Fed Faith Is Not An Investment Strategy

An insightful article in the FT today courtesy of John Hussman (see The Myths behind the current stock market bubble) considers the belief system widely held today that central bank liquidity can support extreme and irrational asset valuations indefinitely: “Years of intervention have cast central banks as tools of self-reinforcing speculation. Mere phrases such as “Fed support” now suffice as complete investment strategies.” While today is certainly not the first time that this misplaced faith has been widely held, the current episode is so extreme that only 2000 and 1929 offer a comparable data set:

In 1934, Graham and David Dodd described the errors that contributed to the 1929 extreme, and the collapse that followed. They observed that investors had abandoned attention to valuations in favour of prevailing trends, while “the rewards offered by the future had become irresistibly alluring”. Moreover, the backward-looking success of passive stock ownership had encouraged investors to ignore price as an investment consideration. Graham and Dodd lamented: “It was only necessary to buy ‘good’ stocks, regardless of price, and then to let nature take her upward course. The results of such a doctrine could not fail to be tragic.”

It is widely acknowledged that corporate profits are one of the most reliably mean-reverting financial series (aka capitalism). With this fact in mind, the chart below offers some illumination. The lower left shows S&P 500 prices divided by profit margin-adjusted price to earnings since 1928, and the lower right shows US stock prices divided by revenues since 1947. Suffice to say permanently high plateaus have been non-existent and past episodes of euphoric pricing have brutally punished those who held high.

Two line charts showing that investors need to consider whether historically high stock market valuations are justified - or can last

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