The Biden stock market
John Maynard Keynes famously remarked that stock markets could stay irrational for longer than you could stay solvent. By this he meant that upward market trends could persist for a long while even in the face of the clearest of indications that a day of reckoning would eventually occur. This makes it unwise to bet the farm that a market correction will occur within a specific time period no matter how shaky the underlying economic fundamentals might appear to be.
Keynes had in mind the stock market experience in the run up to the World War I. Even though there were very many advance warnings that it was only a matter of time before the world would be at an economically destructive war, the U.S. and British stock markets traded at record levels right up to the eve of that war. But immediately following the war’s outbreak, both the London and New York stock markets crashed and had to be shut down for several months until more orderly conditions prevailed.
In more recent times, the stock market has failed to anticipate major declines on a number of occasions even though in hindsight the clues pointing to such declines were in plain sight. This appears to have been the case with the bursting of the dot.com bubble in 2000. Already in 1996 then-Fed Chairman Alan Greenspan had famously warned that the high-tech market was suffering from irrational exuberance. It also appears to have been true of the 2008 stock market crash, where it should have been obvious that it was only a matter of time before the once-in-a-century U.S. housing and credit market bubble would burst with very untoward economic consequences.
Today, it would seem that Keynes’s remarks about market irrationality might be particularly applicable to President Biden’s stock market. In the early days of the Biden administration, the stock market has continued to trade at record levels, with lofty valuations last seen on the eve of the 1929 stock market crash. It does so even though Biden’s economic policies all but guarantee that the underlying conditions justifying today’s high stock market valuations will soon be eroded.
The primary justification for today’s record stock market valuations is the belief that today’s ultra-low interest rates will last forever. With a low discount rate expected to last forever, companies do not need to record particularly strong earnings growth to have their stock prices trade at very lofty levels.
Biden’s highly expansive budget policy would seem to guarantee that today’s low interest rates will not persist for very much longer. Together with the December 2020 bipartisan budget stimulus, the Biden stimulus will imply that in 2021 the U.S. economy will receive as much as 13 percent of GDP in fiscal stimulus. It will be receiving that much stimulus at a time that the Congressional Budget Office is estimating that the U.S. output gap is only around 3 percent. It would also be receiving that much budget stimulus at a time that the Federal Reserve has got its pedal fully to the metal and at a time that there is a large amount of pent-up demand in the economy as a result of the pandemic.
The excessive Biden budget stimulus makes it all too likely that before year’s end the U.S. economy will overheat and inflation will begin to accelerate. If that occurs, the Federal Reserve will have little alternative but to taper its bond-buying program and raise interest rates. However, if interest rates were to rise, the stock market bubble could very well burst as today’s record stock market valuations could no longer be justified by the expectation of continued ultra-low interest rates forever.
Biden is also now contemplating tax measures to finance his proposed increase in infrastructure spending that could be harmful to the stock market’s performance. His proposal to roll back at least in part President Trump’s 2017 corporate tax cut must be expected to crimp corporate after-tax earnings as well as to put an end to the wave of corporate equity buybacks that Trump’s tax cut encouraged. Meanwhile, Biden’s proposal to approximately double the tax rate on wealthy investors’ capital gains must be expected to encourage stock market selling in anticipation of that tax increase coming into effect.
All of this would suggest that whatever economic achievements Biden might accomplish in the run-up to next year’s midterm elections, a well performing stock market will not be one of them. Consequently, Biden might be well advised to remind the electorate that it is output and employment growth that really matter and that the stock market is not the economy.
Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.
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