Last week, I discussed the potential for the U.S. government to become insolvent. Unpleasant issues to be sure, but nonetheless important for gaining perspective.
But what if the post-2008 stimulus measures succeed in getting the economy to avoid another recession and stimulate real growth in the private sector?
Further, let's assume that private-sector growth becomes evident in economic reports, along with indications in stabilization in home values over the next year or so, to a degree that the equity markets respond positively, and the S&P 500 achieves nominal record highs. This is completely possible as well. The S&P 500 has gained about 29% in the past six months, and just another 6% from current levels would put it above the early-2000 record levels.
This performance has also been supported by a complete and stellar rebound in corporate earnings from the post-2008 crash, sending the price-to-earnings ratio to about 26 currently.
If all that occurs, the monetary and fiscal authorities will have to begin to focus on removing the monetary stimulus and reducing sovereign debt levels as a percentage of GDP and tax receipts.
The first sobering issue investors need to be aware of is that although new index highs may very well set the stage for even higher levels shortly thereafter, at no time in the history of publicly traded equities in the U.S., going back to 1870, have the indices achieved positive returns on three-, five-, 10- or 20-year rolling basis.
Further, excluding the January 2000 record-high P/E level of about 44, the current and near future trajectory level of about 27 is the point at which the market has begun secular bear markets and from which the largest crashes in history have occurred.
I will discuss this further in the comments section for those wanting more information.
Turning to public-sector financial policy, the Federal Reserve, if economic activity begins to increase, would have to focus on how to shrink its balance sheet from the current roughly $3 trillion level it has grown to over the past five years, from the $850 billion level prior to the beginning of subprime defaults in early 2007.
Because the sovereign debt level has also become elevated above what is healthy for the economy, monetary policy will almost certainly have to be coordinated with fiscal policy, with the goal of both growing the U.S. economy out of debt and inflating the debt away.
This process would require nominal inflation to be managed in the 7%-10% range for at least a decade. Such a process would require long-term Treasury yields of 10%-12% for the 10-30 year maturities and price inflation of 5%-9% in the overall economy.
The problem with such a scenario is that it mandates levels of real inflation that would be higher than income growth. In that situation, the cost of living rises faster than incomes, and the vast majority of the population actually falls further behind.
More insidious would be the social costs. Inflation works to the benefit of asset owners and to the detriment of non-asset owners. This would be exhibited most obviously by housing appreciating again at rates faster than the incomes necessary to service a mortgage.
The end result would be an economy that is divided for perhaps a generation between a small percentage of the population, the haves, and the vast majority of the population, the have-nots.
There is much more to consider, but this represents the foundation of the risks being faced by the economy, policy makers, investors, consumers, and citizens if the current stimulus measures succeed.
I don't intend for this to be doomsday scenario. I'm only reminding investors who are currently focused on immediate growth prospects to be aware of the historical ramifications for capital markets and the economy and to be cognizant of them when making investment decisions now.