Stocks have been on quite a run for the last 5 years. Almost all the major indexes are at record highs or are pretty close. Rising stock prices should mean rising profits in the companies behind those stocks, however if you look at the economic performance over the past 5 years, it has been anything but spectacular. Incomes are stagnant except in the upper income level. Jobs creation has been meagre until recently. It’s pretty hard to justify the spike in stock prices when economic conditions are tepid at best over the same period. So for those new to the investing world or the experienced veterans, I thought I’d try to put some context into answering the question, why have stocks been going up so much?
Fortunately there is only one reason: Super low interest rates thanks to Central Bank money printing
Since the financial crisis of 2008 when it looked like the world was going to fall over a cliff, Central Banks around the world, led by the US Federal Reserve have been on a mission to stimulate economic growth and recover from the trauma of 2008. The formula has been to keep interest rates very low and in some make it cost next to nothing to borrow money. There are many ways Central Banks can do this, but the one that has used the most extensively is to print and inject more money into the market. The Federal Reserve over the past five years has been printing money non-stop and using that money to buy debt, whether it is Government debt or mortgage debt. By buying more debt, the prices of those bonds goes up and interest rate yield go down, thus keeping interest rates very low.
How Do Low Interest Rates Make Stock Prices Go Up?
There are several ways low interest rates can make stocks go up.
One way is that low interest rates make it cheaper for companies to borrow more money. Lower interest rates mean lower loan payments which will allow companies to keep more money and profit. Said another way, lower interest rates will also lower a company’s cost of capital which means when you go to value a company’s stock using a discounted cash flow process, it will be higher because the lower cost of capital allows for future profits to be discounted back to the present and increase the value of the firm.
That’s how interest rates are supposed to stimulate the economy. Low interest rates encourage or motivate companies to borrowing more to finance investments in their business to generate products and services that will create additional cash flow in the company. Low interest rates also normally encourage individuals to borrow more for consumption, however, the recent debt crisis has changed consumption habits for many individuals who are saddled from debt incurred prior to 2008. This is another topic in itself.
The core of this 5-year bull market has been driven by a low interest rate policy created by Central Banks, but it has also indirectly created several other actions that have contributed to this run up in stock prices.
Low Interest Rates Mixed In With A Little Financial Engineering = High Stock Prices
The low interest rate environment has encouraged many companies to borrow more money, however it appears they have been using that new cash for other things besides paying its workers more or buying better equipment and technology or developing new or better products. Many companies have been using the borrowed money to either back existing stock or to pay more money back to the shareholders via a dividend. Buying back stock lowers the amount of shares outstanding which then increases a company’s earnings per share and can ultimately increase demand in its stock leading to higher stock prices. Paying more dividends also increases the value of the company stock as the steady stream of income can attract more investors who are looking for more income, especially the current low interest environment where putting your money a savings account will barely get you 0.10 percent interest.
So when you take combination of low interest rates combined with some financial engineering, you create an environment for stocks to trade at premium, which is what has been happening. In fact the low interest environment has essentially made stocks the only investing game in town.
I’ve got nothing against financial engineering. Buying back stock and paying dividends are legitimate ways to increase the value of stocks. The issue is that normally companies buy back stock when management believes the shares are undervalued. Company’s pay dividends when they are generating excess profits and want to return capital back to investors. The issue right now is that companies are borrowing to buy back stock at inflated prices as well as to pay dividends even though the business may not be generating larger cash flows because business has been mediocre at best. IBM is a textbook example. The company has had flat revenue growth over the past few years, yet they have been aggressively buying back stock and paying dividends, which have enabled the firm’s profits to rise. The stock has been rising, but it is not because of improved business opportunities but because they have been playing around with financial engineering to goose up their profits.
The Future? Will Stocks Continue To Go Up?
The big question for investors is given what we’ve seen in the past 5 years, can stocks continue to go up? Again the answer comes back to whether the Central Banks will continue with their low interest rate policy. If the Central Banks continue to keep interest rates low, then the conditions outlined above will still be in play and stocks could continue to go up. It appears that is what’s happening right now. There have been many geopolitical events this year, but they really haven’t made much of a dent in stock prices. Central Bank money printing continues to carry the day.
If the opposite happens and interest rates increase, then many of these outcomes will unwind. Stocks will come under pressure. Many, including myself thought that when the Federal Reserve began its program of slowing down or “tapering” the rate of bond purchases, that stocks would pull back. Hasn’t happened yet as the reality is they are injecting money into the system just not as much of it. The turning point will come when they raise interest rates. It’s anyone’s guess. Some think it may be later this year or maybe in the middle of next year. One thing is clear. Low interest rates are creating great distortions in asset prices. They can’t stay low forever.
The stock market has become a game of musical chairs. As long as Central Banks keep interest rates low, stocks will hold their own and some. The decision investors face is what to do in anticipation of when the music stops.