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https://osam.com/Commentary/upside-down-marketsTINA markets are guaranteed to be difficult and frustrating for large numbers of people. The problem of how to properly invest in them has no easy solution. Chasing ultra-expensive assets, nervously supervising them in the hopes that you haven't top-ticked them, is stressful and unpleasant. But so is waiting on the sidelines earning negative real returns while everyone else makes money. Time is not on your side in that effort.
Over time, as the COVID-19 deficits collect in the hands of savers, they will end up functioning as direct injections of cash and treasury bonds into investor portfolios. These injections, which will represent insertions of new wealth rather than alterations in the composition of existing wealth, will raise allocations to cash and treasury bonds and reduce allocations to every other asset class—most notably, equities.
Do investors actually want to have their allocations to equities reduced in this way, replaced on a percentage basis with cash and bonds? Probably not, especially with the Fed having just lowered interest rates to zero. But they don't have much choice in the matter; if they don't want to accept the reduced allocations, then their only available option, outside of investing in new companies or in companies that are diluting, will be to push up on the prices and valuations of existing shares.
....on the assumption that investors display zero sensitivity to valuation and invest entirely based on a pre-determined asset allocation preference, we can quantify the exact impact that the COVID-19 deficits would be expected to have on prices, if they found their way into markets. We simply assume that investors would bid up on the price of equity until their pre-pandemic allocation to equity was restored. To restore that allocation amid the COVID-19 debt issuance, the market would have to rise by roughly 18%, from its price at the time of the writing of this piece, roughly 3327, to a final price of roughly 3900, a forward 2-yr GAAP price-earnings ratio of 26 times.
In exploring the supply-driven effects that fiscal policy can have on asset prices and valuations, we've once again arrived at a classic upside-down outcome. An event occurs that damages the economy, forcing extreme issuance of zero-yield government debt, the presence of which pushes down on average equity allocations and up on equity prices and valuations, contrary to the assumed effect of the damage itself.