Crypto News: High interest rates mean the 2023 equities party can't last

The market action has become very frothy of late. Likely this isn't the start of a new bull market. It's just an 'echo' of the previous peak. As interest rates normalize for good, valuations will be pressured and longer-term market returns will drift down.

What if I told you that the interest rates of the pandemic were the lowest in at least 670 years? Would you be surprised or did you sense something unique was happening? Those days are over, of course. Yet, if you looked at the stock-market mania surrounding artificial intelligence, you'd be tempted to think they weren't, given how much valuations have jumped.

Instead, it looks very much like we're in the midst of an echo bubble, with the Nasdaq 100 shares up over 30% this year. And it's just an "echo" because as recently as the beginning of last year, Nasdaq 100 stocks were more than 10% higher than today. I think when one looks at the grand sweep of things, it's going to be difficult to sustain this rally — not because the economy will fade. It will be because the interest rate environment won't allow it. The longer-term outlook for equities is somewhat challenged, which means thinking more about cash and investment-grade bonds. Below, using the "real" interest rate, I'll try to explain why.

As I was thinking about writing this post late last week, I turned back to an old spreadsheet I started about 20 years ago that tracks all sorts of data series to help me figure out when cycles turn. I hadn't updated the stocks section since 2005 though. So I filled in the data and came out with some very interesting results.

Looking at rolling 5- and 10-year inflation-adjusted S&P 500 returns, markets have moved in mean-reverting waves from a low on 5-year returns of 50% in 1974 to a high of 260% for 10 years just after the peak of the Internet bubble in 2000. I knew this but hadn't updated the numbers in a long time. So I was interested to see what the last 18 years looked like.

What I found was that the longer-term 10-year returns through the pandemic rivaled but didn't quite get to those tech bubble levels. Moreover, as heady as recent five-year returns were, it was much less than at the peak of internet mania in the late 1990s. But alas, where we are now, after a terrible 2022 and a big snapback through the end of May is still in the downward mean-reverting period.

To give you some numbers, I'll give you 10-year inflation-adjusted gains at secular bull market peaks. We had 174% in November 1961, a mere 42% in October 1972, a whopping 260% in October 2000 and an almost equally-high 218% in February 2019.

The gains in the 1960s stayed and almost double-peaked through 1963, before dipping and mounting a weak 10-year gain in 1972. Inflation crushed 10-year gains so much that they were negative for every month from October 1973 to July 1984. There was a slow build through the 1980s before the recession diminished gains. But a blow-off top in the late 1990s gave us the largest 10-year gains before they hit lows in February 2009, with a long bull market peaking exactly 10 years later in February 2019.

The pandemic was a lot like the period in the early 1960s, extending the gains into a double-top in September 2021, but never re-assuming the peak gains from 2019. Ten-year gains are now just over 100% in inflation-adjusted terms. That means you've doubled your money after inflation from May 2013.

What do I make of that last number? By historical standards, it's pretty high. And since 5-year gains are also still over 30% after inflation, I think we are in the process of mean-reverting down — with the usual overshoot to the downside to come. If this is anything like the 1960s or the early 1990s, the downside means you won't lose money on a five-year rolling basis. But in worse examples, inflation-adjusted losses top 50% on a five-year basis. The low in February 2009, for example was -54%.

214.8%

- Peak 10-year gains in inflation-adjusted terms during the pandemic (September 2021)

Why does this mean reversion and overshoot happen? Here's my thinking.

Equities are a residual. By that I mean, the equity is what's left over after employees, suppliers, taxes and interest are all paid. That free cash flow can be very volatile if any of those payment streams increases or decreases significantly, especially given any need to reinvest in the business. So equity holders usually get a return far in excess of the so-called risk-free rate that Treasury bond holders do (we'll call it risk free even though we all know the debt ceiling shenanigans make it riskier).

The thing is, this premium is heavily influenced by interest rates because most of the free cash flows equity holders are paying for when they buy a share will only come in the future. And since that future money is less useful and less certain than a dollar in your pocket today, you have to discount it by an interest rate.

Here's the thing, the unprecedented low rate regime we are leaving was unique in terms of the "real" interest rate investors required, both for risk-free Treasuries and for any other asset. Take a look at this chart of 5-year Treasury Inflation-Protected Securities (aka TIPS). It shows you what people have been willing to pay for a risk-free bond after stripping away inflation.

Notice how we were at 4% when the dotcom bubble burst and have never returned to those levels. When Greenspan cut rates to 1%, the real rate (after inflation) plummeted well below 1%, fomenting the housing bubble. When the Fed tried to unwind this excess, it blew up into the Great Financial Crisis.

This time, the Fed dropped rates even lower, to zero, and started asset purchases to boot. And real interest rates fell to nearly -2% in 2013 before Fed Chair Bernanke warned he was going to stop asset purchases. Eventually, his successor's successor, Jerome Powell, got real interest rates all the way back up to 1%. Presently, they're at about 1.7%, having briefly flirted with 2%. That's less than half the peak rate we saw in the late 1990s.

Now, when we talk about real rates we're talking about the so-called breakeven rate on TIPS. That's the level of inflation implied from the interest rate TIPS that makes you indifferent to a normal Treasury security of the same maturity. It's the difference in rate between, say, a 5-year Treasury bond and the 5-year TIPS. And we can take inflation out of the picture here because that rate has remained fairly constant near the Fed's two-percent objective except during a recent inflation scare and the brief GFC deflation scare.

So when we think about why discount rates are higher, let's think of it purely in "real" terms. It's only the real interest rate that's driving this bus. And that bus is being driven a lot faster right now, but nowhere near as fast as in a fully normalized situation. If we had 4% real rates, as we did when the tech bubble blew up, the echo bubble in stocks would blow up in a hurry.

So forget about fiscal policy, the debt ceiling and inflation. Focus purely on real interest rates as you think about how this plays out. And mesh that with the business cycle in terms of corporate profitability. Doing so will go a long way of telling you where we're heading.

A high real interest rate alone won't necessarily kill stocks. But it will when it is combined with a deep cyclical downturn as we saw in 1973-74 and in 2007-08. As bad as the tech bust was (with 4% real rates), it was still a garden-variety recession. Ten-year inflation adjusted returns on the S&P 500 were back to over 100% by November 2004. It took the Great Financial Crisis to wilt longer-term stock returns.

Nvidia is trading at 25 times sales right now, on the back of an AI-centered stock mania. That's four times the level for other chip stocks in the Philadelphia Semiconductor Index. This isn't emblematic of early cycle bull market dynamics. It's the hallmark of late cycle, or echo bubble periods, as a market is coming down. So while inflation-adjusted 10-year returns for the S&P have been cut in half since September 2021, there is more downside to come. How far down depends on how high the real interest rate gets and how deep the recession is.

Right now, this is looking to be a cycle more akin to the early 1990s or 2000s than the oil shock in 1973-74 or the GFC. That means 10-year returns getting cut in half again to around 50%. Not great, but not terrible. But that also means a market that treads water for a considerable period of time. Moreover, the more pronounced the echo bubble becomes, the more pronounced and the longer the mean-reversion is likely to be. For those close to retirement, that presents some minor risks for sure. And it's one reason that overweighting towards investment-grade bonds and cash is looking ever more attractive.

The system is very fragile. If my underlying thesis is correct, that the world can't really cope with higher interest rates without falling to pieces, then central banks will have an extraordinarily tough time ahead of them.

Edward Chancellor

Author, The Price of Time, The Real Story of Interest

Interview from last year as interest rates normalized

Nvidia earnings guidance has seen the stock go sky high. Cathie Wood dumped it before the gains.
The debt ceiling deal may not dent the economy a ton. I hope not.
Interesting piece on so-called " domestic offshoring". It's send ing low-wage jobs OUT of key US cities
Germany is in a recession.

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