Investors have “no choice” but to speculate when interest rates are zero. But, as Graham noted, speculating can be stupid in many ways. The first is speculating as investing.
Stocks may have “investment merit,” “speculative merit,” or neither. Investing discipline measures “investment merit” by valuation, the relationship between a security’s price and the expected stream of long-term cash flows.
The recent market cycle differs from previous cycles in that speculation had a clear limit.
We measured the extremes using “overvalued, overbought, overbullish” syndromes.
The Federal Reserve’s relentless denial of risk-free returns has spawned an all-asset speculative bubble that will provide investors with little but return-free risk.
The only question is how long they can keep stomping on the gas pedal and making things worse.
Meanwhile, keep in mind that easy money does not prevent market losses.
When investors are risk-averse, low-interest safe liquidity becomes a desirable asset. So making more of it doesn’t help stocks.
Those inclined to speculate, on the other hand, psychologically rule out capital losses. They can’t afford zero-interest liquidity in that environment. They feel compelled to sell it, so they chase risky assets regardless of value. Sadly, every dollar a buyer “into” the stock market goes “out” in the hands of a seller.
When investors are inclined to speculate, Fed easing can significantly increase that speculation.
However, when investors are risk-averse, as they were in 2000-2002 and 2007-2009, even aggressive Fed easing may not help stocks.
The idea is simple: when investors are inclined to speculate, they tend to be indiscriminate.
The stock market isn’t ‘held up’ by zero-interest liquidity, at least not mechanically.
That speculative psychology that excludes the possibility of loss, no matter how extreme valuations have become, is bizarre.