Once again, the market has hit new highs. At this point, that may sound like old news, but yesterday was special: All three major U.S. indices closed at new highs on the same day. That hasn’t happened since December 31, 1999.
Even with the mid-2000s boom and the stock market run since 2009, not once have all three indices hit highs at the same time. Only in the biggest bubble of the past 70 years has that happened. And now it's happened again.
Prices soar as fundamentals decline
What makes this particularly striking is the simultaneous decline in fundamentals. Earnings are down, so valuations are up. In fact, we’re seeing the same kind of broad expansion in valuations that we saw during the dot-com bubble. Investors are willing to pay more now than they (almost) ever have in the past.
The reason is different this time, of course. Last time, expanding valuations were based on universal optimism, the idea that the new economy would change the world and result in endless prosperity and higher profits. The world did change—Amazon now owns the retail market, for one—but the higher profits didn’t prove out.
This time, higher valuations aren’t based on optimism about the economy but on interest rates. Markets don’t believe in the Internet any more; now they believe in central banks, which are changing the world by keeping rates low.
Signs of an interest rate bubble
I wrote the other day about a potential bubble in interest rates. One of the characteristics of a bubble is a phase at the end when prices suddenly move sharply as investors pile in. We are seeing signs of that around the world and here in the U.S., as central banks dial up the stimulus. We may be in the blow-off stages of an interest rate bubble, or at least getting close.
One sign of that could be rising prices for bonds and stocks at the same time. The two normally move in opposite directions; good news for bonds is usually bad news for stocks. Not now. Lower rates drive bond prices higher, and a good part of the publicly accepted rationale for current stock valuations is low rates.
Think about that for a minute: low interest rates mean stocks should be worth more. Mathematically, this is unarguable, but let’s consider the underlying reality. The reason rates are low is because economies are weak. Weak economies mean low growth. Low growth means low earnings growth for companies in aggregate. Low earnings growth has always meant low stock valuations. See the contradiction?
In math, one way to prove an idea false is to assume it’s true and then run through the consequences until you hit a contradiction. The stock market is not a mathematical exercise, but the contradiction we just reached should show how problematic it is to rely on low interest rates as a justification for current valuations—specially given that rates will certainly rise at some point.
Where are rates headed?
From where we are now, there are two paths for interest rates.