The latest proclamation by some of the foreseen market observers that the bond market, but not the stock market, is in a bubble has many of the rest of us casual observers scratching our heads.
One of the first things investors learn is the importance of bond interest rates in setting the context for all investing, and most (if not all) of the experts advising us to buy into the stock market now use low bond interest rates as the primary reason , Pointing to the fact that with bond rates so low, stocks are the only choice for investors seeking income. So if the main pillar holding up the stock market right now is low bond interest rates, how is it possible that the bond market is in a bubble but the stock market is not? Moreover, if the bond bubble bursts and interest rates rise, will not bonds become reliably more attractive and cause stock investors to flee the stock market. It would seem the stock and bond markets are inextricably linked right now, and both quite frothy.
The experts contend that history since 1980 indicates that bond yields (more specifically the 10-year Treasury bond) should be higher than the stock market's equity yield (or more specifically the reciprocal of the S & P 500 Index Price / Earnings (P / E) Multiple ). Today, that relationship is reversed with the equity yield higher (at approximately 4 percent) than the bond yield (at 2.25 percent). To those experts that means that either bond yields should be higher (meaning bond prices are in a bubble and need to fall) or stock prices are too low (and should rise higher), assuming that historical relationship should remain in tact.
However, that historical relationship may not be appropriate anymore. Most observers agree that markets and economies have changed rather dramatically since the 1980's and that despite that long-standing relationship no longer applies. The last twenty years of the past century was characterized by high economic growth and moderate inflation, two conditions sorely lacking since the turn of this century. Perhaps going forward equity yields should be higher than bond yields, consistent with the longer term relationship that was actually the norm for the 85 year period from 1871-1956. (Dividend yields compared with bond yields during the past 150-year period provides a similar pattern as equity yields, which actually dividend yields were actually higher than bond yields for most of that time period.) Perhaps that suggests stock yields should be higher than bond Yields today too, and in fact the stock market as well as the bond market is in a bubble!
More compelling evidence suggests the stock market is unquestionably in bubble territory. Stock market values are driven by earnings and P / E multiples and the foregoing analysis shows how low bond interest rates directly propped up P / E multiples. Less obvious is that low bond yields have inflated company earnings too, if indirectly, in many ways. Low rates enable leveraged companies to borrow copiously while keeping interest expense to a minimum. Those same low rates have enabled companies to borrow an unprecensed amount of capital to buy-back their own stock shares, reducing shares outstanding, and thenby inflating their salaries per share. The low-interest rate environment has also enabled margin to reach all time highs, from investors who borrow up to 50 percent of the capital they need to buy stock shares, thus fueling demand for stock and sending prices higher. Imagine how rising interest rates will adversely affect buy-backs and margin buying. If bond rates are too low, then stock prices built upon those low rates are clearly too high!
After factoring in all of that and the fact that earnings have been incrementally finagled and "engineered" through the use of Non-Generally Accepted Accounting Principles (Non-GAAP), which tend to inflate company earnings, it is obvious that the stock market has Was pushed to an unnaturally high level.
Certainly the experts know all this, so how can they possibly conclude that the bond market is in a bubble and the stock market is not? When those bubbles finally do burst, it is not hard to imagine that both markets, and in fact all financial markets, will suffer serious consequences.