Markets are at record levels. Well in the US at least. Considering we’ve just had a year of economic shutdowns and huge falls in outputs, that is simply incredible. We have witnessed the worst economic crisis since the 1930s Great Depression. According to the United Nations, The World Bank and the International Monetary Fund, global GDP in 2020 is expected to contract by around 5 per cent. This is equivalent to wiping out nearly 1 billion full-time equivalent working hours and $28 trillion in lost economic output over the next two years. That is truly unprecedented.
So it definitely worth asking the question, why are stock markets are record levels? Is Wall Street divorced from Main Street? What the hell is going on?
There are a number of reasons why stock markets are at record highs. We look at each factor below:
All assets are judged in terms of interest rates.
Lets look at an example of property as an easy way to understand how interest rates affect asset prices.
Say there is a property you are interested in buying. The amount of rent you can collect from that property is £10,000 a year.
If interest rates are at 8%, you would be more than happy to buy that property for £100,000. This is because the cost to service the mortgage is £8,000 yet you get £10,000 in annual rent. A tidy £2,000 profit.
If the interest rate was 15%, you wouldn’t want to buy the house for £100,000. The cost of servicing your mortgage (£15,000) would be large than the rent you collect (£10,000). Furthermore, why would you risk your money in property when you can invest in a ‘risk-free’ government bond and earn 15%.
At this higher rate of interest, you would only buy the property for a lower price. Thus if you want to make money from the property, you would need to buy it at £50,000 for example. That way your mortgage costs are £7,500 and the rent you collect is £10,000.
On the other hand, If interest rates were to reduce to 5%, the property at £100,000 becomes attractive as your mortgage interest would only be £5,000 so that would leave you with a cool £5,000 profit.
If interest rates were reduced even further, your profit per annum becomes £9,000. With such a high level of profit, do you still expect the house to sell for £100,000? Of course not. Investors will compete with each other and bid up the price of the property. Even if the property is priced double at £200,000, the mortgage cost would only be £2,000 and you’d still make £8,000 in profit.
So you can clearly see how lower interest rates lead to asset price inflation.
In response to the covid crises, many central banks have cut interest rates to historic lows. With interest rates at zero or negative in some instances, stocks have become the only game in town (LINK). What else are you going to invest in? Bonds. Leave in cash?
Many central banks have restarted their Quantitative Easing programmes. Quantitative Easing increases the money supply, lowers long-term interest rates, makes it easier for banks to lend, and this should spurs economic growth. The drawback to this is it leads to asset price inflation. For more information on quantitative easing, have a look at the Bank Of England website.
There has been unprecedented levels of fiscal stimulus this years. It is unlike anything we have seen – ever. Developed Europe is on life support with governments subsidising employees wages as well as providing grants and loans for businesses. In the U.S, the amount of stimulus being dolled out is close to $3 Trillion. These are crazy numbers!
The theory is that expansionary fiscal policy leads to increases in aggregate demand and employment. This translates into more spending and higher levels of consumer confidence. Stocks rise, as these interventions lead to increased sales and earnings for corporations.
With many peoples expenses virtually cut in half due to no commute costs or daily lunches, what is currently happening is akin to fiscal stimulus on steroids. I know a lot of people who had zero savings before the crises now have four and five figure sums sitting in their bank accounts.
And a lot of people are using this new found wealth to invest in the stock market . Easy to use platforms such as Freetrade have been quick to capture these new users with its slick trading app. With more investors entering the market, there is more demand and this has the effect of pushing stock prices higher.
With the high possibility of inflation coming as a result of the various policies implemented by government around the world, cash is increasingly looking like a bad choice. Indeed, the Federal Reserve in the US has indicated that it would tolerate inflation above its target range. It is worried about the fragility of the economy. When borrowing is on the scale required to provide the fiscal support which has stopped the developed world from falling into depression, there is nothing that governments would like more than a little inflation. At present, the outlook is more deflationary than inflationary but the stock market is forward looking and some are pricing in higher levels of inflation.
It is worth taking a brief detour into the underlying factors that will determine the inflationary outlook. Firstly, demographics has been an important contributor to low inflation. An increasing supply of labour, as China and other countries integrated themselves into the global economy, held down wages. Demand also fell. Thirty years after the baby boom, household formation had put upward pressure on goods pricing, and that is what we saw in the 70s and 80s. Now, 70 years after the start of the baby boom, this has reversed – older people buy fewer things.
We now appear to face the opposite of the conditions that led to the great disinflation. With aging populations across the world, you have the prospect of shrinking supply (less workers), which in normal circumstances would equal higher wages and higher prices, but the demand side complicates the picture. There are two other longer-term factors to consider. First is the effect of technological adoption and advancement, both consumer’s increasing power of price discovery allowed by technology (for example, Amazon) as well as enterprise’s reduced costs of labour and capital with increasing automation and process efficiencies. Second is the destruction of traditional industries, accelerated by COVID. Both are big deflationary forces whose full effects we have yet to understand.
This is why there is not a consensus view on inflation at present. The people who are worrying about generalised inflation in the near-term are likely to be wrong because both cyclical and secular influences point the other way. There are some other factors too, such as economic behaviour when interest rates are close to zero. Only time will tell what the future holds.
Big Companies Get Stronger During Recessions
I recently wrote a piece of how lockdowns have helped the biggest companies. Lockdowns have essentially eliminated competition that is faced by many big businesses. With many small and medium businesses shutting shop, it leaves a larger share of the pie to big business.
It can also be argued that the US market has performed extremely well due its heavy tech focus. 2020 has accelerated trends in technology. There are secular shifts of the sort seen, for example, during the depression of the 1930s, as the consumer economy started to displace agriculture. This time, it seems the shift it to the digitisation of the economy.
This has lead to an increase of the market size of many industries these companies operate in – just think about video conferences, online shopping (e-commerce), cloud computing and digital media.
While there will be some genuine new economy tech winners, investors are currently buying tech stocks for no other reason than they are tech stocks. We can already see bubbles beginning to form in some parts of the market. Only time will tell how this will play out.
And this is what we need to be extremely weary off. I’ll leave you with the following from Scott McNealy, CEO of Sun Microsystems, commenting on the tech bubble of 2000-2001:
“At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?”