Where did the inflation go?

In a previous article I analyzed how the FED’s monetary policy compared to Bitcoin’s. An important takeaway from the article is that, since the beginning of the pandemic, the FED has printed more than 3 trillion dollars, increasing the m0 money supply by 90%. At the same time, and according to the Congressional Budget Office (source), the US economy (GDP) is expected to contract by 5.6% by the end of 2020. In a scenario where the amount of money entering the economy increases drastically but the economy contracts, why aren’t we seeing an increase in the inflation rate?

To understand the evolution of the inflation rate we need to first understand how it’s measured through the Consumer Price Index (CPI).

The Consumer Price Index

At an intuitive level, inflation is the increase of price of goods and services. To measure inflation, governments rely on the Consumer Price Index or CPI, that tracks the price of things like food, rent, clothing, transportation, health care, education and communication.

However, some very important areas of the economy are left out of this index. According to the US Bureau of Labor Statistics, the CPI does not include “investment items, such as stocks, bonds, real estate, and life insurance” (source). The stock market and the housing market are precisely two areas that have been growing fast despite the rest of the economy contracting. In other words, the price of the stock of companies like Apple and Tesla has increased significantly while their underlying business and their revenue stream has not. This leads me to believe that the stock market is not increasing because of changes in technology and productivity, it’s increasing because the money printed by the FED is causing inflation.

That was easy, almost too easy. I’m not an economist so I don’t fully trust myself in these topics, I need more proof. How else can I measure if the stock market is overvalued?

The Wilshire 5000

The Wilshire 5000 is an index that tracks the performance of most publicly traded companies whose headquarters are located in the US (source). The fact that the index tracks only “American” companies it’s a crucial characteristic that makes it suitable for comparing it against the US GDP as many “foreign” companies are also traded in exchanges in the US. In theory, every point in the index corresponds to roughly 1 billion USD of market capitalization (some sources claim this be 1.2 billion USD per point but I’ll stick to the more conservative estimate).

Figure 1 compares the evolution of the total market capitalization of American companies against the size of the US economy (GDP) over the last ~30 years. Although this is an apples to oranges comparison, there’s an expectation of both values being correlated and roughly similar in size.

Up until 2015 we can see that both values follow a similar trend even if the market capitalization proves to be more volatile than the GDP. A couple of significant trends can be observed in that time period. After a period of sustained growth in the market capitalization from 1994 to 1999 the index drops as a result of the dot com bubble in 2000. The same can be appreciated right before the financial crisis of 2008: a period of sustained growth followed by a crash.

But the most interesting trend appears after 2015 when both values seem to detach from one another. While the US economy continued to grow at a steady rate from 2015 to 2019 the capitalization of the stock market grew at a much faster rate. Even more interesting is that in 2020 while the US economy is expected to contract, the value held in the stock market ballooned and it’s now almost double the size of the GDP.

I’m no economist but that behaviour doesn’t seem right. How can the stock market suddenly double the value of the US economy? How can it continue to grow even as the GDP drops? Turns out that even Warren Buffet is concerned about this relationship (source). I wonder if this is the reason he decided to drop all his stocks in banks and airlines and started investing in gold mining companies…

Conclusion

Despite the massive amount of money injected into the economy by the FED during the last year, the formal inflation rate has not been affected. This inflation rate is measured by the Consumer Price Index that doesn’t contemplate the value of stocks or real estate. The growth of the stock market has detached from the growth of the US economy signalling that the stock market is overvalued because it has been hit by the first wave of inflation. It’s only a matter of time before the stock market goes through another correction (i.e. crash) that seems likely to be worst than the 2008 financial crisis.

Think twice before betting too hard on the stock market. Those incredible Tesla and Apple stock rallies might be too good to be true after all.

Resources

• Wilshire 5000 (Wikipedia)
• Historical data on Wilshire 5000 (Yahoo)
• Historical data on the US GDP (Trading Economics)
• Warren Buffett’s favorite market indicator nears record high, signaling stocks are overvalued and a crash may be coming (Business Insider)
• US GDP 2020 forecast (Congressional Budget Office)
• US GNI per year (World Bank)
• Gross National Income Definition (Investopedia)
• What goods and services does the CPI cover? (Bureau of Labor Statistics)