Wednesday, March 15, 2017

A reason for caution

I'm cautious about the stock market because credit growth has stalled. Since December, total bank credit in the United States has fallen slightly:

This is important because, in my opinion, credit is the single biggest influence on both economic activity and asset prices. Credit is like a dog, and residual securities like stocks are the tail that it wags. Right now the dog looks mangy.

On Twitter, Harvest Investor argues that falling credit growth historically hasn't predicted stock-market declines. He makes a good point, but I see several differences between today and previous periods of credit scarcity:

• Historically, credit growth stalled toward the end of recessions or after recessions. Periods of flat bank credit include 1975, 1980, 1982, and 1991-93, 2001-02, and 2009-10--all recessionary or post-recessionary years. In each instance, by the time credit had stalled, the stock market had already experienced a correction. Investors had already "digested" the prospect of falling liquidity. Today, by contrast, the market is near an all-time high.

• The Federal Reserve responded to these previous slowdowns with monetary easing. Now the Fed is shrinking the monetary base, which has fallen ~10% since 2015.

• Fueling the stock market's rally is a belief that Trump's economic policies will usher in a new era of growth. I think this optimism is premature and that Trump will struggle to implement many of his policies. In any case, flat-lining credit--along with the lower economic growth that's likely to accompany it--goes against the growth narrative that has lifted stock prices.