Lots of people are asking what's happening to the stock market lately. Are we in for a crash or a protracted bear market? No one, of course, can say for sure. But an understanding of some of the key factors that have driven stock prices up the last few years suggests stocks are headed down from here.
An interesting graphic in The Wall Street Journal two weeks ago, right before stocks fell so hard, showed that all of the world's top 20 stock markets were at yearly or all-time highs. Everybody was buying stocks. And it's not just stocks. Prices on many types of bonds are sky-high. Despite some areas of falling prices, real estate values are also still near all-time highs across the nation.
What could explain this? The biggest reason is that there is a record amount of cash around the world looking for a home. Investors have money to invest and so they're putting it anywhere and everywhere, bidding up the value of the assets mentioned above and many more.
That should be good, right? A record amount of cash means people are doing well, doesn't it?
Not so fast. It's crucial to understand where so much of this cash is coming from: It's borrowed. At some point, it has to be paid back.
For the last few years, investors worldwide have capitalized on rock-bottom interest rates to finance purchases of stocks, bonds, real estate, commodities and so on. When you buy things, their price goes up. But now it's payback time - literally.
Look at real estate. Over the last few years, it was very easy to borrow money to buy a house or a condo. In many cases, lenders stopped asking borrowers to provide proof of income before financing up to 100 percent of the purchase price of a home. But now, borrowers are discovering it's not so easy to pay a mortgage you can't afford.
A similar dynamic is playing out with stocks and bonds: The borrowing phase is ending and the paying-back phase is beginning.
Just as in real estate, investors have been borrowing record amounts of money to buy stocks and bonds the last few years. In late February, for instance, the New York Stock Exchange reported that money borrowed to buy stock (on "margin") reached an all-time high. With interest rates on yen near zero, hedge funds have been borrowing yen for virtually nothing to buy stocks. With junk-bond yields near all-time lows, leveraged-buyout firms have been borrowing billions to finance the purchase of huge public companies such as hospital owner HCA, commercial real estate company Equity Office Properties Trust, and, just last week, the utility TXU.
What's bringing on the payback period in stocks and bonds? One reason is that the Bank of Japan said last week it will raise interest rates on loans made in yen, forcing many hedge fund investors to sell the stocks they bought with borrowed yen. On the housing front, the implosion of subprime lending can only exacerbate the fall in real estate prices as borrowing to buy homes becomes more difficult. The bottom line is that easy credit to buy stocks, bonds and real estate may be a thing of the past.
When markets are driven up with too much borrowed money, it can set them up for a big fall. One of the key factors that led to the dramatic rise of stocks in 1929 was the explosion of broker loans to buy stock. It got pretty ugly when everyone was forced to pay back those loans over a short period.
The next Great Depression is likely not around the corner. The worldwide economy is probably too strong for that to happen. But we should never forget this lesson of 1929:
Markets that fly high with borrowed money can crash hard.
Rolfe Winkler, Chartered Financial Analyst, is an analyst at a hedge fund. His e-mail is firstname.lastname@example.org.