Is It Good Public Policy to Prop Up the Stock Market?
Should policymakers prop up the stock market when it appears to be in danger of crashing down? Q3 2021 hedge fund letters, conferences and more This comes up in regard...
Should policymakers prop up the stock market when it appears to be in danger of crashing down?
This comes up in regard to the Federal Reserve all the time. Even Buy-and-Holders get anxious about the stock market when prices reach insanely high levels. But a lowering of interest rates can cause people who don’t want to remain in the stock market to remain in the stock market on grounds that the low returns available on safe asset classes are flat-out unacceptable. Price crashes do lots of economic damage. So an argument can be made that, when members of the Federal Reserve see evidence that stock prices are about to crash, they should do something to prevent that from happening.
Other policymakers face similar pressures. President Biden has a number of reasons for wanting to keep inflation in check. So he could promote anti-inflation measures without even taking into consideration their effect on stock prices. But it is unlikely that that effect would not at least be mentioned when Biden’s advisers were meeting to determine which measures to advance. Stock price crashes are widely viewed as a negative. So a policy that keeps stock prices up while also combating inflation is generally perceived as better than a policy that only combats inflation.
Policymakers Should Not Prop Up The Stock Market
I generally do not go along with this widespread view. The market should be permitted to price stocks properly, which it cannot do if policymakers knowingly promote policies that they believe will keep stock prices up. So, no, policymakers should not prop up the stock market. If anything, at a time when prices are above fair-value levels, policymakers should promote policies that will bring stock prices down to levels closer to their fair value. I can not recall ever hearing a policy advocated on grounds that it will bring stock prices down. I think that’s unfortunate. We should all want stocks to be priced properly. When prices are too high, we should all at least generally favor policies aimed at bringing them down.
It’s not quite that simple.
Today’s CAPE level is 39. The fair-value CAPE level is 17. A government policy that caused stock prices to fall to fair-value levels would wipe out more than half of the value of the stock market. That would cause a dramatic contraction of our economic system. Hundreds of thousands of businesses would go under. Millions of workers would be thrown out of work. Political frictions would be exacerbated. I would love to see a CAPE value of 17. But not that way. If a genie gave me one wish, I would not wish for stock valuations to drop to fair-value levels.
At least not in a rush.
I would indeed like to see stocks priced properly. There are all sorts of benefits that would flow from that. But how we get there matters. If someone learns when she is going 70 miles per hour on the highway that her brakes have failed, she desperately wants the car to stop so that she can get out of it. But there’s a big difference between stopping the car by crashing into something and letting it slow gradually to a stop by not applying any more pressure to the accelerator.
We need to bring stock prices down gradually, not all at once.
Interest Rates And Stock Prices
The only way that I can see to do that is through educational efforts. I was dismayed a few months ago to see an article written by Robert Shiller that argued that, given today’s low interest rates, today’s stock prices are not quite as absurd as they might appear to be when only the CAPE value is considered. The claim is accurate. Low interest rates pressure people not to sell their stocks. So there is a correlation between low interest rates and high stock prices. But a lowering of interest rates is a desperate way to keep stock prices up. I view the lowering of interest rates as a long-term negative for the stock market because there will be a time when prices will fall anyway and a lowering of interest rates will not then be available as an option for stabilizing the market.
I believe that the high stock prices that applied at the last time interest rates were lowered should have been taken into consideration as a reason not to lower them. Had interest rates not been lowered, we might well have seen a significant drop in stock prices by now. That would have diminished the odds that we will see a more dramatic price drop at some future date. Which would be good news all around.
Perhaps the members of the Fed did indeed take that possibility into consideration when they discussed whether to take actions to lower interest rates. But, if they did, it was not widely perceived that that is what they were doing. For such actions to have their desired effect, investors need to know both that such actions are being taken and why they are being taken. It is sound public policy to keep stock prices from getting out of hand\. But most investors do not see things that way today. High stock prices are viewed as good and low stock prices are viewed as bad.
It’s big price drops that are bad. Big price drops are caused by high stock prices. So we all should view high stock prices as bad. Policymakers feel a lot of pressure not to let today’s high stock prices collapse. Their job is to walk a narrow line. They should do everything they can to prevent a devastating crash. The most important thing they can do to achieve that goal is to encourage a gradual drop in prices that takes us to a place where stock prices are at least no longer entirely insane.
Rob’s bio is here.