How Long Can Stock Prices Stay Up?

Includes: DIA, IWM, QQQ, SPY
by: John M. Mason


More talk on stock market bubbles.

Will rising longer-term interest rates be the catalyst to break the bubble?

Or, will continued foreign flows of funds into the US postpone further the rise in rates?

As I mentioned in my post yesterday, "It seems as if there is a growing concern over credit bubbles these days."

Well, today I found about five articles in the New York Times, the Financial Times, and the Wall Street Journal that mentioned or discussed the possible existence of a credit bubble.

Michel Mackenzie, for example, writes about "Bull Run Stretched and Primed for a Fall" in the Financial Times. He begins, "Keep calm and carry on being optimistic has worked very well for equity investors since the financial crisis."

"Thanks to the rise in US equity and housing prices last year, the net worth of households is now close to its 2007… US households have never been wealthier, in US dollar terms or adjusted for inflation."

He continues, "Such a recovery in household wealth alongside conventional equity valuations suggesting that at a minimum, the US market is fully valued, should worry investors that the bull run is becoming very stretched and primed for a fall."

Mackenzie understands that although it may be true that "the US market is fully valued" it is next to impossible to forecast when a market correction might take place. He writes, "Except few see a catalyst for a big drop, let alone a standard 10 percent correction, in the broad market looming anytime soon."

And, people have argued that the US stock market has been overvalued for a relatively long time. The Nobel prize-winning economist Robert Shiller has seen his leading indicator, the Cyclically Adjusted Price Earnings measure, CAPE, indicate an overvalued stock market for a couple of years now. But, Shiller argues that even though the CAPE measure indicates that the stock market may be overvalued, that it can take a very long time for the market to actually adjust to the situation. And, especially with the Federal Reserve still pumping billions of dollars into the banking system, the stock market may continue to maintain the altitude it has recently reached.

Analysts are now looking for the catalyst that will send the market downwards. For example, A. Gary Shilling fills his contribution to Bloomberg yesterday with a list of possible things that could become the spark that sets off the stock market into a downward movement.

Mackenzie, himself, seems to be contemplating catalysts. He mentions just one in his writing published today…rising interest rates.

He believes that recent data imply faster economic growth. "The danger, however, is that a stronger pace of growth will result in higher interest rates, a prospect the bond market is already preparing for."

In fact, the bond market has been preparing for higher bond rates ever since last summer as it became obvious that the "risk averse" monies that had fled the European continent because of the financial difficulties faced there, were now returning to the continent and were causing longer-term interest rates in the United States to rise. Here is just one of my posts on the issue.

As these longer-term interest rates rose, there was never a question about whether or not the rates should rise, the question was always about how high they would go…and how quickly would they get there.

For myself, I believed that longer-term interest rates should rise, the yield on the US Treasury bond going up to 3.50 percent or 3.75 percent in 2014 and then proceeding to up into the 4.00 percent to 4.50 percent range in 2015. This rise includes little or no anticipated increase in inflationary expectations, which are around 2.20 percent at the present time, during this rise.

But, as readers of this blog know, I have been concerned about credit bubbles and rising interest rates for a long time. For example, here is a post from October 2012. And, one from December 2010.

What I didn't see at these earlier times was the massive flow of funds from Europe into US financial markets. These flows resulted in the yield on the 10-year US Treasury Inflation Protected Securities (TIPS) dropping below 1.00 percent in early 2011, just after my earlier post and dropping into negative territory in early 2012. The yield on these 10-year TIPS remained in negative territory until the middle of June 2013.

With all these funds flowing into the United States along with the quantitative easing on the part of the Federal Reserve it was understandable to me that, as Mackenzie writes, "keeping calm" and continuing to "carry on being optimistic"…"worked very well" in terms of the stock market continuing on it way with little or no threat on the horizon of longer-term interest rates rising.

The S&P 500 stock index broke its record of 1,553 on March 13, 2013, the old record being attained on July 19, 2007. The peak before this came on September 1, 2000 and was at 1,521. The S&P 500 is now almost 21 percent above the old record with its peak coming last Friday at 1,878.

But, when will longer-term interest rates rise to the levels I believe that they will hit in 2014? That is the question.

I thought they would be higher now but we first got hit by a rush of money coming back into the United States in the fall of 2013. The yield on the 10-year Treasury almost closed at 3.00 percent on September 5. But, this "rush of money" resulted in this yield closing at about 2.50 percent on October 23. Then the rise began again with the Treasury yield closing above the September number at 3.04 percent on December 31. Then as the Fed's tapering of purchases began in January, money from investors that had purchased emerging markets securities flowed into the United States and on March 3, the yield on the 10-year Treasury closed around 2.60 percent.

Today, the 10-year Treasury closed to yield in the upper 2.70s.

As Mackenzie has suggested, rising longer-term interest rates could be the catalyst that "tips" the stock market from around its current peak…resulting in a correction of its overvalued state.

Then again, the United States could get hit with another flow of "risk averse" money that would postpone longer-term interest rates from rising in the near future.

I still believe that longer-term interest rates will rise…in something like the pattern mentioned above. And, rising interest rates could cause a reaction…it could cause an adjustment of the credit bubble. As Mackenzie closes with the statement "equity markets do not fare well when bond traders challenge the Fed and pull forward the start line for rate rises."

Calling the timing is always a difficult task. Who would have forecasted all the international capital flows that we have seen over the past three years and who could have forecasted the impact these flows would have on longer-term US interest rates.

But, as Gary Shilling suggested…there are a long of other things that might prove to be the catalyst. Interest rates are going to rise…but exactly why…and exactly when…is a mystery.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.