Is the Market Rising Because the Market is Rising?
Dear Fellow Shareholders:
Over the past year, the market has risen more than 30%. Investors everywhere are happy with this result. Only a few pause to wonder how this came to be. A year ago the words “late cycle” were on everyone’s lips. How is it that a “late cycle” market can put up “early cycle” returns?
During the year the underlying fundamentals (bond prices and economic activity) sent mixed signals. Bond prices have risen, which should push stock prices higher. But economic activity as measured by Gross Domestic Product (GDP) has fallen. A weaker economy should push stock prices lower. So the fundamentals underlying stock prices have been mixed over the past year. Thus it would be reasonable to expect stock prices to be mixed as well. Instead, they rose strongly.
This raises the following questions: Does the market even care about fundamentals? Are prices rising on their own Newtonian momentum? Is the market going up because the market is going up? And, if so, are we experiencing a market bubble?
Sometime around 2012 the market began to accept that interest rates would be “lower for longer.” And that these low rates were consistent with a slow but steady improvement in the economy. This was a radical idea. Prior to that time, continuing low rates would have sparked strong economic growth. For example, after the collapse of the internet bubble, the Federal Reserve (Fed) cut rates from 6.5% to 1.0% and held them there for a year. The result of this low rate policy was to spur a strong economy and create a boom in home prices. Rising home prices led to deterioration in credit standards–after all, why worry about the quality of the borrower if the home price was rising, thus assuring that the loan could be repaid? The subsequent collapse of housing prices led to many home loan defaults which resulted in the 2008 global financial crisis (GFC).
Post the GFC, the Fed held rates at 0.25% for almost seven years before gradually increasing them to 2.5% this year. Yet these “lower for longer” rates didn’t provoke a boom as they had on prior occasions. In fact, recently the Fed was forced to reverse its gradual rate increase policy. So far they have walked back rates from 2.5% to 1.75% to ensure that our slow, steady expansion continues. It appears that both the economy and investors are hooked on low rates. So long as rates stay low, the economy will expand and investors will buy stocks. It seems as though we may have found the golden goose.
But it is rarely that simple. There has to be more to the story. Prior episodes of prolonged low rates have inevitably led to problems. Are things different this time? Why haven’t low rates triggered the usual surge in investments? Unless the entrepreneurial spirit in our economy has suddenly vanished, the answer must be that, even with a low cost of funds, investments are producing insufficient profits to be worthwhile. Without new investments, there is no basis for an economic boom.
Low investment is an attribute of a maturing population. For example, Japan is demographically the oldest major nation. The Japanese stock market peaked in 1989 along with Japanese interest rates. Japanese interest rates collapsed and have remained low ever since. But these low rates haven’t produced a surge of new investment. The likely explanation is that demand from Japan’s aging populace is so low that current production capacity is fully satisfying that demand. Adding more capacity would simply be a waste.
Europe seems to be following in Japan’s path. Interest rates have been cut everywhere in Europe, in some cases to negative levels. But businesses aren’t investing in new capacity, as the current capacity is capable of meeting consumer demand. Low and declining birth rates around the globe imply that, sooner or later, all nations, even the United States, will follow the Japanese path.
Consider the life cycle of one man. When he is young, he has no savings, no assets, and no productive capacity. He can only consume. And he can only do that by borrowing from the future. As he grows older, he invests in himself via education, increasing his productive capacity. He borrows more from the future to pay for this training. Ultimately he adds his capabilities to the labor force and starts producing. But he may borrow still more so that he can have a home and a car. At some point, his output begins to exceed his consumption. The excess is first used to retire the debt he has accumulated, and is then used to build savings to prepare for his retirement years. During his retirement, he will spend his savings and may sell his home to provide for his consumption. He will leave life the same way he entered — no assets and no productive capacity.
Economies, as aggregations of individuals, go through a similar life cycle. In the early years, when both productive assets and savings are low, interest rates are high in order to call forth the funds required for adding capacity. Over time, interest rates decline as there is both less demand for additional capacity, and more savings. Finally, as an economy ages, there will be abundant savings and no demand for additional capacity, so rates will tend towards zero.
Notice that the movement of rates in this prototypical economy went from high to low with no intervention by a central bank such as the Fed. The movement of rates is due to the interplay of saving and investment. Can the monetary policies of a central bank modify this rate pattern? Central banks everywhere have tried. Their efforts have met with failure much more often than they have met with success. The Fed’s low rate policy following the collapse of the internet bubble led to a housing price bubble. Arguably, the Fed’s attempt to stimulate the economy post the GFC has led to a financial asset price bubble, with both stocks and bonds at record highs.
When central banks try to force rates below their natural levels, they make it easier to borrow than it otherwise would be. Easier borrowing means that investments get made that otherwise would not. Capital gets misallocated. Of particular concern is capital allocated to buy existing stocks and bonds. Such purchases inflate stock and bond prices beyond levels which can be supported by their underlying fundamentals. Once cut free from fundamentals, these rising prices tend to keep rising. Hence the question at the outset: Are prices rising because prices are rising?
Prices rising due to their own momentum is the definition of a bubble. If we are in a bubble, does this mean that stock and bond prices will soon collapse? Not necessarily. After all, the stock market is really a market of individual stocks. Even during the GFC some stocks such as WalMart and AutoZone rose. During any market turmoil, the key is careful stock selection. How is Seven Canyons navigating these tricky markets? We are cautiously picking and choosing among investments to find stocks that trade based on their fundamental values—that is, the prices of these stocks are not inflated by speculation but supported by the foundation of the underlying business. We don’t want to own stocks that aren’t providing adequate returns. We are increasingly turning to non-U.S. stocks where prices have been more subdued than they have been in the U.S. We hope that our carefully selected portfolios fare better than most during any market turbulence.
This letter is for informational purposes only and does not constitute investment advice or a recommendation of any particular security, strategy, or investment product. The expressed views and opinions presented are for informational purposes only, are based on current market conditions, and are subject to change without notice. Although information and statistics contained herein have been obtained from sources believed to be reliable and are accurate to the best of our knowledge, Seven Canyons Advisors cannot and does not guarantee the accuracy, validity, timeliness, or completeness of such information and statistics made available to you for any particular purpose. Past performance is not indicative of future results.
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