So I just had a "eureka" moment about why crypto is where it is and it's all related to monetary policy and inflation. This may be obvious to some of you but to others this may be a completely new idea. I'm going to start with a background/premise section where I lay out some foundational issues before I get into the thesis. Hope you enjoy.
Premise/background
This section should be relatively uncontroversial as most of what I say in here has been well established by prominent economic/finance figures and is pretty regularly talked about (again this will be new to some and obvious to others). So, covid. The Covid crash happened in March 2020, the FED instituted unprecedented monetary stimulus and the market formed a V shaped recovery and regained pre-pandemic levels around August 2020. Now, many investors/pundits are saying that the market is wildly overvalued and is a bubble similar or (if you're Charlie Munger) worse than 2000. Whether it is a bubble is debatable (I don't believe it is for the proceeding reasons) but it's pretty obvious that when analyzing it through traditional valuation methods, the market is indeed overvalued or on the cusp of being overvalued (Shiller PE, GDP/SPY, etc.). I'm not here to discuss if it's a bubble or not (but feel free to do so in the comments), I am here to discuss why stocks are at these valuations.
Stocks are at the current valuations because of the FED's monetary policies. In 2020, the FED instituted unprecedented stimulus through quantitative easing and lowering the federal funds rate (interest rates). We all know what lower interest rates mean - market go boom. Quantitative Easing (QE) is where the FED buys billions (I think it's 200B rn) in corporate and treasury bonds. What is the effect? The FED pushes up the bond market. The result of this is that the face value of the bond rises. What happens when the face value rises? The yield declines. Currently, US treasury yields are near all time lows with most yielding well below 2%. This information is well established. Additionally, inflation seems to be rampant. With the government's fiscal stimulus and increased demand, we are seeing inflation rise pretty rapidly. Additionally, the ultra-low interest rate environment makes borrowing easier, spending increase, and the velocity of money increase. I'm not here to discuss if inflation is transitory, I'm just stating the obvious that at this very moment and for the past year or so, inflation, beyond the normal level of 2%, has been pretty apparent. So, monetary policy (and to a lesser extent fiscal policy) has created: low bond yields, high inflation, and easy low-cost borrowing. What does this mean for stocks?
The reason why stocks are so high right now and the reason why it's blatantly obvious that stocks are overvalued or on the cusp of being overvalued but only seem to fall due to Covid concerns, not overvaluation concerns is because of the previously explained monetary policies. So why are stocks so high? It's because when bond yields are ultra low and will continue to be ultra low because of the FED's continued purchasing of them, they produce net negative returns when adjusted for inflation. Since inflation is particularly high, this effect is exacerbated. For example, let's say a bond yields 1.5% annually and let's say inflation is projected to be 4% for the next year (these are arbitrary numbers). Holding the bond will provide you a return of 1.5% over that year, HOWEVER, this is a losing proposition because inflation reduces the value of your money by 4%, so although you are positive, nominally, on your bond return, when you adjust for inflation, your net return is negative. Ray Dalio has talked about this extensively. So why does this make stocks go higher?
Investors want to be positive on the year in terms of nominal returns and also want to be net positive when adjusted for inflation (if you can produce a 10% return per year that's impressive, but if inflation is at 50% (impossible but an arbitrary number used as an example) your 10% return means nothing). So, since investors can't go to the bond market to outpace inflation, where do they put their money? Equities. Most estimates put inflation at 6% on the high end (as of now). Well, equities are known to return anywhere from 5% - 10% per year but even higher post-bear market. So, if you want to produce a return that will beat inflation, you have to go risk-on and dump it into equities, which is why investors are still putting money into a stock market that many say is overvalued (this is why I don't think it's a bubble in the sense that it's irrational greed like 2000, instead it's the result of monetary policies. You could say that's a bubble too but I digress).
This explains why equities are where they are now and it's exactly as the FED planned. The FED essentially made the fixed-income market undesirable so that investors would pour money into the stock market. Why? JPOW has continuously stated that his goal is for the market to reach full employment. When a company's stock is higher, it is flush with cash, and demand is high, it hires more people thus completing the FED's goal. Again all of this has been well established by prominent financial figures and should be nothing new to some of you.
To further explain the above point, you've probably noticed that tech stocks have outperformed the broader market. Why? Monetary policy. Most tech stocks are growth stocks - stocks where investors base the value on the stock's predicted cash flows (i.e. investors pay now assuming that the stock will reach a higher value in the future). How do investors predict future value? Discounted cash flow method. The DCF method requires a discount rate (a "risk free rate"). US treasuries are the go to risk free rate because they are essentially a risk free way to make money (the odds of the US defaulting on its debt are ultra low even with the current debt ceiling problems). Well, the current risk free rate of US treasuries is ultra low because of the FED, so investors only have to discount tech stocks at ultra low rates, which is why they are so high right now - this again explains why there are some days where the dow is up by nasdaq is down - these are usually days where yields rise.
How Crypto Plays Into This
What I've just explained in short is: monetary policy has made this a reality in terms of return: Tech (super high return) > broad market (high return) > corporate bonds (low return or negative return) > treasuries (low or negative return). Now what about crypto? Well, this is where I had my eureka moment. The reason for crypto's valuations and continued overperformance despite most thinking it's at the very least overvalued, is for the exact same reason as stocks: with inflation high and the bond market producing net negative returns, investors turn to riskier assets in order to produce a net positive return adjusted for inflation. Thus, this is the hierarchy when you include crypto: Crypto > tech stocks > broader market > corporate bonds > treasuries.
Further proof of this is evident in how the crypto market has behaved in relation to the stock market. When did crypto start getting hot? Around August 2020, which is the exact same time that the market was near pre-pandemic levels, investors were certain that monetary stimulus would continue for the near future (as evident by JPOW's constant reassurances), and when investors started to notice/predict that inflation would become a problem. Also notice that the only thing that pushes the stock market down significantly is Covid concerns and monetary policy concerns. We saw a pretty strong sell off last week because of Omicron and because JPOW stated that he wants to tighten faster than expected. Well, you'll notice that investors went to bonds, went out of stocks (which is why they dropped), went out of tech stocks even more (which is why they dropped more than the broader market), and absolutely dumped crypto (which is why it fell the most). In this way, it is apparent that the above hierarchy means that the market is extremely risk-on because of monetary policy. So, when monetary policy threatens this, assets fall in proportion to their risk.
So where does that leave us in the future? Well, based on this, crypto (and stocks but to a lesser magnitude) will fall when monetary policy tightens. It won't fall all at once but will fall in proportion to the tightening. HOWEVER, crypto (and again stocks but to a lesser magnitude) will rise as inflation increases. Thus, we are in an environment where high-risk assets are paramount (high inflation, loose monetary policy). High risk assets will decrease but not crash if: monetary policy tightens but inflation rises OR if monetary policy stays the same but inflation decreases. High risk assets will crash proportionately to their risk (again not all at once but in proportion to the time period this plays out) if BOTH monetary policy tightens AND inflation lowers. The only other factor affecting this relationship is a market panic due to: Covid concerns or some systemic market malfunction (like 2008) both of which seem very unlikely ATM. Thus, though it seems like monetary policy will be tightening in the future, high-risk assets like crypto and equities are still primed to remain high (but not necessarily as high as they are now) due to inflation. My opinion is that the market and crypto are not a bubble in the sense that it is due to greed and irrational exuberance. Instead, it is due to monetary policy, which you could say is a bubble. However, I would disagree that it's a bubble because a bubble implies a quick "pop" and crash, which is unlikely because monetary policy tightens gradually rather than all at once. Please do not misinterpret this as me saying go all in on tech stocks and crypto - that's idiotic it should be obvious that that's not a good idea from the above information (I also don't own any crypto and haven't traded it in months). The point of this post was basically just to explain why all of this bubble talk is pretty inaccurate. I could get into things that I have talked about in the past such as the 17.5 year bull market / ranging market cycle or the 4 year correction cycle as further reasons why we aren't in a bubble but I'm not gonna. The point is that the current valuations of risky assets are completely understandable and are according to the FED's plan (the FED didn't want crypto specifically to rise, it was just an unintentional product of their policies), and that this current environment is not a bubble because a bubble implies a quick "pop" and crash, which is unlikely since the current environment is propped up on monetary policy, which by design reverses gradually over time. Thanks for reading my absolute Iliad of a rant.
Submitted December 05, 2021 at 11:36AM by josh34521 https://ift.tt/3rDjJdl
