Stocks and bonds rally: Are markets getting overpriced?

Markets rallied in August.

The MSCI All-Country World Index jumped 2.0 percent last month, the Standard & Poor’s 500 Index surged 3.8 percent to a record high and the STOXX Europe 600 Index rose 1.8 percent.

Bonds also rose. The United States 10-year note yield fell 21 basis points in August to 2.34 percent as yields in Europe collapsed to record lows. The German 10-year bund yield reached 0.866 percent on 28 August while the French 10-year government-bond yield fell to 1.217 percent.

The US 10-year note yield exceeded those of its Group of Seven counterparts by 79 basis points on 26 August, the most since June 2007, according to Bloomberg.

Jim Hamilton at Econbrowser looked at the longer term trend in bond yields and noted that, apart from a rebound in the spring of 2013, the general trend since the end of the Great Recession has been down.

Once you correct for pricing of risk, it looks like investors have been anticipating a negative real rate well into the future ever since the end of the recession. Expectations lifted in the first half of 2013, but have been falling sharply this year.

What could produce such a pattern? It’s hard to attribute it to changing perceptions about the Fed, which should surely matter more for the next 5 years than they would for 5 to 10 years from now. More confidence that the U.S. government will be able to keep debt from growing relative to GDP over the next decade may have played a role.

Another possibility is that more people are starting to take seriously the suggestion that we’re on a path now of secular stagnation with weak economic growth and poor investment opportunities over the next decade. But that’s hard to reconcile with the stock market, which climbed impressively this year.

Or then again, maybe the market has simply overpriced both stocks and long-term bonds.

The answer appears clearer to Chris Martenson. He wrote on MarketWatch that markets are in a bubble:

While there are a fair number of warning signs now that the free money policies of the world’s central banks have given us another stock bubble, they’re outnumbered by the flashing red lights we see over in the bonds market...

In a normal, non-bubble, environment, we’d expect that more supply coupled with lower credit-worthiness would lead to higher yields. But in the midst of a bubble, we often see the reverse. And today, we are.

Take Italian debt, for example. Italy’s gross domestic product is actually smaller than it was in 2008, and it has issued bonds at a furious pace to keep its economy afloat. As a result, it now sports a frighteningly high debt-to-GDP ratio of over 135%. And yet the yield on its 10-year bond has sunk from 7.1% in 2012 to just 2.4% today.

Martenson also sees rising issuance in corporate bonds, falling credit quality, fewer creditor protections, diminishing yields, insider selling, and evaporating liquidity, and thinks that they add up to a bubble, one that is “larger than any we’ve yet lived through”.