Equity Market Valuation

When the govt runs a deficit to inject wealth into the private sector, the wealth is spent boosting corporate profits and influences inflation. The fallout from the preference to spend was explored in the profits and inflation section. The preference to withhold the wealth (ie save it by storing it on your balance sheet) the more it will affect the valuation of existing assets esp equities. This section will explore possible upside-down outcomes from stimulative fiscal policy on market valuation:

1. Understand the marginal saver

Marginal spenders will cash a govt check, buy stuff, and kick off the multiplication process that gets filtered thru the income distribution.

In contrast the marginal saver will deploy that check into investments. Recall that capital "S" "saving" is considered withholding if it goes into secondary markets, and investment if it forms new capital.

2. How do market injections influence valuations?

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Start with 2 assumptions:

The supply of capital grows more slowly than the increase in aggregate savings

The marginal saved dollar esp in a mature economy, is flowing into secondary markets, not being used to form new capital in primary markets (the reason for this is intuitive...newer investments have more frictions — you need to locate them, be ok with the risk, and take the time to implement them. It's much easier to buy SPY than make an angel investment, build a house from scratch or start a business.)

The idea of preferred average allocation

As wealth ends up on household balance sheets in the form of cash or savings deposits it alters the household's portfolio allocations. If we assume that households maintain a preferred average portfolio allocation, it needs to deploy some of this cash into equities. I find the assumption that households prefer a relatively constant allocation to assets irrespective of risk/reward unintuitive. For example, if stocks offered no equity risk premia over the risk free rate my preferred allocation would be close to zero. But Jesse points out a puzzle that can lend credence to this "preference for an average allocation" idea. Consider this:

American households have a much stronger preference for holding equities than Japanese and European households (the paper shows charts of aggregate asset allocations over time). This fact is surprising because cash and bonds in Japan and Europe offer negative yields, a key difference in comparison with the United States, which respects the zero-lower bound. Despite the negative cash yields in Europe and Japan, investors in those countries have priced their equity markets to offer strong earnings yields, higher than in the United States, even after adjusting for sector differences. The inefficiency is puzzling on both ends. Why don't European and Japanese households take advantage of the enormous premium over cash and bonds that their equities appear to be offering? Why don't they bid up the prices of those equities, driving up the overall allocation to equity? The answer is a mystery; it likely has something to do with differences in the respective financial cultures and in the lived experiences of market participants of the different countries.

This means fiscal injections are market injections as the govt spending will quickly be used to bid for existing assets. To accommodate this inflow into a fixed pool of assets prices must rise which necessarily compresses returns.

(The paper goes into a technical discussion of the interaction of buy pressure in trading. Despite every transaction having a buyer and a seller, in the aggregate an inflow into a fixed asset supply must have a lasting upward price impact)

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Is it valid to assume that investors' allocation preference is independent of valuation?

TINA as evidence

It has indeed been difficult for valuation to gain traction as a consideration in the current environment. The relevant value proposition that investors have to consider is an awkward proposition that pits positive-but-historically-depressed earnings yields in equities against zero yields in everything else. Rising equity valuations cannot easily shift the balance of that proposition for at least two reasons. First, equities can produce attractive returns even when purchased at elevated valuations, provided that they stay at those valuations—and in the current case, they very well might. Second, the alternative proposition—earning a negative real return for an indefinite period of time while others continue to make money--is simply unacceptable to many investors.

By now savers are all familiar with the TINA dilemma. TINA. "There is no alternative"

As Jesse explains, this is a classic trap between a rock and a hard place:

TINA markets are guaranteed to be difficult and frustrating for large numbers of people. The problem of how to properly invest in them has no easy solution. Chasing ultra-expensive assets, nervously supervising them in the hopes that you haven't top-ticked them, is stressful and unpleasant. But so is waiting on the sidelines earning negative real returns while everyone else makes money. Time is not on your side in that effort.

The upside down outcome

The fiscal stimulus has once again created an upside-down outcome

If investors display zero sensitivity to valuation and invest entirely based on a pre-determined asset allocation preference...we've once again arrived at a classic upside-down outcome. An event occurs that damages the economy, forcing extreme issuance of zero-yield government debt, pushing down average equity allocations and up on equity prices and valuations, contrary to the assumed effect of the damage itself.