This Unexpected Event Will Cut the S&P 500 in Half

So what's ahead for 2014? We don't know… but we know what most people think they know is not so. Most people think 2014 will be a "return to normal." Don't count on it.

Whatever happens, it will be hard for the stock market to match 2013. During the last 12 months the S&P 500 gained an astounding $3.7 trillion. To put this in perspective, the S&P lost 1% a year from 2000 to 2009. Then, with the Fed's jet engine behind them, stocks took off… bringing the total return to 3.6% a year. Still not great. But a lot better.

But what does it mean when stocks gain $3.7 trillion in a single year? The underlying companies couldn't possibly have changed in any fundamental way. Most likely, they are the same now as they were at the start of the year – run by the same people, doing the same business, making the same sales. So, why are they worth so much more?

Profits are higher – in no small part because the Fed's ZIRP has made it possible to borrow cheaply. Companies used the cheap credit to do two important things:

1) Refinance expensive debt, lowering interest expenses and thereby pushing
up net profit margins

2) Buy back their own shares, raising their share prices

It's not likely they'll be able to repeat the trick in 2014. Because interest rates are moving up …

 

Big News

The Financial Times announced the big news at the end of last week. "Yield on 10-year Treasuries Reaches Above 3%," was the top headline (or words to that effect). It was big news, because bond yields affect the cost of credit, and the cost of credit affects all financial transactions.

How will debtors be able to keep up with rising interest charges now that refinancing means making higher payments? How will homeowners pay their mortgages? If you can earn 3% on "risk free" Treasurys… does it make sense to buy overvalued stocks? Real estate? Andy Warhol doodles? Will any investment do better than 3%? Is the extra risk worth the extra reward?

Those are questions corporate treasurers and investors barely needed to ask at all a few months ago. When the 10-year yield hit its low of 1.6%, it put the "risk free" yield on a par with the rate of increase in the Consumer Price Index. This meant any investment with a positive yield – no matter how small – was a good one in relative terms.

The hurdle was so low even a snake could slither over it. Bad investments? Stupid spending? Incompetent managers? It hardly mattered; money was essentially free. Now, in 2014, nominal yields are twice as high. And the real (inflation-adjusted) yield has gone from about 0% to about 1.8%.

That brings back the question marks. But the main question is: Are rates headed back to "normal" levels? And what will happen if they rise to above "normal" levels?

 

What Happens When Rates Rise?

Since World War II, the average yield on the 10-year Treasury note was about 5.9%. Heading back to that normal level… from today's abnormally low levels… would not bring a normal financial world. It would bring a disaster.

At normal yields, it would cost the federal government $440 billion more to service its debt costs. That would push the budget deficit to back over $1 trillion… and it would set off a chain reaction of bad news in the private sector and in government.

Yes, dear reader, the US economy depends on cheap credit. When credit gets to be more expensive, millions of retirement plans, investments and budgets get busted. In fact, they will almost all be busted. US stocks will go down – probably crashing down to about half their values today. That $3.7 trillion they gained this year will disappear… and then some!

Well… Easy come, easy go. But normal? Far from it …

 


 

TNX

10 year treasury yield – going the wrong way – via StockCharts – click to enlarge.

 


 

The above article is from Diary of a Rogue Economist originally written for Bonner & Partners.

Bill Bonner founded Agora, Inc in 1978. It has since grown into one of the largest independent newsletter publishing companies in the world. He has also written three New York Times bestselling books, Financial Reckoning Day, Empire of Debt and Mobs, Messiahs and Markets.

 


 

 

 

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