Originally posted at Briefing.com.
Albert Einstein introduced his Theory of General Relativity in 1915. His finding, according to a helpful Space.com article, was that massive objects cause a distortion in space-time, which is felt as gravity.
I'm going to end my invocation of Einstein there, because, well, he is Einstein and I am not. I graduated from college with a Bachelor of Arts degree, which means I can write eloquently about Einstein's theory without having any true understanding of his thinking.
Fortunately, I have an understanding of the capital markets and I can even write eloquently about them from time to time. So, if you'll allow me a little space and time here, I'd like to talk about the theory of general relativity that has consumed the stock market.
Start Here
It all begins with interest rates.
What we hear time and again these days is that stocks are a better investment alternative to bonds because interest rates are so low. It is a textbook argument and lately it has been framed increasingly around the differential between the dividend yield on the S&P 500 and the yield on the 10-yr Treasury note.
The former is higher than the latter; accordingly, market participants have been"seeking yield" in equities that they can't find in Treasuries (or, for that matter, in savings accounts and time deposits).
That search for yield has been a byproduct of the Federal Reserve's monetary policy, which has artificially suppressed long-term interest rates (along with the policies of other central banks) and has forced savers into riskier asset classes like stocks.
That forced march, if you will, has driven stock prices sharply higher—not just of late, but since the 2009 lows when the stock market's valuation was much lower.
For instance, the Shiller P/E ratio, which is based on average inflation-adjusted earnings from the previous 10 years, was 13.3 in March 2009. Today it is 27.0. To be fair, the current yield of 1.55% on the 10-yr note is nearly half of what it was in March 2009.
Falling rates, rising stock prices—the connection is obvious.
So, while the stock market's valuation is high today, it gets discounted by the understanding that long-term rates are extremely low. That is, it's all relative.
That theory of general relativity has indeed been proven with the S&P 500 climbing to a new record high at the same time the yield on the 10-yr note hit a record low. Even more remarkable is that the S&P 500 did so with S&P 500 operating earnings on the verge of declining year-over-year for the fourth consecutive quarter, according to S&P Capital IQ data.
Listen to Jim Puplava’s Big Picture: Surviving the Yield Crash
Have there been some setbacks along the way? Yes, but time and again the Fed's stance on monetary policy and declining long-term rates have been the great reset buttons raising the relative appeal of equities.
So, if one wonders how the stock market might perform if interest rates ever go up again in a meaningful way, keep in mind how the stock market has done as interest rates have come down.
Falling interest rates are a tailwind for stocks. Rising interest rates are a headwind.
The Chase Is On
The theory of general relativity applies to the sovereign bond markets as well.
The nominal yield on the 10-yr Treasury note is remarkably low. Compared to other sovereign bonds for developed countries, however, it is remarkably high.
Hence, while many market participants are chasing stocks higher because long-term rates here are so low, many participants from abroad are chasing the 10-yr note and 30-yr bond because yields on comparable securities in their own markets are even lower.
It doesn't matter so much to them that the yield on US government securities is so low. What matters to them is that it is relatively high compared to what they can get at home.
The Positive of Negative Earnings
The market's view toward earnings reporting is also grounded in the theory of general relativity. That perspective is on full display again with the second quarter earnings reporting period.
Most companies are reporting better than expected earnings, as we suggested would be the case in our preview for the period. That doesn't mean the earnings results in aggregate are good in an absolute sense.
Notwithstanding all of the "good" earnings news, second quarter earnings are still expected to decline 3.7% year-over-year, according to S&P Capital IQ. That's better than the 4.9% decline projected on July 1, but it is still a decline.
See Acampora: With Rates at These Levels, Stocks May Have Years Left to Run
The market, though, has traded the relative quality of the reports, which is to say it has been enthused by the understanding that the results have not been as bad as feared. That understanding, in turn, has fostered a belief that the third and fourth quarters will mark a return to earnings growth, as currently forecast by analysts.
Notably, S&P 500 operating earnings are expected to increase 1.6% in the third quarter and 7.5% in the fourth quarter. What doesn't get much billing is that those growth estimates have come down since the start of the second quarter reporting period when they stood at 2.7% and 8.5%, respectively.
The trend there is lower, but alas, in a world governed by the theory of general relativity, the third and fourth quarter estimates look much better compared to prior quarters, so they still qualify as a positive.
What It All Means
Everything it seems is lofty at the moment—stock prices, bond prices, and earnings expectations.
Each has been given a lot of space to run and each has been running for some time. That space-time continuum, though, has been distorted by the Federal Reserve, which was ultimately established to contain risk (as the lender of last resort) but is instead now promoting all kinds of risk (as the lender of every sort).
The persistence of low policy rates has driven market rates lower and equity valuations higher. It has pulled forward future demand and has stolen future returns from savers. It has killed the meaning of absolutes and has given life to an era of relative qualifications.
Monetary policy has been a massive distortion and we suspect even Einstein would agree that one day it will act as a force of gravity on stock and bond prices, either because of the attempt to unwind it or the market's disavowal of it.
When that time comes, the gravitational pull will be absolutely tied to the market's relative valuation.
