Why are we so taken with Greenspan’s words?
We’ve been hearing an increasing amount of talk of “how high” the market is right now. And seemingly, that perception is accurate. But by what standards do we make this assumption? Based on historical valuations, it’s not difficult to arrive at this conclusion.
Three elements can be viewed as major factors fueling the “bull run” in the market. First, let’s look at new money coming into the market. As our industry has educated the general public, more and more people are investing in mutual funds within their retirement accounts. This strong flow of cash into the stock market has increased demand for equities over the years. Money managers are compelled to buy as additional dollars flow into their mutual funds.
Second, low interest rates have been a wonderful backdrop against which companies can achieve profitability. Having low interest rate payments on existing loans frees up cash for other uses. Additionally, a business can borrow money cheaply to expand existing operations. As a company successfully executes its business plan, the value of its stock presumably appreciates in value.
Third, we have seen a lack of attractive alternatives to investing in the stock market. Granted, bonds–with the low interest rate/low inflation environment–have done very well. But most will agree that the future is built on equity, not debt. The unusually attractive returns and the usual liquidity of the stock market has drawn millions of new investors to participate.
In a nutshell, these are three very basic reasons for the market’s tremendous run-up. Can all of these factors continue to provide resilience? What would it take to shake the confidence of the investing public? And, if shaken, how would investors react? Obviously, the scope of change in the status quo would determine to what degree investors would react negatively.
With interest rates at historically low levels, the attractiveness of the market becomes increasingly apparent. A low interest rate environment compiled with corporate America’s ability to grow its earning (increase profitability) has been nirvana. Corporations have successfully restructured to become more efficient, low-cost producers. Although somewhat unable to raise their margins via price hikes passed onto the consumer, the low interest rate/low inflation background has assisted in the quest for profitability.
At the very least, if interest rates begin to rise, you can reasonably expect an adverse reaction in the stock and bond markets. Perhaps the most significant catalyst for the market’s success would at best be weakened and at worst eliminated. It would follow, then, that the degree of the adverse reaction relates directly to the level of an increase in interest rates or inflation.
It is here that Chairman Alan Greenspan’s testimony comes into play. Currently his focus appears to be on wage pressures, as low levels of unemployment mean a smaller pool of potential employees.
If Greenspan sees evidence that the strong economy and wage pressures may produce inflation pressures, he will surely move to slow our economy. By raising interest rates upward, he would hope to stem the tide of rising inflationary pressures.
In so doing, one of the most (if not the most) significant factors fueling the tremendous run-up in the stock market could be considerably weakened. With higher interest rates in place, corporations would likely find it more difficult to increase profitability (grow earnings), especially if competitive pressures prevented one from passing on price hikes to customers.
Depending upon the level of interest rates, investors could determine that interest paid on fixed income investments (bonds, CDs, etc.) as sufficient given the increased level of short term stability.
Psychology plays a significant role in the greed/fear battle of investors. Do you know where your own psychological levels are? If you do, then you probably have already formulated a game plan for a rise in interest rates and the effects that it would likely bring.
Keep in mind that all of this musing over the level of the market is for a short-term perspective. Yes, it may be all very interesting and exciting. But in reality, if your personal situation encompasses a time horizon of at least five years, you probably have more worthy concerns assuming you have a sound approach to your investments in place.
Buz Zamarron is vice president/financial consultant at Roney & Co., member SIPC and NYSE. Roney’s Traverse City office is at 522 E. Front Street. BIZNEWS