Inflation occuring in financial asset prices

By DAVID MOON, Moon Capital Management, LLC
November 22, 2009


The most recent U.S. unemployment report indicated that the jobless rate increased almost a full percentage point in the past three months, to 10.2 percent in October. During that same period, however, the Dow Jones Industrial Average increased another 541 points.

Is this just an example of the Wall Street fat cats getting richer while the working class suffers?

No. It is symptomatic of inflation in financial asset prices, not consumer goods.

The official measurement of inflation is the Consumer Price Index (CPI.) This measures the price change of a basket of goods and services that some statistician thinks is representative of typical U.S. household expenditures. The CPI increased only 0.3 percent in October according to the most recent report this week. It has actually declined over the past 12 months.

After the huge increases in stock prices over the past year, the S&P 500 now trades at a P/E ratio of 17. The long-term average market P/E ratio is only 15. In less than a year, stock prices have increased so much that extraordinary economic and earnings growth are required to support these prices.

Few investors expect that to happen.

The rapid stock price increase is, in large degree, a function of an increase in the supply of money.

One gauge of the money supply is an esoteric measurement called the monetary aggregate. The monetary aggregate doubled in the 11 years from 1984 to 1995. It doubled again in the 12 years from 1995 to 2007.

It then doubled again in the 12 months from January 2008 to January 2009. That’s months, not years.

Very little of this money is finding its way into the core economy. In the past six months, loans at commercial banks have fallen six percent. Banks are hoarding capital. Banks typically hold more reserves than regulators require. For years, the combined excess reserves of the entire U.S. banking system never exceeded $50 billion. Excess reserves currently approach $1 trillion, up from $40 billion a year ago.

The Federal Reserve has a couple of primary ways to impact the economy. It can set certain interest rates, and it can go into the open market and purchase securities. With short-term rates close to zero, there is little room for further decline. That leaves securities purchases as its remaining tool.

In September, the Fed announced that it would begin purchasing $1.25 trillion in mortgage backed securities. These purchases have provided liquidity to the bond market and increased the demand for these securities, resulting in an artificial and (in my opinion) temporary increase in their prices.

As mortgage securities have become more expensive and their yields lower, where has much of the increased supply of investment capital flowed? To the stock market.

The Fed’s mortgage purchase program is set to expire in the first quarter of 2010.

That’s when we may find out the true value of many stock and bond investments.


David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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