Why stock bubble continues to inflate and it is just fine?
It is an eventual reality that the current stock bubble will burst as our economy is preparing for a soft landing. The question is when. It is not uncommon to see high flying stocks with value increased by more than 50% over the past year. This phenomenon is indicative that a paradigm shift has taken place in this fragile economy. Companies with persisting negative EPS and evidence of high growth continue to sustain and expand in valuation as long as they can finance new CAPEX and refinance old debt with bonds and CLO. The new accounting procedure ASC 606 also comes timely to dress up companies’ balance sheet. When the cost of money is low, companies can borrow money to buy back shares so as to improve its share price. As a result, these companies are partly responsible for creating jobs and stock bubbles.
Ever since the central bank countered the financial crisis of 2008 with QE, the flood of cheap money is helping businesses to expand by borrowing money at very low cost. Many companies are dependent on the low interest rate to prevail in order to finance it business. As a result of the expansion, near full employment prevails and growth stocks have dominated investors’ focus. Fueled by huge borrowing appetite, low quality bonds, CLO and its derivatives are among popular high yield alternatives for investors. With high yields from junk bonds, investors are happy with the ROI. These high yield assets come with high risks. As long as the central bank continues to maintain low rate or cut existing rate to even lower, the party continues.
In recent days, many risky businesses with negative EPS and huge valuation went IPO. The share price of many of these unprofitable businesses went through the roof in the name of growth. As long as investors see double digit growth in share price, many of them are willing to ignore the high risk. Consequently, many new jobs are created by these over-valued companies while further inflating the stock bubble. Central bank uses interest rate to regulate the economy. Its objective is to achieve near full employment and to ensure financial stability within a preset inflation target. As long as the companies can borrow more and refinance their debts, earnings and revenue is secondary in the eye of investors.
Many companies are at risk if they are unable to refinance their debt. When these companies go kaput, so are the employment. If central bank would ever increase interest rate, these companies will likely to go defunct, in the process creating huge unemployment and pushing a fragile economy for the worse. Knowing that the central bank is preparing to use low interest rate as a tool to pop-up the economy, we should expect stock bubble to continue for the time being while near full employment persists.