I am a marketing professional holding a postgraduate degree in management. I am an active retail investor in Indian stock markets.
Forest fires have been a major problem for mankind, as the forest fires could engulf entire villages or towns. Man had tried to control the forest fires for a long time but saw little luck till the end of the 19th century. But with mobility and machinery, he started getting better and devised novel ways to douse the forest fires.
Men try to control the fire locally using sand and water. It works when it is not a raging fire. For raging fires spread over large areas, they try to pump water from nearby lakes to douse the fire. They even create a ring of fire by burning all the organic matter within the ring. When the fire reaches the ring, it can not spread further as the ring act as a defense for the rest of the forest. This technique is rightly called fighting fire with fire.
In forests where there would be one wild fire every five years, they could prevent forest fires for up to 20 years. The organic matter on the forest floor was increasing since forest fires were not happening. When the forest fire struck finally after 20 years, it was devastating as there was a large quantity of organic matter to be burned. Now, people view forest fires as the natural way of clearing the organic waste accumulated on the forest floor. Any attempts to stop it would be futile, though it can be managed so as not to affect human settlements.
Forest Fires and Stock Markets
Why am I talking about forest fires in an article on stock markets? Let me establish the connection. Stock markets have a healthy growth in the long run but they have occasional corrections or crashes from time to time. These corrections are healthy and should be allowed to happen much the same way forest fires should be allowed to happen.
When central banks interfere too much with their easy money policies, corrections in stock markets can be delayed. In fact, corrections can be replaced by a long bull market as we are seeing now. The stock markets can go up even in the middle of a global pandemic that resulted in unemployment issues, bankruptcy of companies, huge levels of debt and a shrinking global GDP. We need not mention the sufferings of millions of people infected with the virus and those who have lost their lives.
Stock Market Bubble
At the time I started writing this article, most of the stock markets in the world were trading near their all-time-high levels. The valuations were expensive whichever way we looked. There were strong signs like PE ratio, price to book ratio and Buffet indicator pointing to an imminent stock market crash or correction.
At the other end, central banks around the world are pumping liquidity into the system in a never-before fashion. The liquidity push is fuelling the bubble that we see in stock markets, bitcoins, real estate and other asset classes.
In this article, we will discuss the following questions.
1) Will liquidity help an ailing economy?
2) Can the stock prices keep going up forever?
3) Will the crash be different this time?
1. Will Liquidity Help an Ailing Economy?
Covid-19 has impacted our lives adversely. There is a noticeable impact on livelihoods as the pandemic has impacted mobility. socializing, supply chains, small businesses and jobs. It will be wonderful if the central bank's actions could reduce the adverse impacts of Covid-19.
At the ground level, we see people losing jobs and small businesses shutting down. So what does the liquidity end up doing? It only goes after the asset classes like stocks, bitcoins, real estate and commodities. So, we see the prices ballooning across all asset categories. Central banks are trying to delay the forest fire (read stock market crash), but eventually the forest fire will strike later with a lethal force proportional to the delay caused by easy money policy.
One may think keeping the stock markets on a stable growth path is desirable. Excess liquidity would cause rising bond yields and rising inflation. This would again hurt the poor and the marginalized sections of the society. If the central banks are happy increasing the gap between the rich and the poor, then they can continue with the easy money policy.
If the governments focus more on putting money in the needy people's pockets than shoring up stock valuations, it will help the economy in the long run. Unfortunately, now the liquidity is only flooding the stock markets and other asset classes. It is not helping the economy.
2. Can Stock Prices Keep Going up Forever?
Let us assume the central banks around the world do not pause their easy money policy. The stock market would continue to thrive for some more time before bond yields and inflation put a brake. So the stock prices cannot go up like this forever. It needs a healthy correction now.
From a valuation perspective, most markets are valued more than double its intrinsic value. This means there is a potential crash of 50% or more for stock markets. This is a scary scenario and it could affect different asset classes differently. Asset classes not backed by solid fundamentals like bitcoins would suffer the most when such a crash occurs.
Valuations apply to stocks as well. At a tiny fraction of the sales of car companies like Toyota, Ford or Volkswagen, Tesla commands a premium hitherto unseen in automobile sector. Can Tesla stay at that level forever? One needs to look at fundamentals and not be driven by mob behavior. That could hurt more during a downturn.
3. Will The Crash be Different This Time?
The central banks around the world love controlling the markets. When they decide they can no longer maintain the over-inflated market bubble, they would start tightening liquidity. This would lead to sharp fall in stock prices. The central banks may interfere when the market corrects around 20% and allow the market to stabilize at that level by pumping liquidity again.
After a while, they may allow the market to drop in stages of 20% till it reaches 50% of its peak value. Since the central banks are so used to controlling the market, they may try to moderate the crash. So, the crash could be in stages and not as drastic as before. The crash could last over a two-year period. When will the crash start? I really do not know. It may be tomorrow or 6 months later.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
Mohan Babu (author) from Chennai, India on May 19, 2021:
Thank you, Doug West. Central banks should allow markets to operate based on fundamentals and not based on liquidity.
Doug West from Missouri on May 19, 2021:
Good article. That is an interesting analogy between a forest fire and a stock market sell off. Looks like the US markets are going through a bit of a sell off right now.