A note for my regular readers: I am taking the next two weeks off to spend time with my family. I won't be totally out of touch—I will still write the Monday Update—but I am turning the blog over to some of my colleagues so you can see what great work they do. For the next two weeks, you'll find new posts here on Monday, Wednesday, and Friday; we will return to the usual daily schedule on Monday, August 29. Until then, take care! — Brad
Once again, the market has hit new highs. At this point, that may sound like old news, but yesterday was special: all three major U.S. indices closed at new highs on the same day. That hasn’t happened since December 31, 1999.
Even with the mid-2000s boom and the stock market run since 2009, not once have all three indices hit highs at the same time. Only in the biggest bubble of the past 70 years has that happened. And now it's happened again.
Prices soar as fundamentals decline
What makes this particularly striking is the simultaneous decline in fundamentals. Earnings are down, so valuations are up. In fact, we’re seeing the same kind of broad expansion in valuations that we saw during the dot-com bubble. Investors are willing to pay more now than they (almost) ever have in the past.
The reason is different this time, of course. Last time, expanding valuations were based on universal optimism, the idea that the new economy would change the world and result in endless prosperity and higher profits. The world did change—Amazon now owns the retail market, for one—but the higher profits didn’t prove out.
This time, higher valuations aren’t based on optimism about the economy but on interest rates. Markets don’t believe in the Internet any more; now they believe in central banks, which are changing the world by keeping rates low.
Signs of an interest rate bubble
I wrote the other day about a potential bubble in interest rates. One of the characteristics of a bubble is a phase at the end when prices suddenly move sharply as investors pile in. We are seeing signs of that around the world and here in the U.S., as central banks dial up the stimulus. We may be in the blow-off stages of an interest rate bubble, or at least getting close.
One sign of that could be rising prices for bonds and stocks at the same time. The two normally move in opposite directions; good news for bonds is usually bad news for stocks. Not now. Lower rates drive bond prices higher, and a good part of the publicly accepted rationale for current stock valuations is low rates.
Think about that for a minute: low interest rates mean stocks should be worth more. Mathematically, this is unarguable, but let’s consider the underlying reality. The reason rates are low is because economies are weak. Weak economies mean low growth. Low growth means low earnings growth for companies in aggregate. Low earnings growth has always meant low stock valuations. See the contradiction?
In math, one way to prove an idea false is to assume it’s true and then run through the consequences until you hit a contradiction. The stock market is not a mathematical exercise, but the contradiction we just reached should show how problematic it is to rely on low interest rates as a justification for current valuations—specially given that rates will certainly rise at some point.
Where are rates headed?
From where we are now, there are two paths for interest rates.
Central banks can continue to force interest rates to decline and keep the party going. Looking back to the late 1990s, this is analogous to the venture capitalists continuing to fund unprofitable companies. The current interest rate bubble, and thus the stock market, depends on this path. This is the bet investors are making right now.
Or, central banks can stop their interventions, leaving interest rates to the market. Central banks have to step back at some point, and for the Fed at least, that might be sooner rather than later. The Bank of Japan is also showing signs that monetary policy has reached its limit. When central banks step back, rates will either stay low and stable (the best case) or start to climb.
Stable rates would be analogous to the venture capitalists telling their companies to start making money. The problem then was that the companies were not profitable and needed constant cash infusions. The problem now is that earnings have been declining, and stock appreciation has depended on lower interest rates. With rates stable, markets will have to grow in line with earnings—a big shift from the past several years.
More likely, rates will start to rise again. Here, the argument that lower rates justify higher stock values, a core of the recent advances, will get turned on its head.
At some point, the party ends
Celebrate the good news, by all means, but keep in mind how we got here. One explicit goal of central bank policy action has been to support asset markets—and in this, they succeeded beyond their wildest dreams.
That doesn’t mean supporting markets is their only goal, however, or that they will keep it up.