Between where war on the Korean peninsula

Between the low-point of the 2007-08
Financial Crisis, March 6th, 2009 and present day, December 19th, 2017, the Dow
Jones Industrial Average (DJI) has risen over 273%. (Yahoo Finance, 2017) This
bull market is unlike any in United States’ history regarding how long and how
high the market has risen. Recently, CBOE Volatility Index (VIX) levels, which
measure volatility in the equities markets, has been historically low; this is
surprising, especially given the great deal of uncertainty politically in both the
United States, with a divided congress and government, and globally, where war
on the Korean peninsula is a distinct possibility. The market has been
surprising to many analysts and there are questions as to how much longer this
market can last and why the market is doing so well with the current political
climate. The reasons for this unprecedented bull market is: the rise of passive
investment vehicles; Fed policy since the Crisis; the unattractive bond market;
and future expectations of government policy.

A new development which has been
funneling money into the market in a non-volatile manner has been the drastic
rise in percentage of money in passive investment vehicles, most notably
Vanguard S 500 ETF (VOO) and SPDR S 500 ETF (SPY). These two funds
alone have a combined market capitalization of around 300 billion dollars.
These funds have been popular lately because they allow for easy and relatively
safe exposure to the market. These funds have microscopic management fees and
have been beating the performance of most mutual funds. The popularity of these
funds has helped to reduce market volatility because they are completely
algorithmic and predictable. Since the funds allocate across the entire S
500, every dollar funneled into the fund means that dollar will be spread in
predictable way across a large cross-section of high-cap equities and held
long-term. This reduces volatility because lack of active management, means
that managers do not disrupt the market through big trades.

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Another part of the reason for this
uninterrupted bull market is the Fed’s monetary policy of quantitative easing
in order to stem the recession that set in as a result of the Financial Crisis.
The Fed underwent three rounds of quantitative easing between 2009 and 2013, by
which the Fed dramatically increased assets on its balance sheet through its
purchases of asset-backed securities (ABS) and Treasury bonds. Additionally, to
combat the recession, the Fed kept its target Federal Funds rate at .25%
between 2009 and 2016. After 2016, the Fed has begun to slightly increase the
interest rate over the past two years to 1.5%. The Fed plans to finish 2018
around 2.25%. The Fed’s policy of low interest rates over such a long term has
made it easier for institutional investors to increase leverage and thereby
increase the amount of money put into the market. This has led to higher equity

An additional result of low interest
rates over such a long time period has been that credit spreads have narrowed
considerably to the point where many investors are concerned that bond prices
are too high. This has made investors predisposed to invest in equities rather
than bonds, because the risk adjusted return associated with equities,
especially index funds, is more attractive than that of higher-yield bonds.
This development means that institutional money has been moving from bonds to
equities, further fueling the bull market.

Lastly, the victory of Donald Trump
in the 2016 presidential election, and the Republican ownership of both houses
of Congress have raised investor expectations regarding taxes and regulatory
policy. The Republican tax reform program has given investors hope that
corporations will have their tax rate reduced to 20%, and will have the ability
to repatriate money sitting overseas. Arguably, the most important part of the
tax plan is the repatriation of money, which is currently sitting around in tax
havens, where it cannot be put to work as investment dollars. President Trump
has also indicated that he plans to dramatically slash regulations, most
prominently in the energy and construction sectors. These two major policies
have suggested to investors that corporations will be able to increase their
earnings and justify any current high P:E ratios.


Analysis of


            The article
is entitled, “The markets believe in goldilocks,” by the Economist. The article
reports that the current equity market is “frothy” and overvalued by citing a
Bank for International Settlements (BIS) report, which says, “that according to traditional
valuation gauges that take a long-term view, some stock markets did look
frothy,” and a Bank of America Merrill Lynch (BAML) survey of fund
managers which found that 48% of fund managers believe the market is
overvalued. (The Economist, 2017)

The article explains that, although
48% of fund managers believe the market is overvalued, 49% had a
higher-than-normal exposure to the stock market. The Economist says that fund
managers rationalize this by having faith in a “Goldilocks” economy, whereby
higher-than-normal growth and lower inflation drive the corporate earnings
higher. Additionally, fund managers are more concerned about overvalued price
of bonds–81% surveyed believe the bond market is overvalued. (The Economist,

The article also lists the momentum
of Q3 2017, where earnings-per-share (EPS) rose 8.5%. Earnings forecasts are
expected to grow at 14% in both the United States and Europe. (The Economist,
2017) Higher corporate profits means companies have excess cash which they can
use to buy-back shares, further driving up their stock price. Since 2005, the
only time corporations have not been net-buyers were Q2 and Q3 of 2009, the
depth of the market.

The article warns that there is a
potential for rapid decline in equity prices if companies chose the “kitchen
sink” approach, whereby, during a bear market, companies decide to write down
loses they had not previously disclosed in the bull market. This could mean
that stocks tumble at a rapid rate.


Analysis –
Federal Reserve policy and the “Goldilocks” economy assumption

The article assumes that a
Goldilocks economy is a probability in the United States. This belief is flawed
because there are a variety of important counterpoints which dispute the
assumption of a combination of both above-average growth and low inflation.

The article doesn’t take into
account recent Fed policy of lifting off the interest rate. A Fed liftoff will
reduce liquidity in the capital markets and will reduce the ability for
companies to borrow and invest. Low interest rates have been propping up the
economy over the past nine years. There is a great deal of concern from FOMC
members like President of the Minneapolis Federal Reserve, Neel Kashkari, and
President of the Chicago Federal Reserve, Charles L. Evans. Both of these
bankers question the necessity for raising rates so rapidly in a low-inflation
environment. (Applebaum, 2017) The argument from the hawkish FOMC members is
that inflation lags behind the data, so it is right to raise rates even when
inflation is suppressed compared to historical numbers. The important point of
the Fed’s policy is that a rapid rise in interest rates to 2.25% by Q4 2018
could result in suppression of inflation, which could further weaken the
ability for companies to borrow and invest and for consumers to buy financed
goods such as appliances, cars, etc. (Condon and Torres, 2017) This would
result in weakened growth and deflationary forces, both of which would bode
poorly for the equity market. It is an important counterpoint that the article
did not address this at all in it’s blind assumption of a Goldilocks economy.

Additionally, there is a possibility
that too-rapid a rise in rates could invert the yield curve, thus prompting a
recession. The yield curve has been persistently depressed over the long-term,
which indicates that there is low expectations of future growth. Too quick a
rise in rates would make short term borrowing more expensive than long term
borrowing and cause a recession as a result of reduced consumer and corporate
borrowing. Of course, recessionary conditions will weaken corporate profits and
hurt equity valuations on the market.

In addition, to the lack of
mentioning Fed policy and its implications in the article, the article also
left out the issues that come with weak inflation and its implications.
Inflation has been weak since 2015 (under 2%) and wage growth has been stagnant,
indicating that worker productivity has not been improving. Both of these data
points bode poorly for the health of the economy. Productivity per worker is
one of the most important indicators of real economic growth. Stagnant wages
imply that growth is as high as it is said to be.


Analysis –
Share buy-backs and the health of the economy

            The article
addressed the role of share buy-backs in propping up equity prices; however, it
did not look at the implications of this action by many corporations. The assumption
behind share buy-backs is that corporations have so much excess cash on their
balance sheets but they cannot find an investment opportunity to generate
future cash flows, so instead they choose to simply buy back their own shares
to boost their valuation.

            It is
concerning regarding the health of the economy that corporations cannot find
more attractive investments other than buying back their own shares. This
implies that it is too difficult or too unprofitable to invest in the United
States. Either one of these implications is a negative sign for general
economic health of the country.

Share buy-backs are effective at
propping up the paper price of the company but they do not add much beyond
shareholder value. Rather than pay a dividend so that their shareholders could
decide what to do with excess gains; companies prefer buy-backs because it
allows them to dictate policy and increase the value of executive stock



            There are
numerous questions as to whether this bull market can last, and if so, how
long. The belief in a Goldilocks economy, fueling corporate earnings and
sending the market even higher is flawed. First, the current Federal Reserve
policy is essentially going to destroy what is currently dubbed the Goldilocks
scenario. This is because a lift-off in rates will both hurt consumption,
investment, and reduce inflation, even as inflation is already low and beneath
2%. This will cause deflationary forces which will further erode consumption
and investment, thus lowering corporate earnings and the values of stocks.  Second, weak inflation is not necessarily a
good thing for corporate earnings. Weak inflation means stagnant wages, which
implies low productivity per worker. This indicates that the economy is not
growing in real terms, at least domestically, and that the economy is said to
be healthier than it really is. Third, the fact that corporations have been so
aggressively buying shares back post-Crisis indicates that it is either too
hard or too unprofitable to take their excess cash and invest it in the United
States. This poses a policy challenge to a currently incompetent and divided
government. The assumption that Congress can pass regulatory overhauls and tax
reform is flawed, as it does not recognize how divided the government currently
is. Overall, the health of the economy is overstated and the potential for a
Goldilocks scenario is unlikely. This implies that the current bull market will
not last much longer, as the Fed raises rates the economy will hurt and prompt
a downward trend in the stock market.