In the 1930s, John Maynard Keynes famously likened the stock market to a casino or to something like a beauty contest where investors pick stocks not on the basis of their intrinsic value but rather on what they believe others might find attractive. He also cautioned that the stock market could stay irrational for longer than you could stay solvent. He did so as a warning about the dangers of selling stocks short too early against the crowd’s denial of economic reality.
One has to suppose that if Keynes were alive today, it would come as no surprise to him that the US stock market today is priced at close to record levels, practically unchanged from where it was some eight weeks ago at the start of the US-Israel war with Iran. Nor would he be surprised that today’s stock market trades at a historically very high valuation, despite a geopolitical situation where all the clues are pointing to the likelihood of a severe economic fallout.
Start with the stock market’s valuation. By any reasonable measure, the US stock market seems priced to perfection. Indeed, both the Shiller and the Warren Buffett indexes of market overvaluation are flashing red. Today, Shiller’s Cyclically Adjusted Price Earnings (CAPE) ratio is 40.5. This represents a 135 percent premium over its long-term average and is at a level that has only been surpassed during the 2000 dot.com bubble. Meanwhile, Warren Buffett’s preferred valuation measure of the ratio between the market’s total capitalization and Gross Domestic Product stands at around 225 percent. That is approximately 2.5 standard deviations above its historical trend.
With these nosebleed stock market valuations, you would not know that the US and Iran are engaged in an economically destructive war that could lead to a substantial slowing in the world economy and to higher long-term interest rates. Never mind that Iran maintains an effective chokehold on the Strait of Hormuz with the explicit objective of damaging the US and world economies to improve its bargaining position with the United States. Never mind that the United States maintains a blockade on all ingoing and outgoing traffic from the Persian Gulf with the objective of causing an Iranian economic collapse.
It is difficult to overstate the potential damage that this war could cause to both the US and world economies. This would be especially the case if the current negotiation stalemate keeps the Strait of Hormuz closed for several more weeks. It is not simply that 20 percent of the world’s oil and natural gas supply passes through the strait. It is also worth noting that 30 percent of the world’s seaborne fertilizers pass through those straits, as well as some 10 percent of the world’s aluminum supply and 30 percent of the world’s helium supply, which is necessary for the world’s semiconductor production.
One indication of how the Strait’s closure will adversely affect both the US and the world economies is the more than 50 percent increase that has already occurred in international energy and fertilizer prices. Another is the physical energy supply shortages that are already occurring in Asia, as well as the shortages being experienced in the world’s helium supply. The longer that the Strait is closed, the greater will be the energy and fertilizer price shock, and the more serious will supply chain disruptions become.
One way that the Strait’s closure does not bode well for the stock market outlook is that it must be expected to cause a significant slowing in the US and world economies, if not precipitate a US and world economic recession. The effective energy and food price increase tax on households must be expected to slow down consumption, while heightened economic uncertainty must be expected to slow down investment, especially in the energy-intensive Artificial Intelligence sector.
Another way that the Iran crisis can negatively impact the stock market is that it can lead to significantly higher long-term interest rates, at which corporate earnings will need to be discounted. The spike in gasoline, diesel, and food prices will forestall any early resumption of the Fed’s interest rate-cutting cycle. Meanwhile, Trump’s request for additional defense spending will exacerbate the country’s already poor public finances. In a sign of things to come, since the start of the Iran war, the 10-year Treasury bond yield has risen even at a time when one would have expected it to decline on increased safe-haven demand.
That the stock market is holding up well now despite the gathering storm clouds for the US and world economies is reminiscent of the stock market’s robust performance in the run-up to the 2020 COVID-19 crisis. Then, too, the stock market held up very well until it did not.