How Supply in the Bond Market Is Inflating Stocks

Investors are stuck between a rock and a hard place. At the same time that bonds are offering historically low yields, stocks are trading for a healthy premium over their 60-year average. According to the most widely cited estimate, the current premium on the S&P 500 (SNPINDEX: ^GSPC  ) is upwards of 24%.

Given the sluggish economic recovery, what's causing asset prices to inflate?

The obvious, though incomplete, answer is that there's been an increase in demand for debt securities from the Federal Reserve. Since the fourth quarter of last year, the central bank has purchased $85 billion each month in long-term treasuries and agency mortgage-backed securities. The effect has been to hold long-term interest rates at their current low levels -- indeed, had you told someone 10 years ago that the yield on the 10-year treasury would go below 2%, they would have called you crazy.

The Fed's actions are also a proximate cause for the recent ascent in equity prices. The connection here was discussed by Warren Buffett in a famous speech he gave at the height of the dot-com bubble (if you've never read it, I strongly encourage you to do so).

[Interest rates] act on financial valuations the way gravity acts on matter: The higher the rate, the greater the downward pull. That's because the rates of return that investors need from any kind of investment are directly tied to the risk-free rate that they can earn from government securities. So if the government rate rises, the prices of all other investments must adjust downward, to a level that brings their expected rates of return into line. Conversely, if government interest rates fall, the move pushes the prices of all other investments upward. The basic proposition is this: What an investor should pay today for a dollar to be received tomorrow can only be determined by first looking at the risk-free interest rate.

Consequently, every time the risk-free rate moves by one basis point -- by 0.01% -- the value of every investment in the country changes. People can see this easily in the case of bonds, whose value is normally affected only by interest rates. In the case of equities or real estate or farms or whatever, other very important variables are almost always at work, and that means the effect of interest rate changes is usually obscured. Nonetheless, the effect -- like the invisible pull of gravity -- is constantly there.

What Buffett is implying is that stocks and bonds are substitute goods. If one gets too expensive -- say, bond yields goes down (and, thus, bond prices go up) relative to stocks -- then investors will substitute away from one in favor of the other, and vice versa.

Not coincidentally, the chairman of the Federal Reserve Ben Bernanke touched on this issue in a recent speech about the bank's stepped-up efforts to monitor the financial system. "In light of the current low interest rate environment, we are watching particularly closely for instances of 'reaching for yield' and other forms of excessive risk-taking, which may affect asset prices and their relationships with fundamentals."

Adding to this substitution effect is leverage, which acts as an accelerant in the demand for stocks. Take a look at the chart below, which shows the amount of margin debt used to buy equities on the New York Stock Exchange. As you can see, there have been three distinct periods of excessive leverage over the last 15 years, all of which correspond to periods of inflated stock prices: the dot-com bubble, the housing bubble, and today.

But, again, even this should come as no surprise to investors. Just last week, The Wall Street Journal published an article titled "Investors Rediscovering Margin Debt." As the author noted, "In March, the level of margin debt stood 28% higher than one year earlier, a time frame that saw the [S&P 500] rise 11.4%."

What I'm getting at is that there's more to this story than meets the eye. That is, the pressure on asset values is not limited to the demand side of the equation; there are issues on the supply side as well.

As the following chart shows, between 1981 and 2007, the size of the overall bond market (which includes the aggregate outstanding value of government and corporate bonds as well as multiple types of asset-backed securities) grew at an average rate of 10% a year. Since the financial crisis, however, the growth rate has slowed to an average of only 3%, as banks such as Goldman Sachs (NYSE: GS  ) , JPMorgan Chase (NYSE: JPM  ) , Morgan Stanley (NYSE: MS  ) , and Bank of America (NYSE: BAC  ) have ratcheted back the production of private-label asset-backed securities.

The deceleration in growth is even more interesting when we look at the absolute dollar values at issue. Since the beginning of 2008, the total value of outstanding bond market debt has increased by $3.5 trillion -- no small amount, to be sure. But over the same time period, the Fed's balance sheet has expanded by nearly $2.5 trillion – and it's done so through the purchase of securities in the bond market. The central bank, in other words, has absorbed the equivalent of 71% of all new bond issues. If you net this out, that leaves an adjusted annual growth rate in outstanding bonds of less than 1%, or roughly a tenth of the analogous rate over the preceding two and a half decades.

The point is this: While there's no question that the Federal Reserve is stoking the proverbial flames when it comes to stock prices, the financial industry also shares some of the responsibility, as it controls the pipeline of securities that reach the market. So long as the demand for substitutable securities (i.e., stocks and bonds) continues to exceed the supply, there's no reason to think that either will descend from their current heights.

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 17, 2013, at 8:54 PM, CatchTwentyTwo wrote:

    You nailed it! I am really impressed, I've discussed this with my colleagues countless times and your conclusions fall right in line with us.

    Now comes timing the bubble, with QE still going strong the good times will continue to roll, but the question is will the end of QE be the end of the good times? I personally believe that we will experience a dip with the end of QE but that will not burst the bubble. The Fed has set 2016 as the time when they will allow interest rates to rise and boys, that is when we will see the bubble burst.

    Let the good times roll.

  • Report this Comment On May 17, 2013, at 9:27 PM, harmonyjoe wrote:

    If the Federal Reserve has contrived Quantitative easing all these years only to let everything crash into a heap in 2016, what was the point? Admittedly things don't always end up the way they are planned, but I have to believe the Feds have figured out by now that the economy has to be eased into higher interest rates, and also how to do it. If not what's been going on these last five years was just a wasted effort.

  • Report this Comment On May 17, 2013, at 11:37 PM, TMFDiogenes wrote:

    Interesting stuff, John

  • Report this Comment On May 18, 2013, at 3:34 AM, dxgmmpa wrote:

    I maybe wrong but I believe that Goldman Sachs changed its chart to a National Bank at the start of the banking crisis. This subjected it to government regulation and leveraging limits of all national banks. That is when Buffet put up $10 Billion in exchange for convertible preferred GS stock @ $115/share. Before the Financial crisis Goldman was trading at around $215. Current value:Goldman Sachs Group, Inc.

    NYSE: GS - May 17 4:01pm ET 158.18

    Why is Goldman a screaming buy?

  • Report this Comment On May 20, 2013, at 11:25 AM, SkepikI wrote:

    "Investors are stuck between a rock and a hard place"... Nope. Someday soon, yes indeed as the supply of good companies at 10 or 12 P/E and 3% yield dry up, but not yet.

    Furthermore, while I agree with your premise, AND congratulate you for a very informative and worthy think piece, I also believe Bond owners are not now being compensated for the downside price risk they are taking at these current low yields. Which is why I own no bonds until yields come up...likely when Bernanke stops oppressing yields. Possibly when the rest of the investors realize the fearsome risks (price declines) they are running.

    Lastly, I would suggest you look at the lack of issue (supply) in another possible light. At these low rates private parties should be scrambling for debt and debt retirement...I wonder if the lack of demand for private (non-treasury) debt is the real culprit here, after all, the Fed wont buy it will they? If the rest of the investors are turning up their noses and Goldman et all CANT sell these low rate bonds because no one wants them (due to the fearsome price risk) THAT would explain less supply too....

  • Report this Comment On May 20, 2013, at 7:22 PM, dsciola wrote:

    John,

    Interesting take, but beggin ur pardon, I dont get ur point.

    Your article is titled 'How supply in the bond market is inflating stocks'...Yet ur conclusion, I believe, reads 'So long as the demand for substitutable securities (i.e., stocks and bonds) continues to exceed the supply, there's no reason to think that either will descend from their current heights.'...

    So then are you basically concluding that given all the above facts, stocks and bonds should both continue upwards? That seems quite contradictory to the article's title, in my opinion.

    Please correct me if I'm wrong here on what you're saying...allow me to add a few observations of my own...

    1 - Rather ironic Buffett quote. I would agree with his assessment that bonds and stocks are somewhat substituble goods, but probably not as 'much' as I think he indicates in his quote...a 60+ retiree needing income won't substititute stocks for bonds just because bonds are expensive, in my opinion.

    Granted, I'm just a 20-ish college grad, so my opinion may be quite null in that example :)

    FWIW, Buffett also appears to be quite confident in the Fed / Bernanke's ability to wind-down QE, per his recent Annual Omaha Meeting.

    2 - Don't expect a 'Great Rotation' from richly-priced bonds to stocks...some commentators have argued that investors will eventually 'Rotate' from bonds to stocks, thus buoying equities further...If the Fed is accoutning for 70% of all bond purchases and real bond supply growth is only 1%, then in reality there are no real investors to 'Rotate' out of bonds to stocks...unless Bernanke wants to pad his personal portfolio soon.

    3 - Investors are definitely clamoring for yield in my opinion. Data I've come across tells me that major PE firms / institutionals are seeking alternative yield-producing securities, such as rental income. See below Housel article for further thoughts, links, etc. As for LT consequences, not really sure how that will play out.

    http://www.fool.com/investing/general/2013/04/30/whats-this-...

    4 - What do you mean by, 'the current premium on the S&P 500 (SNPINDEX: ^GSPC ) is upwards of 24%.'...do u mean the current p/e multiple on the S&P is 24x?

    Your thoughts? Am I missing some brilliant conclusion / insight per above? Seems there's a quite a few things someone could draw from or argue based on ur piece...e.g. if bonds supply is artificially inflated by the Fed then really what will happen when QE unwinds is a 'Great Rotation' into bonds out of stocks, not other way around as I previously mentioned.

    Thanks,

    Dom

  • Report this Comment On May 25, 2013, at 4:27 PM, crca99 wrote:

    Some of this logic has gone over my head. If you have time in a future article, help us/me understand...

    If the government buys 71% of what the government issues, what's the point?

  • Report this Comment On May 25, 2013, at 4:38 PM, ChrisBern wrote:

    Good article. When the Fed buys $85B/month of ANY security, we must all remember that is suppressing the overall supply of purchasable securities by $85B/month. Point? They will eventually have to stop these purchases, which will necessarily increase the supply of purchasable securities. What happens when supply increases? Prices decrease of course. Which for bonds means yields (rates) will go up. What happens to corporate profits and consumer spending when rates go up? They decrease of course. What happens to stocks when corporate profits decline and consumer spending decreases? Stocks decline of course, and companies lay off workers. Vicious cycle...

    This is why I believe the Fed is in a self-made trap that will be significantly difficult to get out of, because the minute it decreases the AMOUNT of securities it is purchasing, this will increase the supply of securities that will be purchased by everyone else, which will have the above negative consequences for bonds, companies, consumers and stocks. Look what happened the last couple of times the Fed tried to taper or exit QE, or heck even when they MENTIONED doing it. Within a month or two that had to start QE back up.

    And I'm not even talking about the Fed reducing its enormous STOCK of securities (its balance sheet)--that's another complicating factor that will further increase the supply of securities. I'm only talking about the Fed discontinuing or reducing its $85B/month FLOW of purchases. That's why IMO the Fed will have a huge balance sheet for many years to come, perhaps even decades. Should be verrrry interesting to watch!

  • Report this Comment On May 27, 2013, at 2:26 AM, palofire wrote:

    My two cents worth:

    Looking back across my 71 years, I think that I have discovered a few truths that are not simply educated guesses.

    For example, when it comes to any government's fiscal and monetary policies, there is no need to "Guess," as ample empirical evidence permeates history, as to eliminate all guesswork!

    Politicians make promises, some of them with the noblest of intentions. Times change, though:

    Demographics, technology, educational needs, extinction of "blue collar" labor, expansion of government bureaucracies necessary to run the programs of good intentions which the taxpayers grow increasingly unable to fund, and government borrowing to supplement the promises it has made on behalf of the taxpayers. Thus, a perfect example of the old saying about the path to hell being paved with the bricks of good intentions.

    But "factual" and "without a doubt," the end result of the aforementioned process has always been and will always be "Devaluation of the Currency." Us dummies call it "InflATION!.

    In the final analysis, the government must monetize its debt. There is no alternative. Thus, I pass on my little bit of investing wisdom to my children and grandchildren. Get your pens ready.

    'HON, I KNOW YOU CAN'T IMAGINE THIS, BUT THE DOW WILL EASILY BREAK 56,000 BY 2050.'

    'and today's 5 dollar burger at McDonalds will cost $20.' Where will McDonalds' stock be priced? Go figure.

    Step one: Choose to live within your actual means. A used car, a moderate house and public schools for the kids are good. If you cannot invest at least 10% of your take home pay, then you are living beyond your means.

    Step two: Every payday invest in well established growth or growth and income stocks when the stock market is in an uptrend, as commonly established by weekly and or monthly charts, utilizing stochastics, exponential moving averages, or the like. (If a market is in an established downtrend, put your payday investment money in savings.)

    NEVER sell one of your established growth and income stocks just because the stock market is turned and or trending down. Wait patiently for a month or two or a year or three for the broad market to once again renew its uptrend, and then throw in your savings and return to investing every payday.

    Never buy on margin; never speculate in a futures contract of any kind. Put every dividend back into stocks, and pay the taxes due.

    Remember, very few things come with a lifetime guarantee; but you can be assured that your government absolutely guarantees that the stock market marches pretty much in lock step in the opposite direction to the value of the dollar--over time. Which means, dollar down:market up.

    Palofire

  • Report this Comment On May 28, 2013, at 5:58 PM, jpaulgreer40 wrote:

    When interest rates rise, as one way or another they eventually must, the price of all existing conventional bonds will decline, willy-nilly. That's just math.

    Higher risk-free rates (i.e., US Treasuries -- free from credit risk, if not from continuing interest rate risk) raise the discount rate that must be applied to future dividend streams from common stocks, so stocks will reprice downward as well.

    Imagine that, the prices of both longer-dated bonds and stocks falling in tandem. Couldn't happen? Check out the period (e.g.) 11/28/80-8/12/82. On the first date, the 30-year Treasury was priced to yield 10.09% and the S&P 500 closed at 140.52. On the second date, the 30-year was priced to yield 13.15% and the S&P 500 closed at 102.42 -- down 27.1% over the 20 1/2-month interval.

    Timing? No one knows, but the loss of confidence in financial markets ALWAYS happens when exuberance is at it's peak (yeah, I do know that's a truism), and it happens much faster than almost all market participants are prepared for. And, believe it or not, the market IS bigger than the Fed.

    So, are we comforted when the Fed announces it has a plan for ceasing it's seemingly endless rounds of QE (read: printing money) and de-leveraging its balance sheet?

    Buffett called the former "the shot that will be heard round the world." You bet it will.

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