In late October, Harvard economist and former head of President Reagan’s Council of Economic Advisors, Martin Feldstein, laid out a scenario for a substantial decline in the United States stock market.
The picture he drew was one of rising interest rates.. Mr. Feldstein perceived the yield on the 10-year US Treasury note rising to 5.00 percent or more.
At the time, I felt there was little reason to argue with his story.
To Mr. Feldstein, the consequence of the rising longer-term interest rates was a following drop in stock prices.
Well, over the past month or so, the scene has changed.
There may be a decline in the US stock market in the future, but the fall may be for entirely different reasons.
And, the question follows, does today’s large drop in stock market prices anticipate a further fall that might be more than just a correction in the level of the stock market?
Some, including myself, have argued that the US stock market is over valued. After nine years or so of easy monetary policy, a policy specifically aimed at “goosing up” stock prices so as to create a wealth effect to generate more consumer spending, which would underwrite the economic recovery, the US stock market has produced levels that seem substantially out of line with corporate earnings.
For example, the Cyclically Adjusted Price Earnings (CAPE) measure, created by Yale economist Robert Shiller in July 2018, touched a level, 33.31, that was higher than the level reached in September 1929, just at the beginning of the stock market crash that was connected with the Great Depression.
The CAPE measure has dropped off a little since then; it came in at 30.57 in November 2018, but even this was substantially above the mean for the series, something that the CAPE measure always reverts to over time.
Note, CAPE says nothing about the timing of when the measure will revert to the mean again…just that at some time, CAPE always returns to its mean.
So, the question is, when will CAPE drop to return to its mean…and, what will be the thing that starts off the cumulative drop?
Well, Mr. Feldstein had a view on what might start off the cumulative drop in stock prices…although he could only argue that the move would come over the next year or two.
Well, the bond market is now presenting us with another picture of why stock market prices might drop. And, they have nothing to do with rising interest rates.
In fact, this picture of a stock market collapse is associated with falling longer-term interest rates.
Over the past month, the yield on the 10-year Treasury note dropped from its near term high of about 3.25 percent, and has fallen to close at just over 2.90 percent on Tuesday, December 4.
The fall in the 10-yield bond yield, as I have tried to explain, has been centered on the market’s falling expectations for inflation.
Furthermore, as officials of the Federal Reserve System have indicated that they will continue to raise the Fed’s policy rate of interest in December 2018 and possibly three more times in 2019, although they have indicated that they will be careful about moving too rapidly to move rates next year.
But, with short-term interest rates rising and long-term interest rates falling, the term structure of interest rates has gone almost completely flat and has even inverted for some maturities. This, in the past, has served as a sign that a recession is nearing.
Three causes have been identified as impacting the term structure. First, over the past two months or so, the price of oil has been declining…and, by more than 30 percent. The short-run cause is an oversupply of oil in world markets.
The argument goes that this decline in oil prices has broken inflationary expectations and so have caused the yield on the 10-year Treasury note to fall.
The second concern has been the state of economies throughout the globe. After a pretty robust start to the year, economic growth has been seen to be softening almost everywhere, leading to feelings that the global economy will not be very strong in 2019 and possibly 2020.
This would mean that oil prices would stay near current levels or even decline further. This outcome is seen as seriously hurting energy companies that have over-borrowed during times of very low interest rates. The declining oil prices could result in serious financial difficulties for the energy firms and even cause the debt problem to “radiate” out into other markets.
A spreading financial market disequilibrium could further impact economies that were already working in stressful conditions and accelerate global problems.
And, with US interest rates still below “normal” historical levels and with the Fed’s balance sheet still pretty full of government and mortgage-backed securities, the Federal Reserve is seen as being limited in its ability to respond to another financial crisis.
The federal government is not in any better shape as the current fiscal efforts of the current administration have resulted in an out of control budget scene that would limit what Washington, D. C. could do in terms of providing any fiscal relief to an economy needing help.
A third factor is playing into perceptions of the financial markets and that is the looming possibility of a trade war, especially between the United States and China. The stock market responded positively to Mr. Trump’s assessment of his meeting with President Xi of China at the G20 meeting on Saturday. However, when it became obvious that Mr. Trump had obviously over-played his comments on what he and Mr. Xi had accomplished, the market moved dramatically in the other direction.
Trade wars cannot be eliminated from this picture along with the “disaster” known as Brexit in the UK and the fiscal mess that exists in Italy. There are lots of financial and debt issues on the table that could contribute to economic dislocations in the new year.
All these things could contribute to a growing stock market problem in 2019.
Just don’t lose sight of the bond market in 2019 because it contains a lot of information that is relevant to what happens in the stock market in 2019.
Disclosure: I/we 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.