Financial Update 7-30

The economy is finally shaking off the last effects of the 2008 financial crash, and going by some indicators things are even better than they were before. The Standard and Poor 500 hasn’t just fully recovered from its plunge six years ago; it’s a full 30 percent higher than it was at the peak of the pre-crash housing bubble. Investor confidence now seems to be high and that’s being reflected in the price of stocks; the Dow Jones is also rising steadily and traders are moving out of safe hedges and back into equities in a big way.
Of course after the last two big stock market peaks – 2008 and the internet boom at the turn of the century – many analysts are looking at the ballooning market with a justifiable concern. Is this another bubble? Is it all going to crash again? Unemployment has been falling all this year, with at least 200,000 net new jobs created every month, but the national rate is still at 6 percent and actual economic growth is slow. It’s easy to understand the fear that this is a rising market with no real support under it.

One source of concern is that the Federal Reserve is holding interest rates down at or near a historic low. That worries many people because it was low interest rates, and the unsafe borrowing they encouraged, that attract much of the blame for the housing bubble that did so much damage. Will cheap borrowing cause another crash in the near future? The answer, in fact, is probably not.
While low rates do make borrowing more attractive they’re not, in themselves, inherently risky. It wasn’t actually low interest rates that blew up the housing bubble. As so often happens it was unsafe assumptions. Lenders thought that the risk of default had been eliminated by new derivatives and asset-backed securities. Then it was taken for granted that house prices would keep rising indefinitely. Finally it was assumed that reparcelling mortgage debt – including the sub-prime loans that brought the whole mess crashing down – reduced any remaining risk, where in fact the risky mortgages contaminated every other debt they were packaged with. If mortgage lenders had kept on applying basic safeguards before approving loans the low interest wouldn’t have caused any problems at all. It was the mistaken assumptions that led to precautions being abandoned that did the damage.
Now the Fed’s cheap money supply is pushing stock prices higher, and there’s a simple reason for that. Low interest increases the real future payoff of a financial asset, so that pushes up the value – and that’s exactly what’s happening now. Far from being a bubble the rising S&P is a normal and unthreatening response to low rates. That’s not to say nothing can go wrong, but it isn’t an irrational bubble.
Given recent history it’s only to be expected that sharp rises in stock prices will alarm many market watchers, but right now there isn’t much to worry about from that direction. Sluggish growth is more of a concern but low rates might actually help that, by encouraging businesses to borrow for capital improvements. Overall the stock market looks pretty healthy right now, so it’s best to sit back and enjoy the ride.