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I read a transcript this week of a talk given by legendary investor Stan Druckenmiller, which has a tremendous amount of good stuff in it. (You can find it here.)
I was particularly struck by Druckenmiller’s comment, on page 31, that the current economic and market situation feels bad, much as it did for him in 2004. When you hear this kind of statement from someone with his record, it’s worth considering what might happen if he’s right.
With that in mind, let's look at a few factors that could send things south.
Interest rates are bound to rise
Arguably, the performance of an investment depends more than anything else on what the Federal Reserve does. You can make a good case that the 30-plus-year bull market in stocks here in the U.S. was based primarily on the Fed’s decision to cut interest rates more or less continuously over that time period. The correlation, at −0.84, is about as good as it gets in economics, and there is a strong fundamental reason to believe there’s a connection.
The question, then, is what happens when the Fed raises rates? Will the market move down? Based on this relationship, it seems quite possible. Looking at history, the Fed has almost always ended up raising rates later than it should have, and then moved faster and higher than anyone expected. That kind of interest rate shock could well pull markets down.
With the first interest rate increase in years widely expected before the end of the year, this is something we need to watch carefully.
Boomers are starting to retire
Another point is that the rise in the markets has coincided with the baby boom generation moving into their primary earning and saving years. What happens when they retire, which we're starting to see now? I believe the effects of baby boomer retirement are already showing in the employment participation numbers, and they should start showing up in the aggregate demand for investment assets very soon now, if they haven’t already.
Debt is increasing
Finally, and very relevant to Druckenmiller’s comments, the rise in markets has been associated with a rise in debt across the board—particularly debt associated with buying stocks. Just as with the housing crisis, where mortgages enabled higher housing prices, low interest rates have enabled investors to borrow more to buy stocks. Margin debt to the total value of the stock market is close to an all-time high. Other metrics are also at very high levels historically, as I mentioned recently.
Tough times ahead?
Druckenmiller’s invocation of 2004 should give us pause. At that point, the boom had three years to run. In 1998, when things were similarly overvalued, the boom also had a couple of years left. With the U.S. economy heating up, in my opinion, and interest rates quite likely to be held at low levels while the European and Japanese central banks continue their stimulus policy, we remain in a supportive environment for stock prices.
These factors will change, though, over the next couple of years. It’s easy to see how, just as the market benefited from a conjunction of many favorable characteristics in the past, the reversal of those trends could mean tough times ahead.
