Earlier this year, the stock market experienced some major volatility as two days within a matter of weeks saw the leading stock market indices drop by more than 4%. However, since these significant drops, which were attributed to a correction in the market, the stock market has rebounded and continued its growth from the second half of 2017. In fact, in the past couple weeks, the stock market has been routinely setting all-time highs. Despite the market strength, it is very likely that this strength is not an evidence of a strong economy, but rather, evidence of an economy on the verge of another bubble.
Based on financial and market research, experts have noted that cheap credit and low interest rates are the leading causes of economic bubbles. Low-interest rates and cheap credit help create the bubble in a variety of ways. They allow investors to borrow money at a cheaper rate, and in turn, invest in properties or achieve low margins on stocks. Secondly, they make it cheaper to borrow, which also makes it cheaper for companies to buyback stocks, increase dividends, and possibly even consider a merger or acquisition. Third, these two factors contribute to individuals and companies investing in riskier assets versus holding their assets in the form of cash. Cheap credit and low-interest rates also lead to higher inflation rates, which further contributes to holding assets in stocks and real estate, which achieve larger capital gains than cash in a high inflation environment. Finally, similarly, to making borrowing cheaper, these two factors really encouraging borrowing as a whole for individuals, governments, and businesses alike.
Looking more at the numbers, it is clear that interest rates are trending towards a record low. To analyze the numbers more, experts and investors utilize a number of measures as models. The Taylor Rule is a model created by economist John Taylor, which helps to estimate the best level for interest rates. When there is a high risk for bubbles, the Fed interest rate will be much lower than the Taylor Rule Model. Over the past seven years, Fed Fund rates have been significantly lower than Taylor Rule Model. The difference between the two is comparable to what it looked like during the housing bubble.
Another measure used is the total outstanding corporate debt in comparison to the GDP. High level of the ratio shows that the economy is in a bubble. Currently, corporate debt account for 45% of GDP, a mark that is higher than both the Dot-com Bubble and Housing Bubble. As mentioned earlier, US corporations have been using much of their borrowed capital to buy back their own stock, increase dividends, and fund mergers. Although these activities appease shareholders short-term, this view shows that they may not be the most beneficial approach for the long-term.
Lastly, let’s take a look at quantitative easing. Quantitative easing is the process by which the Federal Reserve creates new money and then uses it to buy bonds or assets. More than that, quantitative easing causes stock prices to surge. The Federal Reserve’s assets have continued to rise due to quantitative easing and so has the stock market.
These models, tools, and methods all show that there is a bubble in the market. While it is unclear when that bubble will pop, one thing is certain, the bubble will pop.