The Continuing Power of Liquidity... Bridging the Gap Between Stock Prices and Fundamentals

US Fed Chair Also Says "Stock Market Is Not Overheated"
Economic Recovery Still Distant but Liquidity Supports the Market

Jerome Powell, Chairman of the U.S. Federal Reserve (Fed), spoke at a hearing hosted by the Senate Banking Committee at the U.S. Capitol in Washington, D.C., on the 1st (local time).
[Image source=Yonhap News]

[Asia Economy Reporter Minwoo Lee] The continued commitment of the U.S. Federal Reserve (Fed) to monetary easing is expected to maintain the current low interest rate and abundant liquidity environment, sustaining the current level of the stock market. A similar trend is expected to continue in the domestic stock market, bridging the gap between stock prices and fundamentals.

On the 19th, IBK Investment & Securities forecasted that the gap between stock prices and fundamentals would persist considering factors such as the winter resurgence shock of COVID-19 and the timing of vaccine distribution. Nevertheless, they explained that the ongoing liquidity conditions would limit stock market corrections.

Low Interest Rates and Liquidity Supporting the Stock Market

First, the U.S. Fed has already guaranteed the power of liquidity. Fed Chair Jerome Powell, during a press conference after the Federal Open Market Committee (FOMC) regular meeting on the 16th (local time), dismissed concerns about overheating in the U.S. stock market, which has reached an all-time high, stating it is not at a dangerous level. He emphasized, "Asset prices are somewhat high, but various situations are mixed," and added, "Given the sustained low interest rate trend since the global COVID-19 pandemic, the current surge in stock prices can be justified." He also expressed willingness to maintain the current zero interest rate and bond purchase scale at existing levels but indicated that additional easing measures could be taken depending on future circumstances.

In fact, a negative relationship is confirmed between the S&P 500’s 12-month forward price-to-earnings ratio (PER) and the 10-year interest rate. Soeun Ahn, a researcher at IBK Investment & Securities, explained, "Since the COVID-19 outbreak, the 10-year interest rate has fallen to the 0% range, causing the PER to surge to the highest level in the past decade," adding, "As Chair Powell mentioned, this means that historically low interest rates have had a significant impact on stock prices."

Liquidity has also had a strong influence. When comparing the S&P 500’s market capitalization with M2 (broad money supply), representing liquidity and economic fundamentals, and nominal GDP respectively, distinct differences appear. Researcher Ahn analyzed, "The ratio of market capitalization to nominal GDP has significantly deviated above the long-term trend line by +1 standard deviation, whereas the ratio of market capitalization to M2 has settled within ±1 standard deviation of the long-term trend line," adding, "Since the COVID-19 outbreak, the gap between stock prices and economic fundamentals has widened, but some of the current stock price levels unexplained by fundamentals can be accounted for by liquidity."

A similar trend appeared in the domestic stock market. While South Korea’s 10-year interest rate remains historically low, the KOSPI’s 12-month forward PER also recorded the highest level in the past decade. The influence of liquidity on stock prices was similar to that in the U.S. Researcher Ahn interpreted, "The ratio of KOSPI market capitalization to nominal GDP has deviated above the long-term trend line by +2 standard deviations, raising concerns about overheating comparable to past bubble periods," and added, "The ratio of KOSPI market capitalization to financial market liquidity (Lf) also exceeds +1 standard deviation of the long-term trend line, which is burdensome, but at least it explains the current stock price level better than nominal GDP."

Stock Price-Fundamental Gap to Continue, but Market Correction Limited

The gap between stock prices and fundamentals is expected to continue for the time being. Although expectations for economic recovery are growing due to the start of COVID-19 vaccinations worldwide and the prospect of additional U.S. stimulus measures within the year, it will take time to confirm actual economic recovery. Additionally, the winter season brings a stronger spread of COVID-19, which is another variable. According to the Health Metrics and Evaluation Institute at Washington University School of Medicine, considering the current COVID-19 spread rate and quarantine conditions, the intensity of private social distancing is expected to improve only after the second quarter of next year.

Although economic recovery is distant, stock market corrections are expected to be limited because both the U.S. and domestic stock markets face strong upward pressure from liquidity and low interest rates. Researcher Ahn explained, "Chair Powell’s statement at this FOMC that the rapid rise in stock prices is not worrisome can be interpreted as a guarantee of low interest rates and liquidity supply sufficient to support the current stock price level," adding, "The Fed intends to maintain the current zero interest rate level until 2023, when U.S. employment conditions recover to pre-COVID-19 levels." In fact, after the FOMC meeting, Chair Powell emphasized, "We will continue purchasing bonds worth more than $120 billion monthly until substantial progress is made in the economy," and stressed, "Despite this level of liquidity supply, there is no concern about inflation occurring in the near term."

This content was produced with the assistance of AI translation services.