The current stock market is a repeat of the irrational NiftyFifty stock market of 1973 with very high Price/Earnings ratios in the 1970’s which had nothing to do with low yields, bailouts, implied promises of Fed put options, corporate buybacks, QE, etc. – it was plain and simple irrational investor emotions in 1973 that created a stock bubble that lead to a crash. OK so the Fed did overstimulate in 1972 election but in those days it was a broadly dispersed benefit instead of today’s QE benefiting only stocks.
It is tempting to feel a new era of permanently high PE’s has occurred but leaping to that conclusion is wrong as it is motivated by a desire to conform with the masses of people’s decision to overpay for stocks. Weighing the odds of going into a socialist phony manipulated market where the Fed prints money and makes sure stocks never fall versus the classic investment expert’s critique of bubbles (very high PE, low earnings growth, buybacks, etc.) clearly the classic criticism of bubbles is correct and eventually the bubble makers will run out of ammunition and credibility, leading to a collapse in prices.
If the very fragile overextended corporate BBB- (lowest rated investment grade) bond asset class cracks and those firms are rerated down to BB junk rating that will act like a large and very sudden interest rate tightening and make stocks crash with more power than the Fed can generate by cutting rates. Once borderline junk credit collapses then true junk and borderline junk will be starved of funds resulting in blowout credit spreads (a sudden leap in rates to “shutoff” rates). Then the economy goes into classic liquidity starved scenario leading to recession for all but the few companies with A to AA rated credit.
The fulcrum or key tipping point in the economy is the use of debt for junk quality borrowers. When lenders suddenly wake up and panic about deteriorating credit quality they rapidly shut down this market, depriving cash starved business of funds they desperately need, resulting in an economic slowdown since these borrowers will have then had their credit and cash exhausted. The critical flaw of central banks is that they can only cut rates for investment grade borrowers, yet the borrowers who need help in a recession are junk quality borrowers who see their rates rise during crashes. Junk bond rates (the ICE BofAML US High Yield Master II Effective Yield on the FRED database) spiked to 21.8% during the 2008 crash, even though 90 day Treasury yields plummeted from 4.91% in 2006 to 0.03% in December, 2008.
The central banks of the world are run by impractical economics Phd’s who don’t want to take risks and think entrepreneurially thus they cave in to fears of an asset bubble crash at the slightest sign of stress. They don’t want to be blamed for being the man with the pin who popped the bubble. By contrast, a soldier or Everest climber learns to be brave and accept risk of death as one key to achieving goals; this unwillingness to take risk by central banks means that they allow fear of a crash to trump analytical academic skills learned in a sterile risk-free classroom. Central bankers fear of being labeled as the cause of a depression mean that they allow themselves to be emotionally hijacked by the demands of bubble making masses of investors and pension funds, etc. who seek to avoid a crash.
Central Banks can’t rescue investors from a deep crash. In Japan the Nikkei crashed from 40,000 in 1990 to 7,700 in 2008 and is now 22,200 but adjusting for devaluation it is equivalent of about 18,000. The gain from the low of 7,700 to 18,000 (currency adjusted) is only 31% of the way back from the low to the old high of 40,000, resulting in a 55% (currency adjusted) loss for foreign investors who waited patiently for 29 years to breakeven. The Japan central bank has bought a lot of stock but the Nikkei price is still way below breaking even with the top.
Investors need independent financial advice about the risks of relying on unreliable central banks.