Investors lost their compass
Since March, stock markets around the world have been on the rise again. The rally has been going on for more than three months now and leads to many people’s surprise and sometimes even disbelief. How can this rally be reconciled with the severe economic crisis and the resurgence of cases of infection with the virus, especially in the United States? The very broad monetary policy of the American central bank — the Federal Reserve — and other central banks worldwide is the main driving force behind this rally. Not only are interest rates kept at historically low levels, but central banks are also buying up huge amounts of bonds, mortgages, and other securities. In fact, just like in Japan there is also yield curve control in the United States. The low-interest-rate is increasingly driving investors to the stock market.
There Is No Alternative
There is no alternative is the motto. Due to the low-interest-rates, there is no alternative left for investment in equities. A savings account is no longer profitable and in some countries even costs money. An investment in bonds also no longer contributes to any form of wealth accumulation. It is then not so strange that more and more investors are finding their way to the stock market. The Federal Reserve recently made it clear that it does not intend to raise interest rates in the coming years. In fact, they’re not thinking about it. The low-interest-rate should be a stimulus for the economy, but for the time being the money flows seem to end up on the financial markets.
The rally has pushed the prices far higher. It can be heard everywhere that shares have become very expensive. For example, the ratio between the Nasdaq 100 index and the S&P 500 index has risen to 3.28. For the record, that is an equation of this ratio from the illustrious year 2000. Everyone knows what happened to the technology funds afterward. The Nasdaq 100 has never rallied more than 45 percent in three months since the glorious 1990s. Are shares expensive? The valuation of an asset class is always relative. Compared to bonds, for example, equities are certainly not expensive. The profit return of the S&P 500 is currently 4.6 percent. Compare that with the return on a 10-year government bond in the United States of 0.63 percent. Or with the Fed Funds Rate of 0.08 percent. Compared to these alternatives, equities may even be spotty cheap.
However, this is one side of the coin of broad monetary policy. There is another side. Professional investors such as insurers and pension funds, in particular, have such large sums to invest that good diversification is necessary. For example, a spread across shares and bonds used to lead to a reduction in risk. When economic conditions were less favourable, share prices fell, but so did interest rates. As a result of falling interest rates, bond prices actually rose. As a result, the loss of equities was partly offset by a profit on bonds. However, the historically low-interest rate seems to have put an end to this negative correlation. The interest rate on bonds is so low that they start to behave like equities. Equities and bonds are increasingly moving in the same direction.
Different risk management
If you are a private investor and you are fully in shares, you do not have an immediate problem. But think of insurance companies and pension funds that have generally invested more money in bonds than shares. Because of the low-interest rates, their risk management has suddenly become very different. Market risk has risen sharply. TINA makes these investors a floating boat on a wild ocean. There is something else on top of that. Because the only way to price risk was always to set one risk against the other. After all, every risk is relative. The valuation of equities could only be determined when compared to, for example, bonds or savings interest. When shares were cheap compared to bonds, you bought additional shares. Conversely, you sold.
The historically low-interest rate or the absence of a ‘natural’ interest rate curve has meant that there is no longer any method of pricing risk in the market. In other words, there is no longer a decent word to say whether equities are expensive or cheap. Investors have lost their compass with the de facto abolition of interest rates. That is worrying. After all, stock exchanges are currently nothing more than a large Titanic, sailing in a thick fog. Where does this end?