For the average person trying to decide how to feel about the economy, the
single biggest data point is the stock market. When share prices are rising,
the implicit message is that finance professionals -- who, after all, dedicate
their lives to understanding such things and should therefore know what's happening
-- have decided that life is good and getting better.
So the rest of us relax and go shopping. Known as the "wealth effect," this
tendency of asset prices to affect consumer behavior is now a key policy goal
of the US and pretty much every other major government.
But what if it's all a gigantic, multi-trillion-dollar con? That's the conclusion
a growing number of analysts are reaching as they dig into the reality behind
the recent record highs in US equity prices.
The first part of the story goes like this: The US has lowered interest rates
to the point where it is actually more profitable for many companies to borrow
money and use the proceeds to buy back their own shares, thus eliminating the
need to pay dividends on those shares. Gordon T. Long of Macro Analytics recently
ran the numbers:
What do corporate CEOs and Boards know which everyone is missing and that is
driving them to executing corporate buybacks approximating $2 Trillion over
24 months? The answer is a free tax ride thanks to the Macroprudential Strategy
of the Fed's ongoing game of Financial Repression. A game which may be quickly
getting out of control!
Unprecedented Buybacks Levels
In case you are in the 1% who have been too busy counting your startling
increase in net worth, let me first highlight the velocity with which corporate
buybacks have accelerated to.
90% of all S&P 500 profits are presently being spent on corporate Buybacks
and Dividends. This is historically unheard of. We are approaching nearly
$2 Trillion in buybacks by the S&P 500 members within a forecasted 2
year period. So why is this distortion happening?
A Free Tax Ride
We presently have one of the biggest tax ruses in history going on as the
Fed and US Treasury desperately try and increase the wealth effect to elevate
asset prices and finance government debt. To make low bond yield seem relatively
attractive (at present historic lows), the Fed needs to get stock yields
down via elevating stock prices. Corporations have been willing accomplices
in this charade.
Generic Tax Example
Assumptions:
- Dividend payout rate approximates the S&P 500 average of 2.25% per
annum.
- Borrowing costs approximate 3.5% per annum
- Corporate nominal US tax rate 35%
- Assume stock trades at $100/share with 100 shares outstanding,
- Market Capitalization of $10,000 (100 X 100)
A 2.25% Dividend rate means a $2.25 Dividend payout per year.
If we were to borrow $225 to buyback 2 1/4 shares it would cost $7.89 ($225
@ 3.5%)
The tax deductibility of $7.89 at a nominal tax rate of 35% would be $2.76
Therefore our model corporation would save $0.51 ($2.76 - $2.25)) by borrowing
to buy back their shares.
Long goes on to illustrate the point using Apple and IBM, and concludes that
buying back stock, even at today's elevated levels, is a profitable arbitrage.
What does this mean? The short answer is that the bull market is fake, fueled
primarily by companies looking to save money on taxes rather than invest in
undervalued shares. In effect they are, with the government's help, tricking
both their shareholders and individual investors into buying overvalued equities
in order to generate bigger year-end executive bonuses for themselves.
Arguing for the validity of this cynical conclusion is the fact that corporate
insiders are selling their personal shares while directing their companies
to buy back those same shares. See Rise
in legal insider selling raises yellow flag:
Corporate insiders are selling shares of their own stock at a quickened
pace at the same time the U.S. stock market is making new highs, a bearish
sign that raises a yellow caution flag for investors.
Neil Leeson, an ETF strategist at Ned Davis Research, zapped out a warning
to clients today about "legal" insider trading.
"Despite the fact that most investors feel they have no alternative to being
fully invested (in stocks), there is one crowd of investors who has turned
into pretty consistent sellers, and that's corporate insiders," Leeson told
clients in a video.
In fact, insider selling has picked up so much that is has generated a new "sell
signal" on the market, Leeson said, citing an NDR indicator that tracks and
measures insider buying and selling.
"Insider selling," Leeson says, "is typically bearish for markets."
When insiders are selling, it sends the message that they believe their
company's shares have become fully valued and, therefore, have limited upside.
The second part of the story is even more disturbing, because it involves
the world's central banks which are now, apparently, buying equities directly.
From Cris Sheridan at Financial Sense:
Last month, a report released from the Official Monetary and Financial Institutions
Forum (OMFIF) gained wide attention by shedding light on yet another powerful
force that may contribute to overheating markets around the globe.
In a recently published interview with Financial Sense, David Marsh, Co-Founder
and Managing Director of the OMFIF, explains how central banks are now suffering
the consequences of their own low-rate policies and, like everyone else,
attempting to earn greater returns by shifting directly into stocks.
Although a limited number of central banks have been doing this for quite
some time, on a "worldwide scale it is relatively new...and therefore really
worth taking heed of," said David.
When asked how long this might last, David didn't think this was a temporary
move but "part of a longer-term trend." Central banks, he said, "tend to
be rather herd-like creatures. They will look at this market for a number
of years, figure out how best to attack it...and then once they've discovered
a taste for these markets, they will stay there."
Although careful with his choice of words, David does warn that this growing
trend may contribute to a "slightly overheated international equity market":
"I'm not saying that this is the factor driving the markets but it may be
a factor in some areas leading to a possible tendency for overheating. It
is interesting that the central bankers' bank, the Bank for International
Settlements, just over the weekend has pointed out that some capital market
participants are getting a little bit carried away by euphoria and investing
too much in risky assets. And, of course, this is really like the pot calling
the kettle black because many of the shareholders of the BIS, which includes
60 central banks from around the world, are themselves investing in equities.
Although they are trying to do it, I'm sure, in a way that isn't driving
up equity prices, they may be in aggregate helping to lead to what we might
think in future years has become a slightly overheated international equity
market."
The result of all this more-or-less random stock buying is a market that is,
by pretty much every valuation measure, hyper-expensive and therefore ready
for (at least) a serious correction. For a sense of what happens when our manifestly-false
bull market finally ends, see this evocatively-titled essay from Automatic
Earth: Don't
Go Walk Under Wall Street Windows
