How Supply in the Bond Market Is Inflating Stocks

Investors are stuck between a rock and a hard place. At the same time that bonds are offering historically low yields, stocks are trading for a healthy premium over their 60-year average. According to the most widely cited estimate, the current premium on the S&P 500 (SNPINDEX: ^GSPC  ) is upwards of 24%.

Given the sluggish economic recovery, what's causing asset prices to inflate?

The obvious, though incomplete, answer is that there's been an increase in demand for debt securities from the Federal Reserve. Since the fourth quarter of last year, the central bank has purchased $85 billion each month in long-term treasuries and agency mortgage-backed securities. The effect has been to hold long-term interest rates at their current low levels -- indeed, had you told someone 10 years ago that the yield on the 10-year treasury would go below 2%, they would have called you crazy.

The Fed's actions are also a proximate cause for the recent ascent in equity prices. The connection here was discussed by Warren Buffett in a famous speech he gave at the height of the dot-com bubble (if you've never read it, I strongly encourage you to do so).  (more)

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