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  • Writer's pictureRyan Lipton

Why is the stock market defying economic reality? The Federal Reserve.

The S&P500 index, a collection of the largest 500 American companies, currently sits around 3,800 points and is near an all-time high thanks to the actions of the Federal Reserve during the ongoing fight against the coronavirus pandemic.

The S&P500 has returned about 70 percent since the stock market bottomed out in March. A figure that on its face doesn't make any sense considering the United States has undergone a heavily-contested election, an insurrection, high unemployment, social instability and a drop in company profits due to the coronavirus shutdowns.

But the S&P500's record highs are not without reason. The Federal Reserve's actions are key to understanding why the stock market has shot up leaving reality behind.

In order to stimulate the economy, the Federal Reserve has started printing even more money. It was already printing a lot after the 2008 financial crisis but had to print even more once the coronavirus pandemic started to keep the economy afloat.

When uncertainty persists on the horizon, like it did at the beginning of the pandemic, people are less willing to exchange money as people want to hold on to what they have for security. But flooding the economy with money/liquidity is one way to make sure businesses continue to spend in order to keep the economy moving forward in times of uncertainty.

One of the ways the fed can "print money" is by buying assets such as short-term treasuries. For instance, the one-year US treasury yields about .10 percent per year. Normally, the one-year treasury has averaged a return of about 3 percent per year, but it is now far lower because the federal reserve has tightened supply by buying more short-term treasuries. When the supply gets tightened (there are less to buy), the price to purchase a bond goes up and the yield (expected annual return by owning a bond) goes down.

Why does the fed want lower bond yields?

The fed wants to keep bond yields low because it helps lubricate the economy and gets companies to borrow more money in order to keep their workers employed.

If interest rates were higher, a company would be less willing to borrow money. For example, if someone gave you $100 today and needed the money back one year from now would you be more likely to take the $100 if you had to return $100.10 instead of $103 the next year? The answer is yes.

While lower interest rates can help lubricate the economy, why would those lower rates send the stock market up?

Bonds are inversely related to the stock market. When the yields on bonds are going down, the stock market generally will go up over a long period of time. When the yields on bonds go up, the stock market generally will go down. Yields are the expected return on the bonds (how much money you make per year by lending a certain amount of money to someone).

Why are bonds and the stock market inversely related?

For investors, the United States 10-year treasury can be used as a risk-free rate. The expected return that you would get by investing money without any negligible risk, meaning that if you buy $100 worth of 10-year US treasuries, you are guaranteed to earn about one percent per year for the next ten years on that $100.

As such, it would be idiotic to make an investment in a stock that is expected to return the same rate as the bond because by investing in a stock you risk losing all your money if the company goes bankrupt whereas the United States is guaranteeing that they will pay you the interest rate and return the principal amount of the bond at the end of the 10 years. The United States will exist 10 years from now whereas a company might not.

The 10-year treasury then becomes the risk-free rate because that is the minimal return that anyone should expect on their money without risking losing that money. The higher the risk-free rate is, the less appealing it is to invest in the stock market because a company's stock can go to 0 if a company goes bankrupt unlike a bond.

How does the risk-free rate impact how much a company is worth and the stock market?

The stock market is a collection of what the market/people think many companies are worth. For instance, Apple's stock is trading at about $128 per share currently. Apple has about 16.98B shares available to trade. Therefore, Apple is worth $128 x 16.98B = $2.18 trillion give or take.

For a company to be worth $2.2 trillion, it has to have incoming cash flows in the future that will be worth about $2.2 trillion. So by an extremely rough estimate, if Apple could bring in about $200B over the next 10 years per year in profit, it'd be safe to assume the company is worth over $2 trillion. (If Apple made $200B per year in profit, it'd be worth far more than $2.2 trillion but this is a rough example)

A dollar today is not worth the same as a dollar 10 years from now. For instance, $1 today 10 years from now will be worth about 82 cents if inflation is about two percent per year.

This idea is crucial to determining the value of a stock. As I mentioned above, someone needs to know what the future cash flows of a company will be in order to determine the value of a company. But those future cash flows can drastically change in value over time and become harder to predict the farther you move into the future.

Typically, an investor will discount future cash flows by the risk-free rate. So, if you were planning on getting $100 next year, that $100 would be worth about $100 divided by the risk-free rate.

Currently the 10-year bond is yielding about 1.15%. In that case, $100 next year would be worth about $100/1.015 = $98.52 because anyone, without any risk of losing money, could buy $98.52 worth of the 10-year bonds today and have about $100 next year.

But what happens if the yield is higher. What if the yield is three percent per year? Well, $100/1.03 would = $97.09. So a dollar today would be worth even less one year from now than it would be if the rate was 1.15% like it is today.

If a company's value is based upon the future cash flows (profits) that a company can generate for the next 10-15 years, the higher the 10-year interest rate is the less valuable those future profits would be rendering such companies and their stock prices less valuable.

Here is an example.

If a company is projected to earn $100B in each of the next 10 years, there is a huge divergence in what those values are worth if the risk-free rate is 1.15% or is 3%.

If the risk-free rate is 3%, then those future cash flows for the next 10 years will be worth $853B whereas at a rate of 1.15% the cash flows would be worth more at $939B. In that scenario, this company would be worth about 10% more in an environment where the risk-free rate is 1.15% versus an environment where the risk-free rate is 3%.

Changes in the risk-free rate (or the 10-year treasury yield) can make a huge impact on the value of the stock market as a higher yield would mean that the future cash flows of companies will be worth less in the future. If future cash flows are worth less, then stock prices are worth less too.

Historical context

At this point in time, interest rates are at historical lows. So if rates are the lowest they have ever been, then the cash flows that companies will receive in the future are now worth more than they ever have been. If those cash flows are worth more than they have ever been, then companies will see record high stock prices, which is what we are seeing today as the S&P500 sits near an all-time high.

Below is a chart of the 10-year treasury yield since about 1960. As you can see, the yields were at 15.84 percent in 1981 at its peak. Today, they sit at about 1.15%, just off all-time lows. If we took the same cash flows mentioned above ($100B each year for the next 10 years), they would have only been worth $501B in an environment where the risk-free rate was at 15 percent. That is a huge difference in valuation as that same cash flow would have been worth about half as much compared to today's environment.

The reason that rates are low is because the federal reserve prints digital money and then buys the treasuries making the yields move lower and in effect making future cash flows even more valuable shooting up the price of the stock market to heights that are seen today.

As you can see in the chart below, the federal reserve has about $7 trillion of assets on their balance sheet, meaning that they have bought about $7 trillion worth of US treasuries and mortgage-backed securities to help keep interest rates low and the stock market high. That is up about $3 trillion since the pandemic started. All of this spending from the Federal Reserve has indirectly kept stock prices high.

But what does that mean moving forward? If interest rates return to yields that were more commonly seen in the past the stock market will likely go down a lot because company's valuations will not be worth the same amount of money because the future cash flows are less valuable.

Since the Democrats won Georgia, the yields on the 10-year bonds have started to increase rising about 20 percent since the beginning of the year. While still a far way off from making a meaningful change on stock prices, it could be a signal of rates rising in the future which could spell trouble for current stock valuations and the all-time high that the S&P500 is flirting with right now.

(the US treasury 10-year yields from October 15 to January 9th)

Legendary value investor Howard Marks said on Bloomberg that the Federal Reserve, by pushing interest rates to low levels, is forcing people to invest in riskier assets (Bitcoin, Tesla, etc).


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About Ryan Lipton:

Ryan is a recent graduate from the University of North Carolina at Chapel Hill and majored in Business Journalism. He has written in the past for SB Nation's Silver and Black Pride, USA Today Sports Media Group, North Carolina Business News Wire, the Daily Tar Heel, and has worked with Ice Cube's BIG3 basketball league.

For more of Ryan Lipton's articles click here.

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