first thing that takes a loss. But if the government commits to supporting stock prices, both the risk and reward of stocks could drop. Propping up stock prices reduces risk by removing the possibility of crashes. But knowing that the Golden Put existed would draw lots of new money into the market, raising demand and pushing up prices. In the short run that would mean a big windfall for current stockholders, but it would reduce future expected returns for the new investors.

If the government treats stock prices as a key economic target independent of the rest of the economy, it could both distort growth and turn stocks into something more akin to bonds or cash. Both the Fed and Congress should be very wary of establishing a Golden Put.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Noah Smith is a Bloomberg Opinion columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.

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