The bull market for stocks is more than eight years old now, which makes it the second-longest bull market since the end of World War II. There has been a lot of change in the last 8+ years, yet the one constant throughout has been the persistence of low interest rates.
Low interest rates, which have been an offshoot of low inflation, low growth, and a high level of asset purchases by the Federal Reserve, have been the root of the stock market's success.
They have been the basis for every buy-the-dip effort and they have been the signpost for pundits who have suggested there is no better investment alternative than stocks.
Low rates have helped rationalize lofty equity valuations and they have helped underpin corporate earnings expectations.
In brief, low rates are as important for the equity market as Tom Brady is at quarterback for the New England Patriots.
Down to the Root
The bull market for the New England Patriots is almost 16-years old, which makes it the longest bull market on record for that team.
It started in September 2001 when Tom Brady took over for an injured Drew Bledsoe at quarterback. The rest, they say, is history.
Over that span, the New England Patriots have won seven AFC Championships and five Super Bowls. Tom Brady has been the quarterback on every occasion. He is the root of the team's success.
Some will argue that coach Bill Belichick is the root of the team's success, but this analyst believes it is the superstar players who make the coach and not the coach who makes the superstar players.
Take Michael Jordan out of the equation and do you think Phil Jackson wins six NBA Championships with the Chicago Bulls? Wait, come to think of it, Michael Jordan was out of the equation in the 1993-1994 season and the Bulls finished second in their division and lost in the second round of the playoffs. Jordan came back the next year and the Bulls promptly won the next three NBA Championships.
Tom Brady, meanwhile, missed the entire 2008 season with a knee injury. In his absence, the Patriots finished a very respectable 11-5 but did not qualify for the playoffs. Tom Brady hasn't missed a season since and neither have the Patriots missed the playoffs.
Tom Brady has been a constant for the New England Patriots. He has said he would like to play another five or six years, but that may not be possible because that means he wants to play those five or six years at the standard of excellence that has made him Tom Brady, which is asking a lot of himself at 40-years old now.
We'll see what the future brings for him and his team, yet his past success breeds a feeling in every New England Patriots fan, and every fan of their rival teams, that if Tom Brady is playing, the Patriots always have a good chance to win. At the same time, if they happen to lose a game, there is an enduring belief that they will win the next one if Tom Brady is quarterback.
In the same vein, there is an enduring belief in the equity market that, if interest rate stay low, the bull market can continue.
Yes, there may be periods of defeat (i.e. corrections) for the bulls, but if low interest rates persist, the feeling that the stock market will bounce back again from that defeat will persist as well.
The yield on the 10-year note is peculiarly low right now. In fact, it is 30 basis points lower than where it stood at the start of the year.
That drop in yield is remarkable considering the Federal Reserve has raised the fed funds rate two times in the interim, has suggested that it may soon start the process of normalizing its balance sheet by curtailing its reinvestment activity, and GDP growth rates have picked up in the world's leading economies.
What hasn't picked up is inflation. In fact, inflation and inflation expectations have been falling, which helps explain why Treasury yields have been too.
The PCE Price Index was up 2.1% year-over-year in February, but in June it was up only 1.4% year-over-year. The five-year, five year forward inflation breakeven rate, meanwhile, was 2.21% in February, but now it is just 1.97%.
The 10-yr yield hit 2.60% in March, but it now stands at 2.17%.
Inflation is the bane of a fixed-income investor's existence, yet it hasn't been a problem really in the bull market's 8+ year run, so high interest rates haven't been either.
If inflation picks up, as the Federal Reserve thinks it will over the "medium term," then interest rates will follow, but until now, "lowflation" has equated to low interest rates, which has propped up asset values like Tom Brady has propped up New England's win total.
A High-Low Game
Higher interest rates become problematic for stocks on several levels:
- They lower the present value of future cash flows
- They reduce earnings prospects for indebted companies by increasing their interest expense
- They can curtail growth prospects as investment projects get deferred due to higher financing costs
- They create increased competition for stocks by providing other investment alternatives; and
- They leave investors less inclined to pay up for every dollar of current earnings for slower-growing companies, which creates valuation pressure
When the S&P 500 bottomed on March 6, 2009, the yield on the 10-yr note was 2.87% and the S&P 500 traded at 10.0x forward twelve-month earnings. Today, the yield on the 10-yr note is 2.16% and the S&P 500 trades at 17.4x forward twelve-month earnings.
This goes to show how low interest rates can drive multiple expansion, yet it also exposes how rising interest rates can lead to multiple contraction.
What It All Means
The NFL regular season is about to kick off and Tom Brady will be under center again for the New England Patriots. To no one's surprise, the New England Patriots are considered Super Bowl contenders again.
If there is anything that might trigger some concern in the minds of New England Patriots fans about Tom Brady, it is that he is on the cover of the video game "Madden NFL 2018."
There is a purported "Madden curse," which is to say it has been common to see players on the cover get hurt during the course of the football season. Coincidentally, Tom Brady's teammate, Rob Gronkowski, was the 2017 cover boy and he got hurt last year.
Tom Brady says he doesn't believe in curses, which is what you would expect the greatest player of all-time at his position to say. If the curse does strike, though, the fortune of the New England Patriots will be cursed, too, because you can't replace a G.O.A.T with a kid.
Likewise, the bullish fortunes for the stock market would turn if interest rates go up. That's because it trades at an historically high valuation that is predicated on low interest rates.
Take low interest rates away from the market and, well, the good times will get taken away, too, much like they would for Patriots fans if Tom Brady can't finish the season.