The stock and bond markets have been on a truly remarkable run for nearly a decade. Though corporate earnings have increased, valuations have reached tremendous levels, largely due to falling interest rates and quantitative easing–a form of government stimulus meant to boost economic activity. However, many investors and industry experts are starting to worry that such exuberance may be coming to an end.
In 2000, economist Robert Shiller coined the term “Irrational Exuberance” to describe the rising stock market of that time. The term applies even more aptly to the current market situation, as extreme optimism has driven stock prices to record highs while bond yields have sunk to all-time lows.
The ever-increasing prices of stock and bonds seem unsustainable in the long run. Stocks and bonds are expected to move in opposite directions; when one goes up, the other usually goes down. Thus, if stock prices continue to inflate, bond prices will eventually deflate in response. The resulting volatility could destabilize both markets and spur a huge market downturn.
In addition, as valuations continue to skyrocket, it becomes increasingly difficult for companies to justify those prices with performance. At some point, it becomes inefficient for companies to fund growth through stock sales, as these prices may be too high for investors to justify. This could lead to companies seeking other forms of financing, such as bonds or debt, which could put further pressure on the stock market.
Finally, the Federal Reserve’s decision to keep interest rates low for the foreseeable future puts investors in an increasingly precarious position. Low interest rates help to facilitate investment, but they also mean fewer financial incentives for long-term savings and higher risk taking. When quantitate easing ends, rates are expected to return to normal, raising the cost of borrowing and likely causing prices to collapse.
It is difficult to tell when the “Irrational Exuberance 2.0” will come to an end, and if the market will be unscathed by it when it does. All we can do is keep an eye on the market and take steps to protect ourselves from the potential risks of a downturn.
Ultimately, the stock and bond markets are incredibly complex. While they may be due for a reversal, it is impossible to predict when or how this may happen. Taking proper precautions and diversifying your portfolio are the best strategies for mitigating risks associated with a drastic market change.