How To Understand The Impact Of Fiscal Policy Regime Change

Steven L. Miller
24 min readJan 27, 2021
source: Upside Down Markets

22 Lessons Learned Upside Down Markets: Profits, Inflation and Equity Valuation in Fiscal Policy Regimes

As another round of fiscal stimulus makes its way through Congress. Jesse Livermore’s research on Fiscal Policy Regime Change may be more timely now than when it was first published by OSAM back in September.

In Upside-Down Markets: Profits, Inflation and Equity Valuation in Fiscal
Policy Regimes
. Livermore outlines why the stimulus spending triggered by the pandemic may not lead to the inflationary outcome many are expecting.

While I can’t say I feel as relaxed as the author regarding the huge volume of stimulus deployed to fight the pandemic’s consequences. His voice is an important counterpoint with many valuable lessons on why investments in inflation hedges. May not end up the slam dunk investments many expect them to be.

Original notes these lessons are from.

1. Corporate Investment isn’t Lower. Intangible Investments are Replacing Tangible Ones.

The declining trend in corporate investment is sometimes cited as evidence of poor corporate citizenship.

In defense of the corporate sector, we should note that a substantial portion of the decline, if not all of it, is the result of accounting conventions.

Unlike GAAP, NIPA treats research and development expenses as investments, capitalizing them as intellectual property and depreciating them over an assigned useful life.

The average useful life that it assigns to them (4–5 years) tends to be much shorter than the average useful lives that it assigns to traditional investments in equipment (7–8 years) and structures (25–30 years)…

The chart below shows the average percentages of the net stock of different types of corporate fixed assets that were expensed via depreciation in NIPA each year from 1925 through 2018. As you can see, the percentage of intellectual property investments expensed via depreciation each year has grown over time, indicating a shrinking assigned useful life.

Source NIPA

In recent decades, as corporate investment has shifted towards intellectual property and away from equipment and structures, the result has been an effective increase in the depreciation expense assigned to the same level of gross investment, causing an apparent decline in investment net of depreciation…

actual gross corporate investment as a percentage of gross corporate output (value added) has not actually declined…

Source NIPA

Lesson Learned

Understanding accounting conventions is critical for conducting financial analysis on factors subject to large variances based on the standards applied.

2. Covid-19 Did not Impair Capital it Lowered Utilization

When looking out over the long-term, the important point to remember is that the virus doesn’t damage actual physical or intellectual capital — the assets that make corporations valuable. It simply prevents the public from making full use of those assets, despite otherwise wanting to. The lack of utilization is obviously a problem for corporations in that it deprives them of cash flow and exposes them to the risk of bankruptcy. But If the government, through its stimulus and liquidity provisions, can successfully bridge the system through the period of reduced utilization associated with the pandemic, then everything can eventually go back to the way it was, with the only cost being a temporary period of reduced income

even if the pandemic imposes a year or two of profit weakness on the corporate sector, that weakness can get recouped in the strength that follows, assuming that the actual problem — the virus — gets solved.

Lesson Learned

When the impact of Covid-19 dissipates businesses should be well positioned to rebound given limited permanent capital impairment. With the large caveat their cash flows are not so severely impaired by underutilization they are able to survive until the rebound occurs.

3 Causes of Growth Declines

In order to grow, economies need certain monetary and fiscal conditions to be met — e.g., available credit at economically-viable rates, a government deficit sufficient to quench private sector withholding demand, and so on. When these conditions are challenged through policy actions, growth can fall or shift into contraction. Outside of policy, we can identify at least three additional causes of growth declines: Supply Shocks, Supply-Demand Mismatches, and Financial Wealth Contraction. We discuss each cause below:

(1) Supply Shocks: Events can occur that reduce the economy’s capacity to produce goods and services that consumers want to consume. The production of those goods and services is the basis for income and spending, and therefore reductions in that capacity can lead to declines in both

(2) Supply-Demand Mismatches: Parts of the supply-side of the economy can become misaligned with the demand-side, structuring themselves to produce goods and services that are not sufficiently wanted. Alternatively, events can occur that cause the consumption preferences of the demand-side of the economy to change more rapidly than parts of the supply-side can keep up with. In both cases, income and spending growth will slow.

COVID-19 is an example of the latter case. Consumers like to eat at restaurants, go on vacations, attend live events, and so on, and the supply-side of the economy has correctly responded to those preferences by organizing itself to produce the desired supplies of those activities. Unfortunately, the ongoing presence of COVID-19 has dramatically reduced consumer demand to engage in the activities, with the result being a sharp drop in overall consumer spending. Incremental spending that would have gone into the activities has no reason to go elsewhere, so it has disappeared.

(3) Financial Wealth Contraction: The private sector has the ability to create financial wealth through credit expansion and through the pricing of assets. Sometimes, it uses these processes to create wealth that doesn’t deserve to be created — wealth that isn’t tied to the production of goods and services that people actually want. The destruction of this wealth, either naturally or in response to policy action, can force affected individuals to reduce their spending.

Lesson Learned

While economically traumatizing due to its swift onset and severe impact. Economic mechanisms exist to work through the Supply-Demand mismatches caused by COVID-19 over time.

4. Consequences of Intervention

When consumption spending declines, legislators and policymakers have the ability to intervene, delivering liquidity and financial wealth to the places where it’s needed. But intervening comes with costs, including:

(1) unfairness and moral hazard, which can occur when people are protected from market consequences that they should have to face

(2) prevention of necessary adjustments, which can occur when the injected liquidity and financial wealth remove the stress that would otherwise force the adjustments

(3) inflation, which can occur when the liquidity and financial wealth that are injected as a remedy lead to more spending than the economy can support.

The COVID-19 situation is unique in that none of the normal costs associated with intervention are present. With respect to unfairness and moral hazard, nobody did anything wrong, and therefore there’s no need to worry about the implications of providing assistance. With respect to adjustment, if the problem of the virus can eventually be resolved, then there’s no need for the supply-side of the economy to adjust — in fact, we don’t want it to adjust, we want it to maintain the ability to produce the things that it was producing before the virus emerged, because consumers will go back to wanting those things when the virus goes away. With respect to inflation, current rates of inflation are very low and are likely to go even lower in the absence of aggressive policy action.

With these costs eliminated from the equation, it’s no surprise that legislators and policymakers have responded to the pandemic by implementing the single largest stimulus intervention in history. If there were ever a worthy time to intervene, this is it.

Lesson Learned

While expensive in absolute terms. The cost of Government action in response to COVID-19 is potentially lower. Than costs from responding to man made crisis because the consequences are low.

5. Fiscal Income Targeting

We refer to a policy strategy that calibrates deficit spending to achieve a targeted income growth rate as fiscal income targeting. The strategy is not explicitly employed by any market-based economy at present, but it may be employed in the future as politicians become more comfortable with deficit spending. If you are a diversified equity investor, its implementation will significantly change the risk profile of your investments. The prospect of a broad decline in the incomes of the customers of your companies — a serious, unavoidable risk in the traditional laissez-faire framework — will disappear. Bad news won’t be as bad, because it won’t be able to propagate to aggregate household income. As long as the companies in your portfolio continue to produce goods and services that consumers are willing to spend money on, those companies will continue to receive the revenue that they need in order to remain profitable

Instead of targeting aggregate incomes, a more aggressive approach would be to target aggregate spending. In a spending targeting regime, legislators monitor the condition of the economy and inject whatever amount of wealth they need to inject in order to ensure that nominal spending grows at the desired nominal rate — say, 5% per year. If households undermine this effort by withholding the wealth, then legislators can respond by injecting wealth with an explicit “spend by” date. Instead of issuing checks, for example, they can issue gift cards that expire. If that solution proves insufficient to stimulate spending, then they can just do the spending themselves, sending purchase orders directly into the corporate sector. Again, fiscal policy is a cheat code — when it wants to, it will always win.

Lesson Learned

If a high savings rate counteracts the intended impact of fiscal stimulus. We may start to see stimulus gift cards instead of stimulus checks.

6. Types of Keynesian Inflation

(1) cost-push

(2) demand-pull

(3) structural

(4) hyper

Cost-Push Inflation is inflation brought about by increases in the cost of producing goods and services. An example would be a situation in which a critical commodity becomes more expensive to produce. The prices of goods and services that use the commodity will rise as the increased cost is passed through to consumers.

Demand-Pull Inflation is inflation brought about by excessive demand for goods and services. An example would be a situation in which an unproductive expansion of credit leads to a rapid rise in wealth and income that drives spending levels above the economy’s capacity to produce.

Structural Inflation is inflation brought about by the expectations and commitments of economic agents. It occurs most easily in economies that have already been experiencing inflation for other reasons. As participants become accustomed to the inflation, they will come to view it as “normal”, incorporating it into their economic behaviors. Sellers will become more likely to attempt periodic price increases and buyers will become more likely to accept those increases. Workers will become more likely to request periodic wage increases and employers will become more likely to grant those increases. When entering into contracts, participants will build their inflation expectations into the contracts, writing periodic price increases into the terms. These actions will produce a self-fulfilling form of inflation that continues independently of other causal sources.

Hyperinflation is inflation that results from the rejection of a currency as a store of value. It typically emerges out of a feedback loop between two mutually-reinforcing conditions: (a) Economic participants lose confidence in the future purchasing power of a currency and become unwilling to hold it, causing it to depreciate, and (b) The government issuing the currency has hard liabilities — e.g., inflation-linked debt, debt in a foreign currency, real resources that need to be purchased to fund vital causes, etc. — and is forced to issue ever-increasing amounts of the currency to fund those liabilities. The issuance deepens the loss of confidence and accelerates the depreciation, forcing additional issuance in a vicious cycle.

Lesson Learned

If the Covid-19 pandemic catalyzes inflation. It would most likely be of the cost-push variety from disruptions to global supply chains.

7. The Baumol Effect

all industries depend on a common input, labor. In real terms, that input tends to become more expensive over time as employees capture the economy’s overall productivity growth in their wages. For this reason, industries that aren’t able to appreciably increase their productivity tend to experience above-trend inflation. They rely on a labor supply whose cost is increasing faster than inflation, but they aren’t able to use that supply any more efficiently to generate output, so they have to pass the cost on to consumers, raising prices at a pace that exceeds inflation as well. This phenomenon is known as the Baumol effect. It helps explain why industries that are prone to low productivity growth, such as higher education, have experienced above-trend inflation.

Lesson Learned

It’s not just demand driving tuition costs above inflation. Structural supply issues mean tuition would be rising faster than the overall inflation rate even if demand wasn’t increasing.

8. Natural Scarcity Drives Rising Real Estate Prices

Interestingly, the two price indices tied to real estate — residential investment and corporate investment in structures — have experienced the highest inflation of all categories. Their relative inflation is attributable to similar Baumol-like cost-push factors. The natural scarcity of desirable land supply prevents real estate from experiencing the kind of productivity growth that other industries experience. Income drives the ability to purchase real estate, a purchase that every participant in the economy has to make, either directly through ownership or indirectly through renting. Since income grows faster than inflation over time, the cost of real estate tends to grow faster than inflation as well.

Lesson Learned

As long as income growth exceeds inflation. The price of real estate will rise faster than inflation because everyone needs a place to live.

9. The Invisible Fist Imposes Spending Discipline

Now, over the long-term, the financial wealth in an economy needs to grow at a similar pace to the real wealth in the economy. If the financial wealth is allowed to grow faster than the real wealth, spending power will grow faster than the capacity to fulfill spending. The eventual result will be a condition of excess spending — i.e., demand-pull inflation.

For this reason, there needs to be a constraint on the process of deficit spending, a source of pressure that forces it to be deployed in ways that increase the economy’s real wealth in proportion to the increases in financial wealth that are occurring. In a classical market-based economy, this constraint comes from the need to pay interest on liabilities and to eventually repay their principal in full. The constraint operates like an invisible hand — call it an “invisible fist” — that reins in and destroys financial wealth created through unproductive deficit spending, the liabilities of which cannot be properly financed or repaid….

In economic situations where there are many opportunities to add value to an economy through investment, and where those opportunities are crowding on each other, driving aggressive competition for a tight underlying resource pool, higher real interest rates will lead to better supply-side outcomes. They will strengthen the grip of the invisible fist, pushing out the less productive, less profitable opportunities that can’t afford the higher rates and making room for the more productive, more profitable opportunities that can afford them. Conversely, in economic situations where opportunities to add value to an economy through investment are limited, and where significant portions of the underlying resource pool are sitting idle, lower real interest rates will lead to better supply-side outcomes, since they will weaken the threat of the invisible fist and help draw out any value-additive investment opportunities that are there.

Lesson Learned

While the invisible hand ensures the goods and services an economy produces match human desires. The invisible fist ensures these desires are provided in proportion to the real wealth generated by the economy’s output.

10. Governments Are Not Constrained by the Invisible Fist

Because it can bypass the invisible fist, the government can set the total financial wealth of the private sector to be whatever value it wants, without worrying about how it’s going to finance the liabilities that it has to take on in the process. This capacity is what makes it uniquely capable of arresting and reversing demand driven downturns. If the private sector falls into a withholding trap, a situation in which everyone jeopardizes everyone else’s income stream by withholding income, the government can immediately end the problem by injecting whatever amount of wealth and income it needs to inject in order to quench the withholding demand and stimulate desired levels of spending. In taking this action, it won’t have to worry about financing the ensuing liabilities — in the worst case, it can finance them by simply printing up the necessary amount of money.

Lesson Learned

Government’s printing press are a powerful tool for stimulating demand during economic downturns.

11. Stock versus Flow

Spending is a flow phenomenon, whereas wealth is a stock phenomenon. The addition of stock (wealth) to the private sector via government deficits can lead to an increase in flow (spending), but it doesn’t have to lead to such an increase. If it does lead to such an increase, the spending will multiply by some factor, going from participant to participant as spending-turned-income-turned-spending, until it gets withheld. But if relevant participants in this chain are inclined to withhold the income rather than spend it, then the effective multiplier on the process can end up being small. The economy may have the spare capacity needed to fully accommodate the new spending, preventing an inflationary impact on prices.

Lesson Learned

Government money printing is not inflationary if consumers choose to save their share, stock, instead of spending it, flow. Explaining why the first Covid-19 related stimulus did not lead to rising inflation. Large portions of this injection were saved.

While it is presumed pent up demand will materialize once herd immunity is achieved. If spending does not materialize than the impact of the stimulus packages on inflation will be muted.

12. Interest Rates Are a Tool Governments Use to Manage the Level of Economic Activity in their Economies

Liquidity is a condition for transactions and for price support, it’s not their cause. Once a system is saturated with it, the impact of adding more of it rapidly drops off to zero

In using asset purchases to drive down the yields of long-term government bonds, and of all long-term bonds by substitution, central banks can reduce the incentive that investors have to commit to withholding wealth over the long-term, and also increase the incentive that borrowers have to commit to borrowing it over that term. This effect can stimulate consumption and investment spending from both sides, but it’s not any different in principle from the effects that central banks exert when they control interest rates at shorter maturities. When central banks lower the interest rate on cash, they reduce the incentive to withhold wealth over the short-term and increase the incentive to borrow and spend it over that term. Importantly, the purpose of adjusting interest rates in this way is not to “help” or “hinder” the government in its efforts to fund itself, but rather to manage the level of spending that the economy will experience given the amount of wealth and spending power contained inside it, so that inflation can be maintained on target.

Lesson Learned

Central Bankers' ability to drive activity by supplying additional liquidity to markets is minimal. At least in developed economies where interest rates are near or below 0.

13. Money Supply Increases From Asset Purchases Are Not Always Inflationary

In the aftermath of the pandemic, we’ve seen the broad money supply (M2) explode. Many investors have expressed shock at the increase, expecting it to yield inflation (source: FRED):

But the increase is primarily an artifact of the Fed’s asset purchases, which the Fed has been conducting at an extraordinarily rapid pace. When the Fed purchases treasury bonds, agency bonds and other fixed income assets from private investors through bank dealer intermediaries, it takes those assets, which don’t count as part of the broad money supply, and converts them into cash, which does count as part of the broad money supply. The broad money supply therefore increases. The increase isn’t inflationary, however, because it doesn’t entail an actual increase in the wealth and spending power of the private sector. All it represents is a change in in the current environment, the yields on safe fixed income assets are already very low and the cost of borrowing for prime borrowers is already very cheap. The effect of lowering those yields and costs further — say, from 1.5% on the 10-year treasury to 0.6%, or from 3.5% on the 30-year mortgage to 2.9%, is not likely to change behaviors in a significant way.

Lesson Learned

Money supply increases from asset purchases focused on transforming the duration of fixed income investments. I.e. buying longer term bonds and mortgages with shorter term cash.

Is unlikely to lead to inflation when the yield on the longer term instruments is low. Because the purchases do not trigger the behavioral changes needed to spark inflation.

14. Fiscal Policy Sparked the COVID-19 Stock Market Rally

with respect to the COVID-19 stock market rally, it’s not clear that the Fed’s purchases have been a significant contributor to the price increases that have occurred. Some of the rally is surely attributable to the Fed’s efforts to re-liquefy and backstop the corporate bond market, but the real driver of the rally has been the unexpectedly strong fiscal response, which has dramatically boosted corporate revenue, profit, and solvency relative to what they would have otherwise fallen to.

Lesson Learned

Handing Davey Day Trader and his follower's piles of cash with nothing else to do. Right after commission-free equity trading became widespread.

Has been the true driver of the stock market rally versus the Federal Reserve’s liquidity focused operations.

15. Estimating Fiscal Constraints

How much spending power can the government inject into the private sector before it pushes actual spending above the level that the economy’s productive capacity can support? More specifically, how much spending power can it inject before it creates conditions under which harmful policy responses, to include those highlighted below, become necessary to keep inflation on target?

Interest Rates: Large increases in real interest rates that strain indebted portions of the private sector, that disincentivize necessary productive investments, and that necessitate tax increases to fund elevated government interest burdens.

Taxes: Large increases in income taxes that discourage production and that shift valuable resources into useless tax avoidance. Large increases in wealth taxes that drive capital flight. Large increases in consumption taxes that further inflate final prices.

Controls: Price, wage, profit and credit controls that infringe on economic liberties and that suppress necessary supply-side responses.

The answers to these questions define the true fiscal limits that are in effect…

How much financial wealth can we inject into the economy before we provoke unacceptable outcomes? That amount is our true fiscal constraint.

We can separate available strategies for estimating the fiscal constraints that we face into three categories: (1) Blanket Dismissal, (2) Trial-and-Error, and (3) Analysis. In the numbered blocks below, I describe each strategy in turn.

(1) Blanket Dismissal: Instead of trying to estimate the likely inflationary impact of a proposed level of debt accumulation, some people will simply choose to trust in a continuation of the recent trend of low inflation.

(2) Trial-and-Error: A better approach to identifying the inflationary limits of fiscal policy would be to use an empirical process of trial-and-error. We add a given amount of debt, wait and see what happens with inflation, add more debt, wait and see what happens, and so on. When inflationary pressure starts to build, we slow down and possibly change directions, raising interest rates and taking wealth out of the system through tax increases and spending cuts, as necessary.

(3) Analysis: In an analytic approach, we use data and reasoning to estimate the inflationary limits of fiscal policy. The advantage of an analytic approach is that it gives us a sense of the likely effects of our actions before we’ve irreversibly committed to them. The disadvantage is that it’s easy to miss relevant details and arrive at incorrect conclusions. For this reason, we need to be conservative in our assumptions and inferences, seeking out margins of safety in the conclusions that we ultimately arrive at.

Lesson Learned

An essential aspect of the government deciding to bypass the iron fist is understanding how far it can be bypassed. Before harmful policy measures become necessary to contain the consequences of too much spending power being made available in the economy.

16. Money is not the Ultimate Source of Spending Power

we need to connect wealth to actual spending, particularly for the segments of the economy that are going to receive the wealth injections. We can do this by introducing the concept of wealth velocity, defined as spending per unit of wealth. If we multiply the amount of wealth injected into each segment by its wealth velocity, we will be able to estimate the increases in spending that each segment will experience. Summing up the projected spending increases of all of the segments, we can then estimate the potential inflationary impact…

The problem with money velocity as a concept is that money is not the ultimate source of spending power. The ultimate source of spending power — both the ability to spend directly and, sometimes more importantly, the ability to borrow to spend — is wealth. Wealth is frequently held in the form of money, but it’s also held in many other forms, the vast majority of which are readily convertible into money, given the liquidity provided by financial markets. Wealth velocity improves on money velocity by including these other forms in its denominator…

we’re going to specifically define wealth velocity as consumption spending per unit of wealth, which is the most important type of spending in a normal economy…

we end up estimating that consumption spending will increase by a certain percentage in response to a given wealth injection, we can reasonably infer that the injection will bring about increases in magnitude similar to other forms of spending…

Almost all wealth in the economy is directly or indirectly owned by households, so we can formally define wealth velocity as annual personal consumption expenditures (PCE) divided by household net worth…

The relationship between wealth and spending is far from perfect. Increases in wealth tend to lead to increases in spending, but they don’t necessarily lead to proportionate increases in spending, and they certainly don’t have to lead to such increases, or to any increases at all. When wealth levels increase in ways that do not lead to proportionate increases in spending — as has occurred in the equity and real estate valuation boom of the last three decades — the mathematical result ends up being a drop in wealth velocity.

Lesson Learned

Government wealth injections into the economy do not lead to inflation. If the injections predominantly flow to those more likely to save than spend.

Instead of leading to asset bubbles as the incremental savings from the wealth injections look for a home. Usually metaphorically, sometimes literally, as is the case in the post-Covid-19 world.

17. Pandemic Related Stimulus is Unlikely to Induce Inflation

in our efforts to forecast the amount of inflationary pressure that the U.S. economy will experience, there are a number of relevant disinflationary factors that we need to consider. These include: (1) Income Inequality, (2) Anchored Inflation Expectations, (3) Cost-Push Deflation, (4) High Private Sector Debt Levels and (5) Aging Demographics…

In considering the impacts of these disinflationary factors, my sense is that in the aftermath of the pandemic, the economy will be able to absorb the additional spending introduced by the wealth injection without experiencing significant inflationary pressure…

When a government runs a deficit, it adds financial wealth to the private sector. The greater the preference to spend this wealth — whether on consumption or on investment in the real economy — the more it will affect profits and inflation, which we examined in the first two sections. The greater the preference to withhold the wealth — store it on a balance sheet — the more it will affect the valuations of existing assets, particularly equities…

Lesson Learned

The pandemic induced stimulus is unlikely to lead to inflation in the US because of 5 structural disinflationary factors.

(1) Income Inequality

(2) Anchored Inflation Expectations

(3) Cost-Push Deflation

(4) High Private Sector Debt Levels

(5) Aging Demographics

18. Even If the Stimulus is Spent Initially

To summarize the point, fiscal injections are market injections. Over time, they send financial wealth “into” financial markets, where it can bid on assets. This point holds true even when the injections are spent, because spending tends to migrate into savings over time, particularly in economies such as our own that exhibit high levels of income inequality and that offer limited opportunities for profitable new investment…

an increase in the stock of an asset, i.e., its outstanding supply, will tend to translate into at least some increase in its attempted flow, because each unit of its supply will have some probability of attempting to flow in a given period. If that probability stays constant as the supply of the asset increases, then the amount of attempted flow emanating from the asset will increase as well…

The increase in attempted buying flow that emanates from the saver’s efforts will represent a temporary condition that ceases after the desired transaction is executed. But the ensuing price increase can still hold, for two reasons:

(1) Supply Will Change in the Rest of the System

(2) Prices are Sticky

For this reason, as the price of an equity security such as $AMZN rises or falls in response to attempted flow imbalances, there’s not going to be a point where an obvious arbitrage opportunity will emerge, or where the security will turn into an obvious buy or an obvious sell. The factors that eventually bring attempted flows in the security into balance are going to be much more crude and erratic, involving forces such as:

(1) Price Anchoring

(2) Expectations of Mean-Reversion

Lesson Learned

When the stock of existing assets is high versus new investment opportunities, the situation currently in the US. Flows from government wealth injections naturally bid up the price of existing assets.

A portion of the price increase from these flows is likely to stick even when the flows from governments are reduced or unwound.

19. Fiscal Spending Leads to Rising Prices for Equities

The traditional process of fiscal spending consists of two separate events: (1) Spending and (2) Sterilization.

(1) Spending: The government directly spends money into the system. All of the previously described impacts, where the income multiplies and eventually lands as cash in the hands of savers that send it into financial markets, happen from this event. Pending their allocation preferences, the event will push up on the prices of all asset classes, to include equities.

(2) Sterilization: To keep the money supply constant, the government sells a bond to investors, removing an amount of money from the system equal to the amount that the spending event introduced. This event is its own separate event, involving separate market participants. It affects the market by creating additional supply and selling flow in government bonds, directly pulling down on the price of that one asset class…

When the government engages in fiscal spending, the net effect of its action is to inject assets into investor portfolios — either government bonds or cash, depending on how the spending is financed. The injection will ultimately reduce investor allocations to all other asset classes, including equities. it’s going to put upward pressure on prices, as investors attempt to get their allocations back to where they had them before the injection.

The difference between an injection of cash and an injection of government bonds is unlikely to make much difference to this outcome since cash and government bonds are extremely similar as asset classes. They’ve been rendered especially similar in the current environment, where Fed signaling and quantitative easing — the reverse of the sterilization process described above — have pushed the yields on government bonds almost all the way down to zero, the same yield as cash. If the government wanted to, it could use quantitative easing to convert all of its bonds into cash. Outside of possible placebo effects, the difference would make little difference to equity prices since those bonds are already essentially functioning as cash in portfolios…

Over time, as the COVID-19 deficits collect in the hands of savers, they will end up functioning as direct injections of cash and treasury bonds into investor portfolios. These injections, which will represent insertions of new wealth rather than alterations in the composition of existing wealth, will raise allocations to cash and treasury bonds and reduce allocations to every other asset class — most notably, equities.

Do investors actually want to have their allocations to equities reduced in this way, replaced on a percentage basis with cash and bonds? Probably not, especially with the Fed having just lowered interest rates to zero. But they don’t have much choice in the matter; if they don’t want to accept the reduced allocations, then their only available option, outside of investing in new companies or in companies that are diluting, will be to push up on the prices and valuations of existing shares.

Lesson Learned

Quantitative Easing impacts equity prices due to the portfolio allocation effect. If capital market participants receiving the injections have a target allocation to equities. They are forced sellers of the cash/fixed income assets injected and forced buyers of equities to maintain their target allocation.

20. Valuation Doesn’t Matter

it’s 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.

Lesson Learned

In a world where bonds yield little and cash yields are often negative. Investors feel forced to invest in equities absent critical evaluation of the fundamentals in an attempt to at least earn something.

21. Until It Does

As equities become more expensive, they become more “needy”, more sensitive to declines in buyer enthusiasm. Their neediness and dependence on continued buyer enthusiasm increases their potential for inflicting losses.

Lesson Learned

Equity markets driven by the only game in town mentality are inherently fragile and prone to violent drawdowns when the party finally ends.

22. Valuations Will Remain Elevated as Long as Positive Psychology Remains Intact

Ultimately, the only way that a market can be stable is if everyone is more-or-less happy with what they are holding — willing to transact, but not feeling an urgent need to do so.

Lesson Learned

Wager against r/wallstreetbets in the face of additional stimulus at your peril.

Thank you for Reading

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