It is all about liquidity

Author: Value Investor

Date of publication: 2020-10-12

Have you ever wondered what is happening with the market? Of course you did. The whole world is in the recession, people are barely working if at all, whole sectors of the economy are shut down, etc. But, despite all of this, the stock market is at record highs, as if the economy is booming as never before.

To me, there is only one plausible explanation for this disconnect. It can be summarized by one word: liquidity. All this stimulus packages pumped so much money into the economy, that it is almost inevitable that the stock market shot up. Looking at the sheer numbers of such “stimulus”, when people and businesses are actually being paid for not working, it is only surprising that the stock market is not even higher.

How long this party can continue? Well, the U.S, Treasury has theoretically unlimited capacity to “print” new money - it can flood us with it forever. But is it a good thing? It can be - for a while, but definitely not for ever. At the end of the day, somebody will have to foot the bill. The US has a great advantage of having the reserve currency of the world. So, as long as there is a global demand for US dollars, the US government can afford to be a bit (or a lot) slacky fiscally. But everything has its boundaries. So, there will be a point at which newly “minted” dollars will not find buyers. From that point on all “stimulus” of the US economy will have to be shouldered by the people of this great country. That will be the end of the party.

I am afraid, we are very close to that point or might even have already passed it. Just look at the US dollar weakening in the past weeks. It is not dramatic yet, but, definitely, a sign of worry.

I truly believe that nobody can predict the market - especially in the shorter-term horizon. But looking forward, I think that the stock market will go down in real terms, I.e. adjusted for inflation.

The reason that I mention inflation is that it is a real possibility in the current environment, and when the purchasing capacity of the currency diminishes, the prices of all assets (including equity) go up. The current bull market could be also considered as a byproduct of the inflation, which needs to be measured differently from the consumer price index. Stocks could also be conceded as a hedge against inflation: it is better to own something of real value than a depreciating “paper”.