by Thorsten Polleit

The U.S. stock market index S&P 500 has reached a new record high at 7,330 points. The NASDAQ has done the same at 25,800 points. European and Japanese stock markets are also at all-time highs, and Chinese stock prices are not far from their previous record levels.

This may be a rather surprising outcome for many market observers — given the multitude of current stress factors and fears: just think of the war against Iran, the energy price shock, the Ukraine-Russia war, excessive government debt burdens, increasing political disagreement within the Western world, etc.

Are stock investors too optimistic in their (world) view? Or are the skeptics too pessimistic? To answer these questions — and above all to take an informed look into the future — let us first recall the most important factors that fundamentally drive stock markets:

• Rising corporate profits and rising dividends make stocks more valuable and drive their prices higher (especially when profits and dividends come in higher than previously expected).
• Falling interest rates increase the present value of expected corporate profits and dividends and also drive stock prices up; the opposite applies when rates rise.
• Decreasing risk aversion among investors reduces the discount rate, increases the present value of dividends, and raises stock prices.

In addition to these “normal” price-determining factors, there are also “special factors” that can influence stock prices:

• For example, a large-scale reallocation in which savers and investors now wish to hold less fiat money and more stocks can increase demand for equities and drive stock prices (and thus their valuations) higher.
• Rising stock prices can also result from exaggerations, i.e., “bubble formation,” because investors overestimate profit potential and future rate cuts and/or underestimate risks. Conversely, persistent undervaluation can also occur and persist in stock markets.

The expansion of the money supply and the interest rate cuts by central banks have played a particularly important role in stock market developments in recent years. A quick look back: Since the early 1980s, U.S. interest rates have been on a downward trend that continued almost uninterrupted until 2020. During this period, U.S. stock prices rose steeply (albeit with considerable ups and downs) — and much more strongly than the U.S. dollar money supply grew. One can interpret this as follows: Over the past roughly 40 years, falling interest rates have, among other factors, inflated stock prices. And the swelling of the money supply has not primarily driven consumer price inflation, but has instead — and to a considerable extent — also caused inflation in stock markets.

Falling interest rates were certainly a reason for many investors to put more of their money in company stocks. In addition, technological progress has made access to the financial markets easier and cheaper for many investors, which has also led to savings being channelled more strongly into stocks, driving their prices upward. Above all, these two developments made it possible for the growth in the money supply to discharge particularly effectively in the form of inflationary price increases in the stock and asset markets.

If a forward-looking investor agrees to this interpretation (at least directionally), two questions immediately arise:

Question #1: What will happen to the money supply? It is very likely that the money supply will continue to expand on both sides of the Atlantic. Either driven by private sector credit demand or, if that is not enough, by increasing monetization of government debt by central banks. The global inflation regime will be maintained — and the widely accepted economic and monetary policies point to it even being inflated more strongly than before.

Question #2: What will happen to interest rates? Interest rates remain under the control of central banks. If capital market rates rise too sharply, the central bank intervenes, buys bonds, pushes up bond prices, and thereby lowers bond yields. The more bonds the central bank buys, the more the money supply expands and the stronger the inflationary effect becomes. Overall, this leads to declining or even negative real (i.e., inflation-adjusted) interest rates: The decline in money’s purchasing power exceeds the nominal capital market interest rate. This, in turn, makes assets such as stocks increasingly attractive.

And an additional question arises in this context: What impact will tokenization have on stock prices? Tokenization means that traditional company shares are represented as tradable digital blockchain tokens. The tokens are 1:1 backed by real shares (held with a regulated custodian) or synthetically (with price tracking via data bridges/”oracles” and smart contracts without direct ownership). This enables fractional ownership, 24/7 trading, instant settlement, and programmable functions.

While tokenization does not change the fundamental value of companies, it reduces transaction costs and increases tradability (liquidity). In a chronically inflationary environment, this will very likely (significantly) increase capital inflows into stock markets and provide additional upward pressure on prices. What are the risk factors for stock markets?

Stock prices remain vulnerable to “negative shocks,” swings in investor sentiment (euphoria, panic), and over- and under-reactions. However, their long-term trend will continue to be determined by the systemic question: Free markets, free international capital flows, unimpeded division of labor, and free trade enable successful economic activity, lead to increased prosperity, and (also) to high and, over time, rising stock prices.

Poison for stock markets, on the other hand, includes things like capital controls, travel and transport restrictions, the rollback or dismantling of market economy structures, wars, and a worldwide, unchecked spread of (semi-)socialism.

What currently concerns investors most is probably the valuation issue, though. For instance, the price-earnings ratio of the S&P 500 stock market index, as calculated by the U.S. economist Robert Shiller, stands at around 36 — as high as it was during the New Economy boom in 2000/2001.

And as always in such situations: Some investors will currently classify the stock markets as overvalued and diagnose a “bubble”; others will agree but consider even higher prices and valuations possible. In short: The current valuation of the U.S. stock market can be interpreted very differently, and so recommendations may differ.

In this context, the investor should remember: An overvaluation can be reduced by stock price declines, or earnings increases, or a combination of both. And even if one diagnoses an exaggeration in stock valuations, that by no means says one should exit immediately. An overvaluation can last for a long time, and it can also normalize if corporate earnings rise more strongly than stock prices for a while. Nevertheless, one should never lose sight of the risk that stock markets could burst.

How should the conservative investor proceed? One piece of advice is: The risk-conscious investor should hold a relatively high liquidity position — around 40 per cent of the portfolio — preferably in gold and silver. With precious metals, the investor should be able to escape the loss of purchasing power of official currencies in the coming years. The high liquidity of gold and silver should also enable him to take advantage of opportunities that arise in certain market situations — for example, selling expensive gold and silver during market panics and using the proceeds to buy cheap stocks.

Furthermore, the prudent investor should bear in mind: The loss of purchasing power of the U.S. dollar, euro, etc., will very likely continue, and the nominal yields on government and bank bonds will not be sufficient to compensate the investor for the erosion of money’s purchasing power. Traditional savings vehicles such as bank deposits, money market funds, and government bonds therefore remain a losing proposition.

And last but not least: For long-term oriented investors, it continues to make sense to remain invested in the (U.S.) stock market. However, it makes sense to proceed selectively: ideally on individual stocks rather than the market as a whole; preferably on shares of companies with inflation-resistant business models and — very importantly — where it is ensured that the company stock is not overvalued, i.e., where the intrinsic, or fair, value of the share is significantly higher than its price.

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