Deflation is bad for stocks

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by moazzam0

To fill the hole in GDP and liquidity crunch caused by corona, the Fed and Treasury pumped in several trillion more than the estimated fall in GDP. Of these trillions, about 2.5 trillion at most was income given to businesses and individual by Treasury. This is more than 10% of annual GDP should more than fill the hole in GDP by most estimates. The rest was in the form of Fed printing and unforgivable loans. This was to offset the capital flight to safe havens like cash and treasuries and restore liquidity to bond markets. Inadvertently, a portion of this government provided income and Fed printing ended up in stocks. Consensus says that since the amount pumped in as income and loans is greater than the fall in GDP and capital flight to safe havens, the recession is cancelled or there’s a Fed put on stocks not specifically doomed or even helped by corona (FAANG, etc).

Note that while stocks have rallied, short term t-bill yields are still falling and long term treasury yields are flat after falling a lot, despite record borrowing by Treasury. Gold is flat since stocks bottomed on March 23rd. Fed futures are expecting negative interest rates. Investment grade bond yields are much lower. All of this means that smart investors expect deflation, not inflation, for several years. This is while the Fed funds rate is already at zero.

Deflation is bad for stocks, good for bonds. It doesn’t matter if you own the stock of a perfect monopoly with zero debt. If your money can earn a return as cold hard cash, why would you buy stock of a business that will have lower earnings due to deflation? Yes monopolies have pricing power, but this will diminish if there’s deflation and could cause a revenue/income drop. Also, deflation increases the real yield on treasuries/bonds, so stocks make less sense as an investment. So why are stocks not pricing in deflation when every other investment asset is?

Stock investors are stupider and more impulsive than bond investors. This has never been more true than in the current age of instant gratification (social media), investment gamification (investing apps), index investing (blind and constant buying), and an 11 year, 500% stock rally that gave investors confidence in stocks and a FOMO. The trillion dollar question is, how long can all this keep stocks diverging from reality? I think over the next month, as Fed printing slows, government income tapers, and people go back to work, we’ll see the top.

What do you think?



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