Now that the US stock market is at an all time high, you might be wondering when is this mania going to end? It’s been about 10 years since the great recession of 2007. When I see the market tick higher and higher every day, I feel as if people have forgotten that bear markets do exist.
The reason the great recession ended is because there was a big surge of credit expansion – Quantitative Easing (money creation) and government spending. Moreover, the US Federal Reserve dropped the interest rates to zero. So, during this Quantitative Easing (QE) and zero interest rate environment, the Feds would lend money to banks and then banks would lend money to business and consumers at little to no interest rates. Hence, making the loan more or less “interest free”. This incentived individuals and businesses to borrow more money, since they only have to pay back the principal. With more money circulating in the economy, businesses started hiring people, people would start making more money, individuals would spend more money, and the cycle goes on. After injecting $4.5 trillion dollars in the US Economy, the Feds ended QE program in 2014. Credit creation and consumption caused growth. That’s how the United States got out of the great recession.
In the recent months, the US Federal Reserve has started to tighten by slowly raising the interest rates. What does this mean? That “interest free” loan that I mentioned earlier is no more “interest free”. In other words, businesses are not going to borrow more money, since they would have to pay interest on loans now. This is when the bond prices drop and bond yields start looking more attractive than the risky stock market. The Feds are indirectly telling investors to take money out of the stock market and invest in something “safe” such as government bonds. Thus, raising interest rates shrinks the economic growth.
Fortunately, even though the Fed’s monetary stimulus might be slowly fading away, congress has injected a little fiscal stimulus by taxing us less. By taxing us less, the government leaves more money in our pocket. We would be using the excess money by buying goods and services, which helps people stay employed and aids in economic growth. Additionally, congress will also be taxing businesses less, which means that business have more money left over. That money can be invested in building factories, hiring workers, ramping up manufacturing, or even buyback shares. So, even though the Fed might be tightening and warning the investor to be wary of the stock market, the Congress has stepped in with fiscal stimulus.
Now coming to the main question, why does the market keep going up? That $4.5 trillion dollars that the Federal Reserve had lent out to banks had to go somewhere. Sure, the banks gave most of the money to big businesses, small business, and average Joe. The question is where did that money that was in the hands of businesses and average Joe go? Could it all have ended up in the stock market? What do you think? With the reduction of business taxes, and companies buying back their shares, do you think the entire stock market might be in a bubble?
I believe that once interest rates (bond yield) increase to about 4%, the stock market would curtail. Intelligent investors would pull their money out of the “risky” stock market and put money in “safe” bonds. However, will the stock market be able to keep running higher until the bond yields get to about 4%? As far as what I can tell, stock market remains jittery and uncertain about the future. Now might not be the best time to get into this aging bull market. As Warren Buffett says, “Be fearful when others are greedy, be greedy when others are fearful.”
It is probably wise to sit tight with your hard earned cash right now. To all my friends who get uneasy when they don’t have their cash invested somewhere, I leave you with some advice from Charlie Munger, “It takes character to sit there with all that cash and do nothing. I didn’t get to where I am by going after mediocre opportunities.”
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Marvelous analysis of QE, interest rates, cash flow and markets. One major point which affects the rise and fall of share market is FI (foreign investments) over all learnt something from this. Thanks.
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Thank you! That’s a good point. Next blog’s topic will be how foreign investments affect US economy.
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Thanks for interacting buddy,
Add one more aspect which affects share markets, if you are interested
is Institutional investments (Life insurance companies etc.)
In India at least they play a major major role (FI and LIC)
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