The stock market was up 16% last year, and in January alone it was up another 6%. The economy is not booming, which leads one to wonder–are prices too high? The best way to answer this question is with another one–are interest rates too low?
Historically there is a negative correlation between stock prices and interest rates. In general, this means that when interest rates go down, stock prices go up and vice-versa. So, how many of you think that current interest rates, at near record lows, will go up in the near future? If you think so, then you can conclude that stock prices will fall.
Why do interest rates have to go up?
Until three weeks ago, the ten year Treasury bond was paying about 1.7% per year. Inflation last year was about the same, so an investor’s real return was zero. That’s ridiculous. Assuming zero inflation, there is a theoretical cost of money of around 2%-3%, and if you add inflation to that, you see that the ten year Treasury bond should be paying nearly twice what it is now. Why are they so unnaturally low?
Interest rates are low mainly because the Federal Reserve is buying billions and billions of bonds. At some point, however, it will have to stop all this massive buying or it will trigger another bubble. And when that happens, interest rates will surely go up and stock prices will come down.
Why are investors buying stocks like there’s no tomorrow?
I think it’s because the professional traders of Wall Street are setting up an ambush. They are enticing the little guy to buy, and then, watch the agony. Watch out; don’t get sucked into this stock market ambush.
What other evidence do I have beyond the fictitiously low interest rates? The economy last year grew around 2.2%. That means the value of all goods and services produced increased by 2.2%. All other things being equal, profits should have grown that much too. But, let’s be generous and assume a bit of operating and financial leverage caused corporate profits to be twice as high as the growth in the economy. That takes us to a theoretical 4.4% profit growth. Add to that a risk premium for investing in stocks of, say 3%, and that gives you a total of about 7.4%, which is what stocks should have earned last year. Round it up some more to make up for the overconfident people out there, and we get to 10%.
The market should have been up around 10% last year, and yet it was up 16% plus another 6% in January. Something is out of sync. There’s no way that the market can be anticipating more growth in the economy because the tax and spending cuts will have a big impact on consumer spending. My conclusion is simple: stocks have peaked and they are likely poised for a substantial drop.
My advice to you? Don’t be drawn into the ambush the stock market pros are setting up to catch the small investor. Now is the time to be cautious and suspicious, not enthusiastic.
Preservation of capital should be the number one financial goal, followed by prudent risk taking to try to earn higher rates of return. I specialize in helping people achieve their vision for retirement. Call me at 714-771-6000, or reply to this email if I can be of help to you.