The Pin for Stock Market Bubble
Roman Chuyan, CFA
Video credit: iStock by Getty
- Last week’s inflation numbers were staggeringly high, which now affects consumer confidence.
- High inflation will likely be followed by rising interest rates.
- I speculate once again why I think this will prove to be the proverbial pin to prick this bubble.
Volatility increased in early May, but the market remains near its all-time high with an extreme bubble-level valuation. As I’ve been writing in client commentaries, reason doesn’t apply here – instead, bubbles are sustained by crowd mentality. Still, all bubbles burst, and the bigger the bubble the more severe the crash. But when? Timing is difficult to determine in advance, but a crash needs a catalyst. In today’s update, I review the latest inflation numbers and speculate once again why I think it will prove to be the proverbial pin to prick this bubble.
Inflation numbers for April reported last week were staggeringly high in the context of the past 20 years. Consumer price index (CPI) inflation jumped to 4.2% (the yellow line on the chart below) – well above the 3.6% expected, and the highest rate in 12.5 years. Core CPI, which excludes food and energy, jumped to 3% – its highest in 24 years, since 1996. Producer price (PPI) inflation jumped to 6.2%. Keep in mind that the earlier consensus expectations already reflected the “base effect,” or the “transitory” nature of inflation that Fed officials have recently quoted. So, the jump in inflation was mostly permanent.
Rising inflation and market yields will be the pin that pricks this bubble, in my view. Market volatility already increased this week, and I think stock investors are rightfully concerned. Higher yields have historically had a negative effect on the stock market. Recall that stocks began to drop the moment the 10-year Treasury yield rose above 3.2% in October of 2018 (see chart below). The concern is that higher rates burden the financial system due to enormous debt. This time, the “too-high” yield level will likely be lower, because there’s even more debt and we’ve been conditioned by near-zero rates in 2020-21. My guess is as good as yours as to what that critical level is, but yields have already begun to rise, with the 10-year currently around 1.65%:
Let me step back and note an important relationship that predicates my argument – one between inflation (and inflation expectations) and yields (say, the 10-year Treasury yield). This relationship has held, albeit somewhat loosely, since Treasury yields were floated in the early 1960s. When inflation was rising, the yields were high and rising, and vice versa (see chart below). Most of the time (but not now), the yield exceeds inflation, to compensate investors.
It’s plausible that the Fed’s newly acquired (since 2008) bond-buying habit forces yields to stay well below inflation. However, this is a double-edged sword: the Fed buying bonds amounts to money-creation, which will likely drive inflation even higher. This possibility aside, we assume that yields will rise from here and follow inflation higher.
Source: Ycharts, shaded are recessions.
Inflation is already affecting consumers. The University of Michigan Consumer Sentiment unexpectedly dropped to 82.8 in May from 88.3, with rising inflation cited by consumers as one of the reasons:
Source: Ycharts, shaded are recessions.
I’ll briefly note the reasons for this jump in inflation, as I see them. Over $4 trillion of money-creation by the Fed and trillions in cash stimulus payments in 2020-21 set the stage. But inflation didn’t begin until the government’s policies contributed to reduced supply of goods (raw materials, computer chips, etc.) coupled with rising demand for them this year. The current administration’s restrict-and-regulate policies reduce production. The generous federal stimulus payments caused several million people to leave the labor force, which created labor shortages and again reduced production. On the demand side, the trillions in these payments kept demand high (think of the housing boom, for example). The result is self-reinforcing shortages and price increases.
These policies come at a bad time: production capacity in most commodities hasn’t increased in decades. So, after slowly falling for decades, raw material prices experienced a huge jump in the past 12 months. The CRB Commodity Index is up 70%, and the CRB Non-Energy index is up 50% since May 1, 2020 (the chart below covers five years). Lumber is the most extreme, with its price now 3-5 times the highest levels seen in 40 years of available history. Most other commodities – for example industrial metals (copper, iron) and foodstuffs (soybeans, wheat, pork) – rose sharply in the past year to 10-year or all-time highs.