I generally agree with fred that monetary policy is driving valuations. However, I think it's not quite as simple as he describes (although he may be intentionally simplifying for his audience).
It's true that financial assets compete with each other for investors. So when the Fed reduces the yield on Treasurys or MBS, the marginal investor will rotate to a riskier asset. This will create a chain reaction that eventually raises equity prices. However, it's not the case that earnings yield (Earnings/price or the inverse of P/E) is going to be equivalent to the interest rate on Treasurys (T-bills). Typically the way that investors think about it is earnings yield = Treasury rate + equity risk premium. So at an equity risk premium of 5%, even a Treasury rate of 0% would result in an earnings yield of 5% or P/E of 20, not infinity. This isn't too far from the market multiple of the S&P 500 right now. (The historical average ERP over the past century has been 4.2%.) So the market multiple implies that the overall market is not in a bubble, but that doesn't eliminate the possibility that some sectors are in a bubble.
The Fed's influence on the market goes beyond their impact on interest rates. One reason for the sharp rise in markets is that investors are fearful of inflation. Although CPI inflation has remained low, investors would rather hold scarce assets such as equities and real estate than a rapidly diminishing percentage of the money supply (i.e., cash) that results from money "printing". While money creation is nothing new, and in a sense, unconventional money creation is not that different than conventional easing, the sheer scale of our current monetary policy is unprecedented. This lack of precedent creates a high degree of uncertainty in the ultimate outcome.
The final reason for the strength of the markets is a widespread belief that the "Fed put" is back. It is almost universally believed that the Fed has taken on a third, unstated mandate of stable and rising equity markets, by easing and talking the market up when it declines. I don’t know to what extent this is true, but the mere notion has created a hidden source of instability in the market by giving investors unusual confidence. While there is no reason to believe that markets will crash, it's also not out of the question.
The Fed has announced that it will "taper" QE purchases from $75 billion / month to $55 billion / month. At the current rate of taper, QE purchases could reach zero by the end of the year. One key question for investors is whether this may reverse any of the three dynamics listed above.
>investors would rather hold scarce assets such as equities and real estate than a rapidly diminishing percentage of the money supply (i.e., cash)
Do you have any data to back this up? It is my understanding that the demand-for and holding-of cash (specifically the USD) reached epic proportions in 2008 (as happens during financial crises, hence the need to print) and remains very high.
At the same time as this tech boom, S&P 500 companies are (I'm told) busy borrowing fistfuls of money in order to pass it on to shareholders through dividends and share buybacks. That seems to suggest that investors are happy to have cash right now; it also puts the complaints about excess or wastefulness against the current SV boom into some perspective ...
Well, to be clear, an asset purchase transaction (ex the Fed) does not change the number of "dollars outstanding" (the money supply). To be more precise in my language, investors prefer holding assets to cash at a specific asset price. The evidence for this is in the rise of asset prices (even more specifically, the rise of multiples, since underlying values change over time). The specific phenomenon you are referring to during the crisis itself is a flight to safety/liquidity, which is unrelated.
The key here is the context of inflation risk. In an inflationary environment, his point holds with the rational investor. Most people would rather invest in something than effectively lose money by holding cash.
Paul Krugman argues that there's too much money chasing too few assets. Combined with low interest rates we have a bidding war for anything that isn't Zynga. Even Greece has seen money pouring in recently because, really, where are you going to put $10B?
And why are there too few assets? To put the question another way, why is it that, even though the Fed has given banks $2.8 trillion in quantitative easing, the banks can find nothing better to do with it than to leave it in their accounts at the Fed earning 0.25%? Is there really nothing more productive going on that they can loan money for?
My worry is that I don't see any "mainstream" economists asking this question.
Be wary of conflating corporate cash with the LP cash backing VC companies. Companies are holding record amounts of cash because (1) it is seen as insurance for financial shock-event; and (2) low interest rates do not penalize them for holding it.
If interest rates were 7%, shareholders would be demanding minimal cash on balance sheets. But with money @ 0.25%, the BOD is telling investors the "option value" is worth the minimal carry cost to the company in terms of FCF and/or NI.
On the other hand, the sources of VC (LP) have excess liquidity they do not want to hold as cash. If they had 7% <paid> on cash they would hold some cash as insurance; but with 0.25% (6.75% forgone) the cost of this insurancs is too high. This is exactly opposite dynamic of the corporate case.
So, you see companies hoarding cash and LPs trying to get rid of it. But for VCs and valuations, it is the LP's dynamics (excess liquidity) which are relevant. The corporate cash piles have second-order effects (via M&A), but the central source of liquidity is driven by LPs wanting to be fully invested.
(There is also the issue of spread/total rate which pushes LPs deeper into the risk spectrum to meet threshold returns. This effect drives allocation to equity vs bonds, and equity market liquidity has carry-through for VC exits both at the iPo and m&a level.)
> Don't confuse corporate cash with the cash backing VC companies.
Actually my post wasn't talking about either: it was talking about all the reserves the banks are holding at the Fed instead of lending them out. Technically those aren't cash since banks can't just hand them to you with no strings attached; they have to give them to you as a loan.
Corporate cash, OTOH, could be paid out as dividends directly, though you're correct that that's not going to happen with rates where they are now.
Banks are hoding cash for the same reason as corporates. The cash is cheaply financed by low-cost debt and it has utility as an insurance-liquidity-pool-of-last resort in the case of a policy reversal by the Fed.
For argument's sake, assume debt is mis-priced right now relative to equity. If you believe that, and you are a bank, what you do is increase ROE through increasing leverage (shor debt markets+long equity). So, if you are a bank you borrow and buy back shares. Or, you borrow and keep shares at a minimum/flat.
On the other side of your ledger, if you are a bank and you believe debt is mis-priced, the last thing you want to be doing is going long credit (to customers). So, what you should expect is increasing debt/equity ratio and flat/decreasing proportion of long-credit/total assets.
The "stingy credit" allegation is perfectly rational if you make the assumption that debt is fundamentally mis-priced as an asset class. That is the essential assuption Wilson is making to explain why money is chasing equity/pe/vc.
The only open issue is whether or not the assumption is correct.
If we look at policy, when regulators ring-fence reserve and increase the reserve level, they are forcing the banks to sell-equity. The reason they are doing this is because--assuming equity is mis-priced--they understand that banks will leverage up. The problem with banks leveraging up increasingly over time is policy hysterisis.
If the fed policy results in increasing bank leverage, the baking system will become increasing more "brittle". This tie the hands of the Fed--when they move to revert policy--they will risk creating a problem due to having added "brittleness" to the financial system.
So, even the fed is acting as if the assumption about debt pricing is true.
That being said, it is a more difficult case to explain from first principles whether or not debt is truly mis-priced as an asset class. But the analysis can be followed as far as I can tell simpley based on the binary assimpyion (yes/no). And one of those assumptinos seems to explain alot, while the other faces a harder time making sense of the data we are seeing.
From your piece:
The hope is that the lower interest rates will encourage people and businesses to take out more loans and thereby start spending again.
What we are seeing is opportunistic borrowing for financial engineering. We are not seeing 1:1 borrowing to spending on operating expenses or PPE. We are seeing borrowing that is being spent on share-buy-backs and/or cash-stockpiles that maked increasing leverage ratios more operationally risk-tolerant. (And it seems this is true for corporates and financials, at least to a first order approximation.)
Yes, there really is nothing more productive to do. Worse, we're going to end up in a situation where unless we make big investments now with negative current ROI, society will be even poorer in the future once the current capital assets have depreciated and been written off.
>>> investors would rather hold scarce assets such as equities and real estate.
Real Estate is not the investment it once was and homes have yet to recover their initial value since the crash in 2006. I doubt this is something people would be actively investing in like they used to.
It's true that financial assets compete with each other for investors. So when the Fed reduces the yield on Treasurys or MBS, the marginal investor will rotate to a riskier asset. This will create a chain reaction that eventually raises equity prices. However, it's not the case that earnings yield (Earnings/price or the inverse of P/E) is going to be equivalent to the interest rate on Treasurys (T-bills). Typically the way that investors think about it is earnings yield = Treasury rate + equity risk premium. So at an equity risk premium of 5%, even a Treasury rate of 0% would result in an earnings yield of 5% or P/E of 20, not infinity. This isn't too far from the market multiple of the S&P 500 right now. (The historical average ERP over the past century has been 4.2%.) So the market multiple implies that the overall market is not in a bubble, but that doesn't eliminate the possibility that some sectors are in a bubble.
The Fed's influence on the market goes beyond their impact on interest rates. One reason for the sharp rise in markets is that investors are fearful of inflation. Although CPI inflation has remained low, investors would rather hold scarce assets such as equities and real estate than a rapidly diminishing percentage of the money supply (i.e., cash) that results from money "printing". While money creation is nothing new, and in a sense, unconventional money creation is not that different than conventional easing, the sheer scale of our current monetary policy is unprecedented. This lack of precedent creates a high degree of uncertainty in the ultimate outcome.
The final reason for the strength of the markets is a widespread belief that the "Fed put" is back. It is almost universally believed that the Fed has taken on a third, unstated mandate of stable and rising equity markets, by easing and talking the market up when it declines. I don’t know to what extent this is true, but the mere notion has created a hidden source of instability in the market by giving investors unusual confidence. While there is no reason to believe that markets will crash, it's also not out of the question.
The Fed has announced that it will "taper" QE purchases from $75 billion / month to $55 billion / month. At the current rate of taper, QE purchases could reach zero by the end of the year. One key question for investors is whether this may reverse any of the three dynamics listed above.