Since the recession, which lasted from 2008 to 2009, the Federal Reserve has held interest rates low through Quantitative Easing. The program created demand for treasuries and mortgage-backed securities. Demand for these assets would have been lower without Quantitative Easing. Without this program, those who issue debt would have had to promise a higher rate of repayment to the buyers of those securities. The buyers of debt would have had to been compensated at a higher rate for lending money in the bond market.
The problem is that low interest rates did not spur the economy. This is because the liquidity did not reach consumers. Those who benefitted from low interest rates were those individuals and corporations that were in the position to borrow money. Apple's (OTC:APPL) bond offering last year was the largest corporate bond offering on record until it was quashed by Verizon's (NYSE:VZ) offering this year. The rationale for Quantitative Easing was that low interest rates would allow small businesses to expand their business and increase hiring.
Low interest rates dramatically lowered the cost of capital for entities in a strong position to repay the loans. The same low rates were not available to small business owners because guaranteed revenue streams were required to qualify for the advantageous terms. Without strong and sustained economic growth, the cost of capital will be significantly higher for small businesses than for large businesses. The market requires a premium when lending to entities with a lower assurance of repayment.
The low cost of capital has benefitted debt-laden companies and created the incentive for companies in a strong financial position to take on debt. The phenomenon has been typified in what are known as "momentum stocks." A company with an untested business model and revenue stream borrows heavily to fuel growth in the expectation that profits will materialize in the future. The company's share price then rises to match this expectation. The widespread phenomena can cause a mature, profitable company like Apple to borrow money and issue a dividend to investors who are considering a switch to the momentum stocks.
There has been a widespread increase in the valuation of risk assets, and assets in general, since the recession. Barron's, the weekly financial magazine, has increased commentary on the so-called "asset bubble." The increased liquidity from Quantitative Easing did not reach small business owners. Small business owners are also those with a low enough lifestyle to spend an increase in profits - as opposed to an established corporation or individual that will tend to invest the increased profitability. The liquidity was channeled to entities that could borrow cheaply, which, in turn, boosted share prices. The liquidity had to go somewhere. Instead of growth in the economy there was growth in investment. Instead of price inflation there was asset inflation.
Outlook for the Economy
The U.S. is poised to see a period of sharp economic growth until the year 2018. The increase in the birthrate from 1985 to 1990 becomes an increase in household formation (and concurrent spending) 28 years later from 2013 to 2018. The increased demand will tend to cause price inflation. Bond yields will tend to rise as investors shift away from bonds as the spread between inflation and yields increase. A negative real return is the result of holding bonds which have a yield below the rate of inflation. Increased inflation is the result of rising demand in an expanding economy.
The period of economic growth, which is set to take place until the year 2018, does not mean that growth in the stock market will match. An individual begins to invest in earnest at age 50, when children are no longer in the house and the realization of insufficient savings for an upcoming retirement becomes a reality. The year 1963 was 50 years ago. The preceding year, 1962, marked the beginning of a sharp downward trend in the number of births. This does not bode well for the stock market. Fewer people turning 50 means reduced demand for stock as an investment vehicle.
The downward trend was temporarily reversed in 1969 and 1970. The trend resumed in 1971 and continued through 1973. The upward trend in 1969 and 1970 means increased demand for stock in 2019 and 2020. Stock gains in 2019 and 2020 look especially likely because of an expected recession in 2018. The year 2018 is 28 years after the sharp decline in births that began in 1990. The decline in births means reduced economic activity 28 years later because there will be fewer households formed.
The stock market dip which accompanies a recession favors the expected increase in 2019 and 2020. A market which is already in a down trend falls even further in a recession before it rebounds off the low. The decline in the number of births after 1990 is sharp, so the recession expected in 2018 is likely to cause a sharp decline in economic activity. The pronounced decline increases the probability of the recession having a strong effect on the stock market.
There was an uptrend in the stock market from 1957 to 1959 and from 1974 to 1982. This is despite downtrends in the number of births 50 years before those periods. There was a recession at the beginning of each period. The market bounced back to end the periods higher, after each recession, when investors rushed in to buy the depressed shares. A market that is already in decline becomes an uncommonly good buy when prices fall even further in a recession. The idea is to wait for a recession in or around 2018, then enjoy a rebound off the recession low to the strength in 2020.
After the stock market gains (post-recession) into the year 2020, the bond market becomes an attractive place to keep those gains. Interest rates are set to fall from 2018 to 2025, which is 28 years after the decline in births from 1990 to 1997. The reduction in the birthrate means reduced inflationary pressure because there will be less household formation. The trend of falling interest rates will have already been in place for two years. Falling interest rates benefit the bond market because bonds issued in the past yield a higher interest rate (hence are more valuable) than a currently issued bond. It's just that, as described above, the stock market is a much more compelling investment immediately after a recession.
The year 2025 marks an opportune time to shift out of bonds and back into stocks. The need for this change is indicated by both the bond market and the stock market. The year 2025 follows 28 years after the number of births began to increase in 1997. The increase in household formation puts upward pressure on inflation and interest rates. This is a negative for the bond market because rising interest rates means bonds purchased in the past will yield less - hence be less valuable - than a currently issued bond.
The year 2025 also follows 50 years after birthrates began to increase in 1975. This means that the number of people set to turn age 50 will increase. The increasing number of people turning 50 will create rising demand for stock as an investment vehicle. The trend is bumpy but is in place from 2025 to 2040, which corresponds to the increase in the number of births from 1975 to 1990. The bumpy trend means that, in this case, the conventional wisdom holds and stock can be bought on the dips. The span from 2025 to 2040 appears as if it will be a strong upward period for the stock market. The middle section of the period, approximately from 2031 to 2035, has patchy growth.
Both the beginning of a sharp decrease in the number of births and the lowest point in the trough of a generation which is smaller than the one which preceded it, can coincide with a recession 28 years later. For instance, the recession of 1960 came 28 years after 1932, which was the lowest point in the Silent Generation. The recession of 2001 came 28 years after 1973 which was the lowest point in Generation X.
There is a possibility of a recession in or around 2025 because it is 28 years after births fell to the lowest point in Generation Y. As covered earlier in the essay, a recession in a declining market is an opportunity to buy. The onset of a recession at that time would be a dream scenario for investors. The recession would correspond with the trough in demand for stocks as an investment vehicle from Generation X. The trough in Generation X precedes 15 years of increasing demand for stock, so a recession would be an ideal entry point. The note of caution is to delay investing in the stock market until 2025, at which point, if there is to be a stock market decline, the recession should be in progress. The trend in the bond market is favorable until 2025, so there is little pressure to protect the bond investment. It is better to continue to hold the bond investment until 2025 than to get into the stock market just before a recession.
In conclusion, both the bond and stock markets are expected to decline until 2019. The bond market is set to decline because of rising interest rates and the stock market because of falling demand for investment as well as reduced Quantitative Easing. There is a recession expected in or around 2018. The stock market is expected to rise in 2019 and 2020, after the recession. In 2021, the downward trend resumes. The bond market is expected to gain after 2018, so stock market gains from the two years, which followed the recession, can be placed in bonds. In 2025, demand for stocks as an investment vehicle will rise. At the same time, rising interest rates make the bond market unfavorable. The switch from bonds to stocks in 2025 should not be done ahead of this date because there could be a recession due to decreased demand in the economy from the trough in the number of births 28 years earlier. A recession at that time would be an ideal entry point for stock investors to participate in the 15-year uptrend for stock which runs until 2040.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.