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.
Jeremy Whitt
May 4, 2013
Tucker, I would be interested on your take regarding Heisenberg’s uncertainty principle as the primary explanation surrounding the current (and oft named “Most Hated Rally”) and most persistent bull market in a generation? That is, the market can’t do something that a vast majority of market participants SEE coming.
My theory suggests that a largely tacit tipping-point was reached shortly after Aug of 2011 (following the debt-ceiling debacle in congress) of wide-spread, mass-media, and even pop-culture bearish sentiment. This bearish mood continues and even accelerates, fueled by the ensuing rally similar to more gamblers betting on black after more and more consecutive reds land in roulette, even though the odds have not fundamentally changed. So I am working on a thought experiment that suggests the market cannot correct right now because of a financial analog to Heisenberg’s uncertainty principle in that because so many people “see” a correction, most have short positions or hedge positions which benefit from each down-turn, such as the mid-April dip in the markets, resulting in them needing to do something with their gains, which ultimately ends up buying stocks. Continuing this thought experiment, bearish conviction by some of the masses leads a few to highly leveraged short positions and a disproportionate number of short-squeezes that sometimes push part (or all of) huge stock price jumps that are mistakenly justified away by pseudo fundamentals banter on the ubiquitous CNBC.
In fact, we should name this theory: “The Counter-Schiff Theory” after perma-bear Peter Schiff.
THESIS: Due to a financial analog to Heisenberg’s uncertainty principle, once a qualitative tipping-point is reached of too many market participants “seeing” a predicted fundamental market move, the markets can no longer operate efficiently and will move counter to the sentiment of the vast majority.
CASE: The current markets cannot correct until we return to below the tipping point first manifest shortly after Aug of 2011 and continually growing ever since of a larger and larger majority predicting the same market correction or crash.
OPPORTUNITY: And a quant-trading strategy could be developed to measure this qualitative “Financial Heisenberg’s Uncertainty Principle” against quantitative market performance, back-tested for decades, and then of course extrapolated into the near future to predict when the true correction will actually occur, and symmetrically, to predict the relative safety (or risk) of continuing to take advantage of the current bull market trend.
What are your thoughts?
Let me know if you want to collaborate further on this thought experiment…
Tucker Balch
May 6, 2013
That is an intriguing hypothesis Jeremy. I guess a first step would be to find out where we would get the historical data regarding historical “expert” sentiment. Beyond that though, it seems quite feasible.
J
May 6, 2013
I agree 100% with your, Mr Tucker.
J.