In last week’s Money and Markets column, I told an imaginary story about a small town on the East Coast to explain Federal Reserve Chairman Ben Bernanke’s unconventional plan for solving the debt problem that plagues the U.S. and the rest of the world.
Bernanke correctly understands that for the U.S. and world economies to begin to grow again and return to prosperity, excessive debt must be eliminated.
|The Fed has continued to dump money into the system, causing the money multiplier to collapse, and thwarting Bernanke’s plan.|
My analogy reveals that, for Bernanke’s plan to work, two elements are required: 1. an expansion of the monetary base through a Fed-initiated easy-money policy; and 2. a normal level of monetary velocity, which is essentially a measure of how many times a dollar circulates through the real economy before it is returned to the banking system.
In Martin Weiss’ Nov. 23 column, he presented the following chart, which shows that the first condition — an easy-money policy — has been more than satisfied as the U.S. monetary base has exploded over the past six years. It’s unbelievable that the monetary base has more than tripled.
With all this money being dumped into the financial system, it would be reasonable to expect that the economy would have sky-rocketed or inflation would have accelerated. But as the following charts reveal, we have had neither inflation nor growth.
Instead, as the Fed has continued to dump money into the system, the money multiplier has collapsed, thus thwarting Bernanke’s plan. Using another analogy, it was as if the harder Bernanke stepped on the gas, the more the economy slowed.
In fact, the money multiplier currently stands at a 100-year low of 3.1, which means that a dollar circulates through the real economy only about three times compared with a pre-2007 average of just over eight times. That’s astonishing!
So where did all the money go? The banks didn’t lend it, as Bernanke thought they would. Turns out, it has gone into the financial markets, fueling the great stock-market recovery wherein the S&P 500 has tripled since March 2009.
And that has caused valuations (as measured by the Shiller P/E ratio) to widen to a dangerous level, currently standing at 25.4. In fact, if the Shiller P/E reverts to a normal level, annual returns on the stock market would be about 1 percent annualized over the next decade, according to Forbes magazine. Without dividends, the market would post losses.
Can the Shiller P/E go higher? Yes, as the chart above shows, the Shiller P/E was higher three times since the late 1800s: 1. before the Great Depression; 2. prior to the bursting of the Internet bubble in 1999; and 3. just before the subprime collapse in 2008.
What all of this tells us is that we are likely approaching a peak in stock prices. I don’t know where the top is — no one does. But from my perspective, it’s clearly in sight — unless we ascend to the even sillier Shiller P/E levels of the dot-com bust.
Prepare yourself properly because we are approaching lofty levels and the air is getting thin.