Thursday, May 16, 2013

Is There a Bubble in U.S. Stock Prices?

Since the Federal Reserve’s Quantitative Easing programs (QE) were launched in October 2008, the stock market, as measured by the Dow Jones Industrial average, has soared by 10.9 percent, compounded annually.

During this same period of time, U.S. GDP expanded by 2.4 percent, wages and salaries advanced by only 1.4 percent, employment climbed at a pace of less than 0.1 percent, and profits increased by approximately 7.6 percent (all compounded annually). The soaring stock price growth, compared to these other economic benchmarks, has forced investors to wonder if the stock market has come too far too fast.

Stock price growth depends on three factors, all which swung in the direction of higher stock prices: 1) higher profits, 2) lower risk free interest rates (U.S. Treasuries), and 3) lower risk. It can be argued that the prime factor driving the stock market higher has been record low interest rates generated by the Fed’s aggressive monetary expansion led by its three bond buying programs, termed QE1, QE2 and QE3.

These programs have pushed rates into record low territory with the 10-year U.S. Treasury yield (interest rate) hovering around 1.8 percent. The rock bottom yields have incentivized investors to abandon safe, low yield investments such as certificates of deposit and money market funds and to embrace higher risks, higher yielding stocks.

My “back of the envelope” calculations indicate that if the Fed allows rates to rise by as little as one percent, the Dow will decline by as much as 6.0 percent assuming profits and risks unchanged. Should rates rise back to their pre-QE1 level, the Dow will slump by 12.7 percent.

Thus, investors need to be on guard for unexpected rate hikes or upturns in risks such as a European debt eruption. Both changes would put downward pressure on stock prices taking air out of the Fed inflated stock bubble.

So is there a bubble in U.S. stock prices?  Not as long as interest rates remain at record lows

Ernie Goss

1 comment:

Jack Heidel said...

Many people expect stock market prices to fall as the Fed withdraws from quantitative easing but I haven't seen percentage estimates before. This is very interesting!