Stocks are not in a bubble, but bonds are. When the bond bubble bursts we should all beware, and it could burst soon.
That, in a nutshell, is an argument that has echoed throughout the eight years of the most hated bull market for stocks in history.
It gained a prestigious adherent this week when Alan Greenspan, long the chairman of the Federal Reserve, made a boldly bearish prognosis in an interview with Bloomberg.
He said: “By any measure, real long-term interest rates are much too low and therefore unsustainable. When they move higher they are likely to move reasonably fast. We are experiencing a bubble, not in stock prices but in bond prices. This is not discounted in the marketplace.”
Ramming the point home, he added: “The real problem is that when the bond-market bubble collapses, long-term interest rates will rise. We are moving into a different phase of the economy — to a stagflation not seen since the 1970s. That is not good for asset prices.”
This is not a particularly novel argument. Those sceptical of the post-crisis recovery in stocks since 2009, current writer very much included, have tended to offer this scenario, or a version of it, for many years.
For example, the London-based hedge fund manager Crispin Odey introduced the concept of a “rational bubble” as early as September 2009.
He argued then that the stock market was already “entering a bubble phase”, and that it must end when quantitative easing ended but until then “this bull market is sponsored by [Her Majesty’s Government] and everyone should enjoy it”.
What is different this time is that the person making the argument is viscerally hated by many of the people who do not believe in the recovery, and indeed blamed by them for most of the financial system’s current problems.
If even Alan Greenspan, he of the ‘’Greenspan Put’’ says that only cheap money from the Fed is propping up stocks, is this the moment to signal a “top”?
Mr Greenspan’s choice of metric, real interest rates — which take inflation into account — do appear to explain moves in markets neatly since the end of 2009.
In that period, 10-year real yields only exceeded 2 per cent, while the two-year real yield only turned positive, for a period of about a year that ended in early 2016 — when stocks’ growth stalled and moved sideways.
For further circumstantial evidence, note that this came immediately after the Federal Reserve halted QE bond purchases at the end of 2014. If equity prices do not depend on the remarkably expensive bond market, it certainly looks like it.
What of his argument that inflation is due to increase? It is interesting to see him line up on the side of the Fed’s current hawks, but this is a more contentious claim.
The labour market looks tight (even if many millions continue to suffer stubborn long-term unemployment), but wage growth has remained slow and core measures of inflation, excluding commodity prices, have declined again in recent months.
Hopes for a big US fiscal stimulus under President Trump, that would snap the economy out of its low-inflation doldrums, are now dwindling.
That leads to a critical question about the bond market. Is it in a bubble, or could the current low interest rates conceivably be justified by fundamentals?
Persistent slow growth would entail low bond yields — and there is a welter of demographic factors that also push down on bond yields. The point that equity valuation depends on the bond market is well made; the contention that bonds are in a bubble remains more contentious. That is the issue on which everyone involved in investment should focus.
Meanwhile, if you want to follow Mr Greenspan and cover yourself against impending rising rates, what to do?
David Kostin of Goldman Sachs recommends a gloriously politically incorrect trade: companies with low labour costs (and therefore less exposed to higher inflation) have been outperforming companies with high wage costs for the past 12 months (after a long period of underperformance).
That should continue if wage inflation takes off, and shows that the market is worried about wage inflation.
Goldman-recommended investments in such companies in the event that Alan Greenspan proves to be right might not be popular, but they should continue to perform well if wage inflation takes off.
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