Is the stock market nothing but a bubble waiting to burst? There are many reasons to believe that there is one last downturn at the exit of this Managed Depression, which may indeed be slowly forming. The risk comes in the nature of how the economy is so carefully managed through monetary policy directed by the Federal Reserve. Years of zero interest and $3.7T in quantitative easing have produced a situation that’s hard to pull out of without a lot of collateral damage.
The problem is that a lot of money is chasing an awful lot of risk these days. Junk Bonds (aka “speculative grade investments”) are making a strong run, selling a record $265B through May 2014. The reason? Interest rates stuck near zero mean no return for investors, and as things turn around they have an appetite for risk. A rise in interest rates would slaughter this market and cause losses that will reverberate through equity markets before things really have a chance to turn around.
It’s not as though there’s nothing behind the run in the stock market these days. Corporate profits remain at a record high as businesses are still slow to re-invest in their own expansion. But therein lies the problem. Large companies that are making a lot of money are finding few places to invest that money at an interest rate that is even remotely compelling, meaning that someday they’ll have to get over their fear and plan for expansion.
In the meantime, stock buybacks that drive up the price of the stocks are a hot item. And some of this is being done with bonds issued at very low rates – even the bonds that are less than stellar looking on the surface of them. Investors don’t seem to care much about the risk anymore, so it’s easy to sell them.
The hot market for high-yield debt has driven down the yield for junk bonds to 5.9%, the lowest that has ever been seen. It’s a paltry 3.8% or so spread over high quality bonds, but investors aren’t spooked yet. The default rate for junk is averaging 2.3%, very low compared to the 4.7% historic rate. It looks like safe money.
But all of this is the process of the markets evening things out as a historic experiment in economic management comes to its logical end. And it is indeed the management that has marked this era. All of this is the creation of a unified policy by the central banks of the world, including our own Federal Reserve.
The problem comes when the big experiment stops. Rising interest rates, which we can reasonably expect in the next two years, will demand higher bond yields. The bonds out there today only realize higher rates by having the underlying price of those bonds drop, meaning that investors will head for the exits very quickly. That will dry up all financing of this kind quickly and turn the stock market down in a hurry.
It should also logically mark the time when corporations start investing money in their own growth, which will drive down profits in the short term. There is no reason to believe that any of the conditions that keep the stock market as high as it is can prevail.
Then there is the low default rate. We recently passed a period in which hardly any junk bonds were issued, when the market was deep at the fear end of the fear / greed dynamic. These new bonds are for new risks and are recently issued. Junk rarely fails in the first year or the second – but sometime after it’s been out on the market. Expect the default rates to revert to the mean, as they always do, and for investors to suddenly realize that they’re called “junk” for a reason.
There is light at the end of this tunnel, of course. When there is faith in a general turnaround in the economy and absolutely no other easy investments to make we can all expect a strong re-investment in core business that create basic goods and services. That will also be a function of rising global demand, which remains dependent on jobs being created that put money in the hands of consumers like we haven’t seen since 2000. It won’t be helped by the aging population, but upward pressure on wages cause by the retirement wave will help boost consumption by those still working.
In short, there is one last bump in the road before we hit the true end of this depression and the secular bull market that is likely to come next. But there is still a possibility that this downturn might be severe enough to delay or even derail that likely event before it happens.
How much faith do you have in those who have heavily managed our economy? They’ve done a reasonable job so far, but there is little doubt that some of their efforts went into nothing more than another bubble that has to pop. We will see how it goes.