(No new forecast here.)

The Everything Bubble is deflating smoothly, and that’s the good news. The bad news is that inflation remains at about 7%, and the Federal Reserve will keep raising interest rates and tightening credit until inflation is in the vacinity of 2% to 4%. Some sort of stock market crash typically is part of this process.

Stocks fell last year by about 15% and they may/may not have further to go; that is what my economic models are supposed to figure out. My models, however, are not good about forecasting market effects of true economic surprises — black swans — that may appear as the bubble continues to go down. There may be a few on the horizon. I have no informed judgment on whether these birds will attack, or simply fly away. None appear to create immediate peril. I am a bit concerned about September….

No stock market bubble here. My long term trend line for the S&P 500 indicates that a stock market price bubble had inflated over the pandemic years. Massive government stimulus was the medicine the country needed to get through the economic chaos that the corona virus brought on. Thanks to that flood of money the economy survived and we all should be grateful. The stock market bubble and high inflation were two of the side effects of the massive economic stimulus.

Last year’s rapid interest rate increases by the Federal Reserve let the air out of the U.S. stock market bubble, now leaving the market right where it ‘should’ be based on interest rates and long term GDP projections. Stocks may need to a bit decline further if interest rates are going to remain higher. Higher rates would lower the long term trend line somewhat.

High government spending , lingering supply disruptions and a tight labor market may cause the Fed to overshoot. The massive omnibus federal spending package just signed into law means the Treasury remains in strong stimulus mode through September when the fiscal year ends. FY2022’s deficit will be roughly $1.71 trillion, about 7% of GDP, a major economic stimulus. That is much lower than the FY2021 deficit of $2.8 trillion, but it will still keep up employment in a number of areas (especially defense and energy) and push prices up for a variety of goods and services.

Wages and salaries are also staying quite strong. The chart below shows year-over-year percentage growth of wages and salaries. While down from the highs of the pandemic stimulus period, recent compensation increases remain at distinctly high levels.

Compensation of Employees

The graph clearly shows that the pressure of rising wages has declined. But, about 3.5 million people are missing from the labor force, compared with what one might have expected based on pre-2020 trends, Jerome H. Powell, the Fed chair, said during a speech last month. Some commentators are concerned that retiring baby boomers may have caused a permanent decline in the labor supply. Others are concerned that even before covid, large numbers of people, especially men, have simply dropped out of the labor market.

The stock market concern here is that continuing economic strength, high energy prices, lingering covid-19 after-effects and worker shortages may force the Fed to raise interest rates more than otherwise and might send the economy into a significant recession — sparking a stock market sell-off.

Republican Congressional Brinksmanship The end of the Federal Government fiscal year September 30 could well bring on a classic display of sudden fiscal responsibility by House Rebublicans. Republican leader Kevin McCarthy is already raising cries against a gaping deficit. With the Presidential election cycle starting to gear up, it would be amazing if House Republicans did not stage one or more episodes of threatening to close, or actually closing the Federal Government. Wall Street has watched this theater act many times, but occasionally, as in 2011, fear grows enough to make the market plummet. Quickly cutting federal spending would guarantee a market crash.

Commercial Real Estate Hurting Despite pandemic fears waning, many office workers have not gone back to the office — at least not full-time. This leaves a huge open question about the fate of commercial real estate and the future of America’s downtowns. Real estate leasing rates have fallen and rents are coming down. It is not easy to convert vacant office space to some other use, and the new rents are much lower. At the same time, the costs of new real estate loans are up roughly 75% from mid-2021. This squeeze of higher costs and decreased demand is strongly reminiscent of the Savings and Loan Crisis of the 1980s and the Black Monday market crash of 1987.

Foreign Financial Disruption According to the International Monetary Fund, median global GDP dropped 3.9% from 2019 to 2020, the worst drop since the Great Depression, and that drop is beyond all government stimulus measures. While economies in most nations have recovered like the U.S., questions remain about the abilities of other nations to cope with the continuing economic fallout from covid-19. The strong position of the U.S. Dollar caused by the Fed’s rate hikes has put heavy strains on many other governments. Likewise the war in Ukraine puts a major question mark on the economies of Western Europe.

I have no idea how all of this will play out, and for a long term investor it shouldn’t really matter. Next year at this time the market will probably be fairly near its long term trend line again.

Happy New Year and Good Luck!