What April Fools' pranks might the market be playing on us right now? There are some obvious candidates, many of which we’ve talked about before.
Sky-high valuations. Stock market valuations have been elevated for years but recently soared to the third-highest level in history (on a Shiller P/E basis). The only times they've been higher were one quarter in 1929 and one quarter in 1999. In both instances, those high levels turned into a bad joke shortly thereafter. Could they this time?
Similarly high confidence. Another potential joke is the very high level of business and consumer confidence. Expectations are as high as they've been for years, but the hard data is trailing the surveys by quite a bit. Historically, when we see this kind of disconnect, the hard data wins, so soaring confidence could turn out to be a big April Fools’ gag over the next six months.
Low interest rates. To my mind, though, the most likely April Fools’ joke we’ll look back on over the next year or so is interest rates. This is both the biggest risk and the one most likely to play out over that time frame. It could also be the factor that causes the other two items, valuations and confidence, to roll over as well.
Why am I skeptical of interest rates? Primarily because of the Federal Reserve’s changing attitude. More and more, Fed members are commenting on how many rate hikes are needed, rather than whether they’re needed at all. A growing number of them are getting nervous, including Janet Yellen. Looking back, the Fed has an almost unbroken record of waiting too long and then having to hike rates aggressively. That exact scenario looks likely to play out over the next 24 months. Higher interest rates seem like a pretty good bet, based on both current and past behavior.
Higher rates, of course, then flow through the rest of the economy and markets. Low rates are a big part of the justification for current high stock valuations; if rates rise, those valuations are likely to come down. Consumer confidence is based on the ability to buy stuff, but housing affordability, for example, is already dropping based on higher mortgage rates, and auto sales are rolling over as well.
Rates are as much below historical norms as stocks are above them. The disconnect there is just as extreme, and arguably even more so. With stocks, we don’t know when that reversion might take place (although we can make some intelligent guesses). With interest rates, we have a much better idea, as we know what the folks who set short-term rates are thinking, and how they have reacted in the past.
So tomorrow, on April Fools’ Day, give some thought to the Federal Reserve and how it sets interest rates. And when you conduct your regular portfolio review (you do conduct a regular review, right?), think about what kind of tricks it might be exposed to, so you don’t end up getting fooled.