Stock market rally: Reality or bubble?

Todd Glass on how conditions are not nearly as rosy as stock prices would indicate

In October of 2007, the Dow Jones peaked at 14,164.53. A financial crisis, a sovereign debt crisis and a global recession later, the Index has finally returned to, and now exceeds, pre-crisis levels. So where does that leave us?

Stocks prices are forward-looking indicators that are supposed to be a signal of a company’s expected earnings, and current market sentiment would suggest that there is much to be optimistic about. However, if we look around, there is reason to believe that this “milestone” is no more than a mirage, and that the current demand for stocks may only be a product of central bank policy, rather than equity fundamentals.

The anaemic growth, high unemployment and debt overhang that have characterized the economies of the West for the past four years have sapped confidence from Wall Street to Main Street. In an attempt to right the ship, central bankers from across the world have engaged in unorthodox monetary policies, such as quantitative easing (QE). In the US, the Federal Reserve is currently in its third round of QE, purchasing $US 85 billion worth of mortgage-backed and longer term Treasury securities each month.

Since 2009, the Bank of England (BOE) has engaged in an asset-purchase programme of £ 375 billion. Even the Bank of Japan (BOJ) has jumped on the QE-bandwagon after recently announcing that it will engage in an open-ended policy of buying US$ 145 billion of Japanese government bonds and Treasury bills a month, beginning in January 2014.

Faced with little alternatives, central banks across the world decided on QE with the intent of boosting spending in stagnating economies. However, despite being awash with cash, banks are not lending, and as quantitative easing drives down yields, investors have decided to park their money in higher-returning assets, such as equities. While it may be difficult to imagine what alternative actions central bankers could have taken, this does put them into a difficult position going forward.

Although signs of turning a corner are evident as industrial output and retail sales have improved in the US, it is hard to believe that the current rally is based on economic realities. While the talk about a Eurozone break-up may have moved to the backburner, and the US may have averted the fiscal cliff for now, conditions are not nearly as rosy as stock prices would indicate. As such, there is a distinct possibility that central bank policy may be propagating a stock market bubble.

The question to ask is: What will happen when the Federal Reserve, BOJ and BOE, among others, decide to pull the plug on their asset-purchase programmes? The answer, unfortunately, is that only time will tell. So while the new highs of the Dow Jones may seem like a reason to celebrate, in reality, we should be cautious that the stock market rally of today will turn into the next destabilizing crisis of tomorrow.

Author: Todd Glass is a Project Associate on the Financial Services Industries Team at the World Economic Forum and Co-Author of the Financial Development Report.

 Image: The New York Stock Exchange REUTERS/Peter Morgan