Opinion: DOW 15,000 is a Sugar High

Posted on May 4, 2013 by

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The DOW recently touched 15,000 and it will probably blast through that mark. It makes me worried.

The recent market highs are significantly driven by the Fed. The Fed is keeping interest rates at historically low levels and  injecting money into the economy with its bond buying program. These actions affect the stock market in several ways:

  • Investors cannot find significant return in treasuries, corporate bonds, CDs and so on. Their alternative is the stock market. So we’re seeing a significant and continuing rotation from fixed income instruments to stock.
  • Investment banks have cash to lend, and therefore,
  • Margin rates are low. Interactive Brokers, for instance, charges only 1.66% to lend money for equity purchase. This provides a magnifying effect through leverage: Buy stocks for return, borrow cheap money to buy more stocks.

A recent blog at the Economist covers some of these issues:

INTEREST rates are very low around the developed world; near-zero in nominal terms and negative in real terms. This is part of a deliberate policy by central banks to discourage saving and encourage borrowing. It has also been seen as a way of boosting the stockmarket and thus as creating a wealth effect for individuals, and boosting confidence.

How might low real rates boost the equity market? There are two theoretical explanations. The first relates to the fact that equities should be priced as the value of future cashflows, discounted to the current day by an interest rate.* Lower that discount rate and you raise the present value of shares. I have argued that this rationale is flawed; if rates are now because economic growth is slow (and it has been), then one needs to lower the estimate of future cashflows. The effects cancel each other out. The second reason is simple asset switching; low rates on bonds and cash make investors seek out the greater attractions of equities; this may well be the driving force behind 2013’s equity rally.

As soon as quantitative easing ends, interest rates rise, or we see inflation, things are going to get scary for the DOW. Bonds will provide a more compelling risk/reward ratio and we’ll see rotation from stocks to bonds. And the leverage equation that is now driving the market up will unwind in reverse. People are going to de-lever in a massive selling spree.

When will this happen? I think we’ve got at least another year of low interest rates that will keep the market indices elevated. I’m not so sure though that we won’t see a correction before that. I’m currently (as of May 2013) rather bearish.

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