How to blow an asset bubble in 3 easy steps.

Nasdaq

1. The Risk-Free-Rate-Of-Return

In my article on bonds we cover Quantitative Easing (QE) and how the Fed uses this QE program to artificially supress yields. We also looked at how the US treasury is considered the “Risk-Free-Rate-Of-Return” and we highlighted how the risk-free-rate-of-return underpins a lot of global finance including the rest of the bond market. By artificially pinning rates low, we are suppressing the natural price discovery that would occur within a free-and-open market. A free and open market would naturally determine what the real cost of capital would be. That is, what would be the natural cost to borrow currency for economic growth.

Figure 1. Discounted Cash Flow Model Example

2. The Search For Yield

Bonds and stocks both played a critical role in typical investment portfolios, especially those investment portfolios of hedge funds, money managers, family offices, pension funds and sovereign wealth funds. The 60/40 stock/bond portfolio was the textbook play for institutional players providing the perfect ratio of risk to reward. This balanced reward/risk ratio does require one key component…. achieving a decent yield on bonds.

3. Passive Inflows.

If you have read any of the popular investing books published in the past few decades including the bible of every self-proclaimed value investor, The Intelligent Investor by Benjamin Graham, there is a common theme that pops up frequently. Buy the market.

Figure 2. Top 10 Stocks S&P 500 — source < https://www.slickcharts.com/sp500>

Bringing it home

There are a number of financial institutions that are mandated to by their charters to purchase certain kinds of instruments, to deviate from stock/bond portfolios is very hard for them to do. They can’t sit in cash, they must deploy these funds as per their charter. Some, like these pension funds discussed, must not only deploy these funds, they have outgoings that dictate the yield they are required to achieve just to remain solvent.

Conclusion

Nearly every single stock within the main global market is priced high in 2021, when using traditional discounted cash flow models. I hope I was able to highlight just a couple of reasons that this may be the case, the search for yield, the risk-free-rate-of-return and the passive inflows really do account for a lot of what we have lost in terms of normal price discovery in a free and open market. It is common to see stocks trading at large multiples of their earnings, even large multiples of their revenues. But the Average Joe is none-the-wiser. The books we have read have encouraged us to use these vehicles like passively managed funds. But when we do, our capital is competing with these indebted pension funds struggling to remain solvent, and the sky-high stock valuations from the guys who “know what they are doing”. This competition keeps fuelling the fire leading to even higher valuations. All the while, high-net-worth individuals and family-offices happy unload their bags.

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