What Does a Bond Collapse Mean for the Stock Market?

Hindsight is 20/20 and for years, investors have been following the advice of major names in finance who anticipated market collapse...or rather, were very vocal about it after the fact. While I doubt we are anywhere near a market collapse (at least not one caused by a major event which can happen any time), former Fed Chair, Alan Greenspan, warns that a bond market bubble is the biggest threat to the stock market right now.

In an article from Investopedia, Greenspan was noted as saying according to the Fed Model (see below) US stocks are priced at one of the most attractive levels ever, at least for the moment, in relation to bond prices.

In comments to Bloomberg, Greenspan was quoted as saying, "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."

Greenspan believes that long-term interest rates will turn upwards when central banks begin withdrawing liquidity from their financial systems by selling bonds. As such, bond prices will collapse and will turn into the worst case of stagflation since the 1970s.

Interest rates are expected by just about everyone else to remain low for now, so the point is not meant to frighten everyone, but just to remember that you need to remain vigilant about occurrences in the market and this will help with great market decisions long-term.

What does the Fed Model Say?

"The so-called Fed Model consulted by Greenspan, as explained by Bloomberg, compares the yields on 10-year U.S. Treasury Inflation Protected Securities (TIPS) to the earnings yield on the S&P 500 Index (SPX). The current figures are 0.47% and 4.7%, respectively, per Bloomberg, which notes that the gap between the two measures is 21% greater than its 20-year average. For those who subscribe to this analytical framework, high valuations for stocks are justified for now. However, another spin on this analysis, per Bloomberg, is that investors are justified in buying the less inflated asset. If bond prices rapidly deflate, as Greenspan foresees, stock prices will soon follow."

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