Why the Market is Making All-Time Highs
Dear Traders,
In basic economics, the direction of interest rates impacts a company’s theoretical value. When interest rates fall, and all else is constant, the share value will likely rise. Conversely, when interest rates rise, the share value will likely fall, especially for companies like technology firms. This is because the majority of their future revenue is projected to be in the future. Therefore, based on the discounted cash flow model, their present value decreases, since the risk-free rate is now higher.
When in 2022, the Fed started to increase the rate, QQQ dropped more than 35%, more than SPY. The reason was that the majority of QQQ companies are technology firms. Based on discount cash flow analysis, their future cash flows, discounted by a higher cost of capital, give their present values.
But as we see now, QQQ is not just back to its all-time high; it’s even higher than S&P 500 companies. The interest rates are still at very high levels, and it does not seem that they are likely to go back down to levels we saw during the pandemic.
What is happening? Most economists are scratching their heads.
The answer lies in the psychology of the market.
If you take a financial risk and it pays off, you might take another one. And if that pays off, then you might take an even bigger risk the next time. And if that pays off, then you might start thinking you’re a genius, and take on way more risk.
There’s a way to make sense of the trajectory of the market in the 2010s, post-financial crisis, through the lens of greater and greater risk-taking. The bull market went on and on and every bet seemed to pay off. Sure there were dips along the way. But they were usually V-shaped dips. And then we got the mother of all V-shaped dips in the spring of 2020 when policymakers were able to stop the Covid recession almost instantly. And so after a decade of a bull market, investors realized that recessions could be stopped in their tracks, and risk-taking went wild, to the point where people were pouring money into profitless SPACs, tokens named after dogs, digital drawings of monkeys, and algorithmic stablecoins promising 20% payouts. 2021 was the natural culmination of a decade-long bull run.
After the Fed started raising rates the meme stuff and crypto and growth stuff got crushed the hardest. But the question was why? What’s the big deal if the Fed Funds rate goes from 0% to 5% or whatever? How does that change the value of Terra or a digital ape? Of course, the Fed Funds rate alone actually doesn’t matter. What matters is that the big risk-taking cycle is doing a 180, and the rate hikes while important are only a part of it.
There isn’t some mechanical or mathematical link between speculative activity and the Fed funds rate. People kind of imagine that you cut rates and everything jumps and then raise rates and everything goes down. But it’s not so simple.
During the dot-com bubble, Fed Funds was around 5%. What’s more, the Fed started hiking again in 2004, but the housing boom just kept going. In fact, a lot of the worst housing assets were created deep into the hiking cycle, around 2006, when the Fed had brought rates back up to 5%. Eventually, the market turned and the housing boom crushed, but the point is that it wasn’t a mechanical function of higher rates. Higher rates were just one contributing factor, ultimately, that caused the risk cycle to move in the other direction.
So, why are the super risky investments going up again now?
It’s basically because the mindset of traders has changed, and they’re now more optimistic. Despite being in the midst of a trade war and two literal wars, we’re seeing a resurgence in risk appetite. The S&P 500, which historically traded at an average forward P/E of 19, is now trading around 25. Although it’s not in bubble territory, it’s trading at a higher price. But, who cares? Traders and investors are comfortable at these prices. Who’s to say the average has to be 18? Maybe the new average is 25.
No one truly knows how the market works, but it seems that risk appetite is really high these days with AMD over $200 and NVIDIA approaching $1,000, and the market reaching all-time highs every day.
For traders and investors, it has never been this good. This market is as good as 2021, if not better. If you’re a new trader, you should learn and equip yourself. If your trading account is still hurting from the burst of 2022, you’re doing something wrong. I’ve recovered all million-dollar losses from 2022 and then some.
I still have friends holding onto the garbage companies of 2021. You need to revisit your investment approach and try to recover the losses if you’ve had any.
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To your success,
Andrew
