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How an Economic Boom Could Eventually be Bad For the Stock Market

How an Economic Boom Could Eventually be Bad For the Stock Market

Posted On November 13, 2020 10:56 am
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By Ben Carlson

On Sunday I wrote the following:

“It’s possible the stock market could see a sustained downturn if the pandemic continues to get out of control, a vaccine is further away than expected or the economy experiences another setback.

I’ve lost my ability to be surprised in 2020 so this certainly isn’t out of the realm of possibilities.

But this realm of possibilities could also see investors completely ignore elevated valuations and send markets to the stratosphere because of ultra low interest rates, a potential vaccine, a possible post-Covid spending boom, a huge fiscal stimulus plan from our new president or a continuation of a rising stock market in the face of terrible news.

The “smart” money has been bearish on the stock market for some time now while the young upstarts at Robinhood have been basking in the glow of seemingly ever-rising stock prices.

Watching other people get rich not only introduces career risk into investment decisions, it also gnaws at your psyche from a behavioral perspective. One of the biggest reasons FOMO exists is because it doesn’t seem fair.

Buffett is right that bubbles are a permanent part of the system in which we invest.

It wouldn’t shock me if the events of 2020 lead to a massive bubble from some combination of low rates and investors seeing people “dumber” than they are getting rich.”

Then on Monday, the big vaccine news from Pfizer hit. So game on? Roaring 2020s is on the table?

I believe this is a possibility…but obviously not a foregone conclusion. When I put this out on Twitter, Jim Bianco threw some cold water on my theory:

At first glance, it’s hard to imagine how an economic boom could actually be bad for the stock market but Jim’s pushback here has some merit. There are always risks in the financial markets, even when there is potentially good news.

First of all, it’s important to note that interest rates rising in and of themselves is not necessarily a bad thing for stocks (or bonds for that matter). I wrote about this a few years ago:

The average performance of the S&P 500 during these past rising rate environments was almost 22 percent in total returns. Only three times did stocks fall when the 10-year rose by 1 percent or more, and the largest losses were just under 2 percent. So stocks have held up well in the face of rising interest rates over the past 50-plus years.

Here’s the accompanying chart:

To Bianco’s point, it’s inflation, not rising rates that present a risk to the markets. I looked back at the calendar year returns for the S&P 500 from 1928-2019 to see how the stock market performed under two different inflation scenarios:

You can see stocks have done much better during years when inflation is below 3% than when it’s above 3%. And if we looked at these returns on a real basis, the differences would be even wider because real returns take inflation into account.You get similar results breaking things down by rising or falling1 inflation:

Disinflationary periods have been shown to benefit the stock market while rising inflation is seen as a negative. So an economic boom combined with above-average inflation could eventually become a risk to the stock market. And higher inflation would be bad for the bond market as well because rates are so low and fixed income investors are punished during inflationary environments.

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About author

Dividend Sensei
Dividend Sensei

I'm an Army veteran and former energy dividend writer for The Motley Fool. I'm a proud co-founder of Wide Moat Research, Dividend Kings, and the Intelligent Dividend Investor. My work can be found on Seeking Alpha, Dividend Kings, iREIT, and the Intelligent Dividend Investor. My goal is to help all people learn how to harness the awesome power of dividend growth investing to achieve their financial dreams and enrich their lives. With 24 years of investing experience, I've learned what works and more importantly, what doesn't, when it comes to building long-term wealth and income streams and achieving long-term financial goals.

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