The bull run on Wall Street is in its seventh year. Some of those years were duds — such as 2011 — while others, in particular the 2012–14 stretch, were spectacular. In all, the S&P 500 index has tripled in value since the dog days of 2009, and all three major indices of U.S. stocks set fresh record highs in the course of 2015. Even the Nasdaq Composite, which was considered grotesquely overvalued at the end of the dot-com boom, surpassed its March 2000 peaks.
In the end, the year 2015 ended up being a wash. In early December, the Dow Jones Industrial Average even fell below its Jan. 1 level. And the year as a whole was characterized by major mood swings and intensified day-to-day volatility. In the dog days of August, for example, the broad S&P 500 index briefly tumbled below 1,900, surrendering all the gains of the previous 10 months.
But as quickly as they dropped, major market indices were back near their all-time highs, having recaptured some 15% of their value in August–December. Nevertheless, bearish voices persist, with dire warnings of weakening fundamentals, a 65% chance of a recession in the new year and bubble-like conditions — even as bulls are predicting another strong run.
Both bulls and bears have made valid points. As we know, the proof of the pudding is in the eating. In other words, we’ll know that we’re in a bubble only when it bursts — just as both the dot-com bubble of the 1990s and the subprime mortgage securities bubble of the mid-2000s were discovered only in retrospect.
More of the Same?
If current conditions persist, stock prices will remain, at worst, at their current elevated levels, safeguarding the gains of the past six years for investors and retirees. Stocks could even do a lot better. Market indices have been impervious to most news except inasmuch as economic and political developments have a direct impact on the U.S. Federal Reserve and its monetary policy decisions.
Perversely, weaker economic data in the United States and signs of poor performance abroad are taken by stock investors in this environment as positive signs because they may keep the Fed from raising its rates. At the same time, markets shrug off international political events, no matter how alarming.
This is an extraordinary situation, because much of what is happening in the world economy and on the political scene would have ordinarily made investors extremely nervous, and the combination of factors taken together could have easily triggered a bear market in stocks.
Let’s look only at the most significant of them:
The Chinese economy is going through a systemic slowdown, which is not merely a period of adjustment after two decades of breakneck growth but, quite possibly, a more lasting breakdown of the country’s economic model. The government has been spending its accumulated reserves to stimulate growth, but that, as the Japanese experience has shown, is not a substitute for genuine sources of growth that are lacking. Japan, meanwhile, has seen its own stock market rise to its highest level in nearly two decades at a time when the economy is once more slipping into a technical recession, defined as two back-to-back quarters of negative GDP growth.
China was a locomotive for growth in other parts of Asia and for commodity-producing economies in Africa and Latin America. Oil and industrial commodity prices are in the doldrums. The PowerShares DB Base Metal ETF was down some 30% for the year through November, and Goldman Sachs’s forecast for oil prices in 2016 included a possibility of a $20 per barrel oil. In early December, the West Texas Intermediate benchmark fell to its lowest level since the subprime crisis, breaking through the $40 mark. Many major emerging economies are in — or on the brink of — recession, and their demand is slumping.
Europe is still gripped by slow growth and deflation, with unemployment — especially youth unemployment — turning into a national catastrophe not just for the heavily indebted countries along its southern perimeters but for major economies such as France, as well. Add to this the influx of refugees from various wars in the Middle East and Africa, and the terror attacks in France. The European Central Bank has continued to cut its rates, and in many countries, including Germany and Switzerland, lenders and savers actually have to pay borrowers and banks for the privilege of taking their money.
Relations with Russia are dangerously strained and the country’s leadership has become erratic and unpredictable. Russia is the first country in post-World War II Europe to redraw national borders by force. It has sent its military forces to Syria and has picked a fight with Turkey, a NATO member. Equally dangerous is the fact Russia is in an economic recession and its population is sliding into poverty. Some Western intelligence analysts privately fear that the world’s second largest nuclear power may become ungovernable.
The United States is facing a presidential election in which one political party is in turmoil while the other is tacking far to the left.
The U.S. dollar has rocketed across the boards, having been buoyed by a combination of political anxieties and expectations that the U.S. Fed will raise its interest rates even as most other major central banks continue to ease, in some cases radically. Combined with sluggish demand around the world, this could hurt U.S. exports and suck in more imports from countries looking to spur their domestic growth.
Amazingly, all of these factors are being dismissed by financial markets. On the contrary, looking at them from the exclusive angle of Fed monetary policy, investors see a classic Goldilocks situation: not too cold and not too hot. The Fed, as it has already announced, is ready to start raising its interest rates for the first time in a decade.
Yet room for a monetary policy tightening remains limited. Domestic inflation is low and slumping commodity prices as well as a stronger dollar point to deflationary pressures rather than to any chance of price increases getting out of control. The jobless rate may be low, at 5% as of November, but labor force participation continues to slump: it went down from 66% in 2008, before the subprime crisis, to a low of 62.4%.
Markets have already priced in a couple of 25-basis-point hikes through mid-2016 and no more than that, in light of a chorus of Fed officials warning that even those tentative rate increases could be dangerous for the economic recovery. The two rate increases would bring the Fed funds rate up to a range between 0.5% and 0.75%, which is still extremely low by historical standards both in nominal and real terms. In fact, the benchmark rate has not been so low in nearly six decades.
At such levels, rate hikes won’t unsettle the fundamentals of the U.S. economy. A gradual consumer rebound will remain on track. Ironically, an environment of rising interest rates may in and of itself spur some homebuyers and car buyers into action. They will likely bring the purchases of big-ticket items forward if they believe that this time next year consumer loan and mortgage rates will be higher.
The dollar exchange rate also incorporates the likelihood of higher U.S. rates, and the upside for the greenback is probably limited.
In short, after a panicked selloff associated with the prospect of a Fed rate hike early in the second half of 2015, financial markets have settled down, realizing that they can live with higher U.S. rates. Moreover, the fact that the Fed is biting the bullet and finally abandoning its zero-percent interest rates may actually be a positive sign, expressing the central bank’s confidence in the sustainability of the U.S. economic recovery.
Free Money Bubbles
This picture suggests that the positive mood on Wall Street seen throughout the fall should carry into the presidential election year. But conditions rarely remain the same, and a bull market riding roughshod over economic and political fundamentals may find itself on slippery ground.
First of all, the view that higher U.S. rates can be easily shrugged off by the domestic and global economy may be overly optimistic. Money has been effectively free — and freely thrown down as though from helicopters — since late 2008. Over this time period businesses have become used to ignore the price of capital. Many projects have been initiated with the view that money is free.
Moreover, given the imbalances in the economy — and a widely different ability to access capital for “good borrowers” and bad credits — there has been considerable overinvestment in many sectors of the economy, including high-tech. Once a more realistic value — albeit still very low — is attached to borrowed funds, such investments will look far less viable.
Moreover, free money has created a variety of bubbles and even pyramid schemes that range from real estate values in a number of cities, such as New York, San Francisco, Chicago, Washington and Miami, to the contemporary art market. Take away the flow of free dollars and the sustainability of these pyramids would be severely tested.
Throughout the history of modern economics, there has never been such a long period of free money. Any shift away from it is untested and should give financial markets a pause.
Plus, there could be a change in what investors look at. Once they stop focusing on the Fed and start paying attention to economics and politics, their optimism may evaporate quickly.
For one thing, we have pointed out before that the last three two-term presidents have all presided over a stock market boom, only to see Wall Street plunge before leaving office. It is not merely a strange coincidence; there are fundamental reasons for this pattern to have developed. Barack Obama became the fourth straight two-term president to have presided over a stock market rally — which has been, moreover, the longest. There is no reason to suggest that he will be luckier than Ronald Reagan, Bill Clinton and George W. Bush.
In any case, 2016 is promising to be an interesting year.