There Will Be No Stock Market Boom From Saving The Banks

Stock indexes have risen over the past week and a half despite banks blowing up and bonds trading like a recession is on the way. Why is this happening?

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Mental gymnastics are required to understand the bullish logic. Another recession could occur later this year as a result of the turmoil, tougher lending standards, and another banking crisis. In response, central banks in the U.S. and elsewhere have taken measures amounting to quantitative easing, or QE, leading to higher share prices.

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At least that's what stocks seem to be thinking. Over the past two weeks, bond yields have declined significantly, indicating greater investor concern.

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"The divergence is partly due to the view that many believe that the Fed/FDIC backstop to deposits represents QE and therefore is 'risk on' for stocks," Morgan Stanley MS +3.62% 's chief U.S. equity strategist Mike Wilson wrote. “As a result of the incrementally restrictive lending and credit environment that we are currently experiencing, we believe that growth is more likely to deteriorate.”

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By increasing the money supply by purchasing Treasuries and other securities directly from banks and on the open market, the Federal Reserve creates money out of thin air. By expanding the availability of credit, banks are able to lower interest rates, increase economic activity, and raise asset prices due to the increased availability of cash on their balance sheets. By doing so, they are able to lend to consumers and businesses more effectively.

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The quantitative easing that was carried out by the Federal Reserve and other central banks all over the world contributed significantly to the massive bull market that took place in the second half of 2020 until early last year, despite the disruptions that this year's Covid-19 brought to companies' operating results. Between the end of the year and the beginning of 2022, the Fed's balance sheet increased by more than $5 trillion.

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As a result of the Fed's sudden expansion of its balance sheet over the past few weeks, Wilson believes that the economy will not benefit from the stimulus package as it did through QE in the past.

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There was a sharp rise of $308 billion in the Federal Reserve's lending to banks during the first week of the current banking turmoil, up by $303 billion from the previous week, when the Fed was lending to banks. The majority of that total was financed by the traditional discount window, $153 billion by the Bank Term Funding Program (BTFP), and $143 billion by Silicon Valley Bank and Signature Bank.

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Banks have used the discount window in recent years to meet their immediate liquidity needs to meet their needs, while funds that are being transferred to banks that have been taken over by regulators will not result in new credit being extended, but rather will be used to make up deposits lost by failed banks. Since the dust has settled on the matter, it is likely that banks will tighten their lending standards until the dust settles out.

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“A short summary of the report would be that none of the reserves will likely be transmitted to the economy as bank deposits normally do. It is our opinion that, given the temporary/emergency nature of these funds, the velocity of money in the banking system will fall sharply, outweighing any increase in reserves more than anything else.”

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As Wilson emphasizes in his research, equity risk premiums or ERPs are essentially the premium returns that investing in stocks should provide in comparison to risk-free rates such as the yield on U.S. Treasury bills. In Wilson's opinion, today's ERP for the S&P 500 averages 230 basis points, or one-hundredth of one percent.

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Considering the current economic climate is characterized by risk to earnings, the credit available to consumers is likely to decline, and the economy may slow in the future, that is simply too low, he argues.

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Wilson wrote that the risk/reward ratio for U.S. equities remains unattractive until the ERP is at least 350-400 basis points, which in our view is at least 350-400 basis points. Based on market expectations, if the 10-year [U.S. Treasury] yields are to continue to fall a bit more as the markets begin to be concerned more about growth than inflation, then that would translate into a price-to-earnings ratio of 14-15x, 15-20% less than it currently is.

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Among Wilson's revised price targets for the S&P 500SPX +0.69% for the year ended December 31, the price target is around 1.3% below the closing price on Monday.