The first full week of 2025 is coming to an end. And the final days of President Biden’s time in office cannot come soon enough. After four years of mega deficits and mega meddling, the economy and stock market have been crudely distorted. They’re both bloated to the max.
President-elect Trump wants to keep both the stock market and economic levitation going. Asset prices and low unemployment provide a superficial appearance of good health. Trump’s a reality TV guy. He wants things to look good. He wants to have rising stock indexes and low unemployment to point to as validation of his policies.
At the same time, Trump says he wants to rein in deficit spending. He wants to cut waste and inefficiency. These are both really good objectives. But they are at odds with the goal of continued levitation of the stock market and economy.
Does Trump understand that the source of the levitation is the deficit spending? What will happen if the $2 trillion in deficit spending is taken away? Will the economy topple over? Will stocks go south?
To be clear, cutting off $2 trillion in deficit spending would be a good start to restoring America’s economic health. But there would also be short-term and mid-term consequences. Namely, the unemployment rate will soar, and the stock market will collapse.
Over several decades or more the economy would rebuild itself upon a sounder footing. Jobs would be tied to productive output, rather than political grift and special interests. Stock prices would also become reflective of the underlying value that their shares represent. Gambling on share prices would no longer be rewarded.
But getting to there from here will be a long and painful slog…
Priced to Perfection
As we observed last week, the odds of Washington balancing the budget are slim to none. Too many promises have been made to too many people for far too long. Trump will not renege on Social Security, Medicare, and defense spending. And without cuts to these spending programs, it will be near impossible to eliminate the deficit.
Perhaps Musk and Ramaswamy can cut some fat around the edges. They can cut off funding for ice-skating drag queens, and grift projects like the $12 million pickleball complex in Las Vegas. This would be a first step towards fiscal restraint. But it won’t change the fundamentals of Washington’s budget challenges.
That is the reality of how things stack up. We don’t like it. But that doesn’t change the unsavory facts.
Still, running massive deficits will not guarantee that 2025 will be another fantastic year for stock market investors. Even if the $2 trillion deficit remains, things have been running hot for so long there’s bound to be a meltdown.
In fact, the stock market has become so overheated that even the Federal Reserve cannot remain silent. On Monday, for example, Federal Reserve Governor Lisa Cook warned that:
“Valuations are elevated in a number of asset classes, including equity and corporate debt markets, where estimated risk premia are near the bottom of their historical distributions, suggesting that markets may be priced to perfection and, therefore, susceptible to large declines, which could result from bad economic news or a change in investor sentiment.”
It is rare for the Fed to comment on the condition of the stock (i.e., equity) market. This hasn’t happened for nearly 30 years as far as we remember. Nonetheless, Cook’s remarks are very much on point and should be taken seriously by investors.
Irrational Exuberance
If you recall, during the early part of the stock market boom of the late 1990s, Alan Greenspan asked if irrational exuberance was at work. On December 5, 1996, while speaking at the American Enterprise Institute, Greenspan asked:
“But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions, as they have in Japan over the past decade? And how do we factor that assessment into monetary policy?”
Irrational exuberance later became a term used to describe a speculative market, where unfounded optimism moves the market well above fundamental valuation. Greenspan’s remarks also implied that monetary policy had some role to play.
Despite Greenspan’s concerns of irrational exuberance on December 5, 1996, he continued to pump credit into the financial system. The Dow Jones Industrial Average rocketed from 6,437 on the day of his speech to a peak of 11,722 on January 14, 2000.
Over the next few years, Greenspan always found a reason to use monetary policy to apply liquidity to the financial system. He cut interest rates after the collapse of hedge fund Long-Term Capital Management in 1998. The NASDAQ, which was ground zero for irrational exuberance, rose 86 percent in 1999 alone, and peaked on March 10, 2000.
Then the irrational exuberance turned to rational despair. The stock market bubble went bust in 2000-02. The DJIA fell nearly 40 percent and the NASDAQ crashed 77 percent.
Greenspan then worked overtime to reignite the flame of irrational exuberance by pumping credit into the financial system. This time the credit found its way not only into the stock market, but into real estate, oil and gold prices. Monetary stimulus was a central factor in inflating this series of bubbles.
Moreover, monetary stimulus became the driving policy at the Fed…
Rational Despair
After the 2008-09 Great Financial Crisis, the Fed pumped additional credit into financial markets. This time the Fed added quantitative easing, where it creates credit from thin air and buys Treasuries and mortgages, to its means and methods for extreme intervention.
Quantitative easing was again employed with reckless abandon during the coronavirus panic of 2020-22. The Fed stimulated without reservation. This time it inflated consumer prices, stocks, real estate, and bitcoin.
All this easy credit has driven the major stock market indexes to their current extreme valuations. The risks are so extreme that even a minor dip in corporate earnings could trigger a rapid stock market sell-off.
Still, irrational exuberance, along with ongoing Fed rate cuts, continues to levitate the stock market higher. Shiller’s cyclically adjusted price-to-equity (CAPE) ratio is over 37 and is approaching its all-time high of 44, which was hit in December 1999 – several months before the dot-com bubble burst.
Perhaps this is why some market analysts are drawing parallels to 1999, with expectations for another monster year in 2025. And they may be right.
The stock market, as measured by the S&P 500, has spent the last 15 years at elevated valuations. As a result, those who were irrational in their expectations for exuberant share price increases did much better than those who were rational.
It has paid to be reckless for so long that being reckless has become ordinary. Blindly throwing money at the stock market has been a rewarding strategy.
Conversely, cooler heads, taking a rational look at the stock market, have observed share price increases that are completely disconnected from reality. Some investors have been sitting on the sidelines since 2016, waiting for the stock market to crash. They’ve been rewarded with nothing but despair.
A sober perception of reality hasn’t paid for many, many years. But that could soon change.
And rising Treasury yields may be the pin that finally pricks the bubble.
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Sincerely,
MN Gordon
for Economic Prism
