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 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).

[Interest rates] act on financial valuations the way gravity acts on matter: The higher the rate, the greater the downward pull. That's because the rates of return that investors need from any kind of investment are directly tied to the risk-free rate that they can earn from government securities. So if the government rate rises, the prices of all other investments must adjust downward, to a level that brings their expected rates of return into line. Conversely, if government interest rates fall, the move pushes the prices of all other investments upward. The basic proposition is this: What an investor should pay today for a dollar to be received tomorrow can only be determined by first looking at the risk-free interest rate.

Consequently, every time the risk-free rate moves by one basis point -- by 0.01% -- the value of every investment in the country changes. People can see this easily in the case of bonds, whose value is normally affected only by interest rates. In the case of equities or real estate or farms or whatever, other very important variables are almost always at work, and that means the effect of interest rate changes is usually obscured. Nonetheless, the effect -- like the invisible pull of gravity -- is constantly there.

What Buffett is implying is that stocks and bonds are substitute goods. If one gets too expensive -- say, bond yields goes down (and, thus, bond prices go up) relative to stocks -- then investors will substitute away from one in favor of the other, and vice versa.

Not coincidentally, the chairman of the Federal Reserve Ben Bernanke touched on this issue in a recent speech about the bank's stepped-up efforts to monitor the financial system. "In light of the current low interest rate environment, we are watching particularly closely for instances of 'reaching for yield' and other forms of excessive risk-taking, which may affect asset prices and their relationships with fundamentals."

Adding to this substitution effect is leverage, which acts as an accelerant in the demand for stocks. Take a look at the chart below, which shows the amount of margin debt used to buy equities on the New York Stock Exchange. As you can see, there have been three distinct periods of excessive leverage over the last 15 years, all of which correspond to periods of inflated stock prices: the dot-com bubble, the housing bubble, and today.

But, again, even this should come as no surprise to investors. Just last week, The Wall Street Journal published an article titled "Investors Rediscovering Margin Debt." As the author noted, "In March, the level of margin debt stood 28% higher than one year earlier, a time frame that saw the [S&P 500] rise 11.4%."

What I'm getting at is that there's more to this story than meets the eye. That is, the pressure on asset values is not limited to the demand side of the equation; there are issues on the supply side as well.

As the following chart shows, between 1981 and 2007, the size of the overall bond market (which includes the aggregate outstanding value of government and corporate bonds as well as multiple types of asset-backed securities) grew at an average rate of 10% a year. Since the financial crisis, however, the growth rate has slowed to an average of only 3%, as banks such as Goldman Sachs , JPMorgan Chase , Morgan Stanley , and Bank of America have ratcheted back the production of private-label asset-backed securities.

The deceleration in growth is even more interesting when we look at the absolute dollar values at issue. Since the beginning of 2008, the total value of outstanding bond market debt has increased by $3.5 trillion -- no small amount, to be sure. But over the same time period, the Fed's balance sheet has expanded by nearly $2.5 trillion - and it's done so through the purchase of securities in the bond market. The central bank, in other words, has absorbed the equivalent of 71% of all new bond issues. If you net this out, that leaves an adjusted annual growth rate in outstanding bonds of less than 1%, or roughly a tenth of the analogous rate over the preceding two and a half decades.

The point is this: While there's no question that the Federal Reserve is stoking the proverbial flames when it comes to stock prices, the financial industry also shares some of the responsibility, as it controls the pipeline of securities that reach the market. So long as the demand for substitutable securities (i.e., stocks and bonds) continues to exceed the supply, there's no reason to think that either will descend from their current heights.

More expert advice from The Motley Fool
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The article How Supply in the Bond Market Is Inflating Stocks originally appeared on Fool.com.

John Maxfield owns shares of Bank of America. The Motley Fool recommends Goldman Sachs. The Motley Fool owns shares of Bank of America and JPMorgan Chase. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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