The S&P 500 keeps going up and the Dow is about to hit 30,000. Equity prices have been on a tear. Last year the S&P was up 22% but profits remained steady. Why is this? I believe that the low interest environment created by the European Central Bank (ECB), Federal Reserve (Fed), and Bank of Japan has forced investors to reach for yield. Additionally, because of low global economic growth these central banks have an incentive to keep interest rates low, even negative. These low interest rates lead to an increase of liquidity. With so much liquidity in the marketplace just sloshing around, investors keep bidding up the prices of equities.
There are many problems with these levels of liquidity. First, their are clearly very limited opportunities to deploy this capital in effective ways. Venture Capitalists used money to seed new ideas, but these ideas are still largely unprofitable (Uber, WeWork). The implication is investors are so desperate for yield they are willing to set cash on fire. Because investors are no longer naive about futuristic ideas, they are buying what they’ve always bought: Common stocks.
The use of this capital to purchase equities is problematic. The capital does not improve productivity, yet people assume there is strong economic growth because of the rise in equity prices. This creates a cyclical effect of people continuing to bid up the prices of common stocks because of the recent rises. But the premiums placed on common stocks looks permanent. With so much capital unable to be deployed in improving productivity, it is forced into the stock market. Until a credit crunch, asset inflation and general market returns look inevitable.