For almost a year, the capital markets have been expecting a scaling-back of the Fed’s open market purchases of treasury bonds and mortgage backed securities. The $100 billion in monthly purchases have acted as a main contributor to today's low rate environment. So, what’s with the extraordinary volatility in the stock market? Like my father in law, who’s life wisdom grows in tandem with the passing of another birthday (that he’s celebrating today), capital markets, too, will grow wiser with each incremental increase in rates. The “QE” campaign that was put in place in early 2009 was a hurried response by the day’s policy makers to stymie a what-could-have-been even more devastating Great Recession. It has since morphed over the last dozen or so years beyond the aptly titled versions of “Quantitative Easing ‘1’, ‘2’ and ‘3’”. Eventually they stopped naming them because it sort of edged its way into becoming the new norm – like the Walking Dead being on tv; serious question: are those seasons even numerically counted anymore? Aside from Chair Yellen appearing to successfully scale back the balance sheet that had ballooned about 15 fold from QE1 to when she became Chair, the very accommodative policy was loved by most who loved rising capital prices, as is normally the case. However, rising stock, bond and home prices don’t necessarily translate to economic prosperity. Without going down the road of whether inflation has, in fact, been transitory or not, the Fed has taken steps to acknowledge the economy will do better without the cheap money policy that had been in place. Growth stocks (think FAANG) have flourished in this low rate environment. The reason has to do with how capital assets are valued. With low rates comes a low cost-of-capital. Companies that are in the early stages of their lives have traded at valuations that are magnitudes higher than mature industrial stocks. “Value” stocks, that historically pay out their predictable earnings through dividends, have a cost of capital well entrenched following years of payback history in the public bond markets. In other words, speculation thrives when money is cheap. What’s happening now is that growth stocks’ valuation multiples should compress as their cost of capital rises. The discount rate at which their cash flows portend future value, increases. In the long run, that’s a good thing. It makes possible a bringing-back-toward a mean in asset valuations around a long-run cost of capital. Growing pains can be ugly, however. The good news is that there are sectors of this market that are increasingly well positioned to thrive in a rising rate environment. Just like my father in law’s wisdom increases as the years pass, assets will begin to resemble their intrinsic values once money becomes, well...less free. I think in today’s world, we could use a little less hot air and speculation, right?
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