2012 Stock Market rise fueled by Supply/Demand Dynamics & Fed Induced Liquidity

By The Curmudgeon

The Curmudgeon does not believe in making predictions about where the stock markets will be at the close of business this year. I don't believe anyone has the ability to accurately forecast the market in the year ahead. 


However, we can look back and assess 2012 as a market dominated by supply/demand and Federal Reserve induced liquidity.  And we think that's what drove stock prices higher this past year!


While individual's and mutual funds were liquidating hundreds of billions $s of equity holdings, U.S. companies repurchased $274 billion more shares than they issued through the first three quarters of the year, according to Yardeni Research.


General Electric recently said it would buy back $10 billion of its stock through 2015. Thatís in addition to the $4.9 billion remaining on its current repurchase authorization. Home Depot has also spent $3.3 billion on share buybacks over the first three quarters of its current fiscal year, and plans to spend an additional $700 million in the current quarter, to bring the total to $4 billion.  International Business Machines plans to repurchase $50 billion of its stock in the five years to 2015.


Meanwhile, JP Morgan said in their 2012 Year End Review: "As the overall IPO market remained sluggish around the world, there were proportionally fewer capital raisings in the first 11 months of 2012 than in the same period last year."  While the final 2012 numbers are not in, we expect the total US $ amount raised from IPOs and secondary offerings to be significantly less than the amount of corporate share buy-backs.


The Fed's zero interest rate policy, QEx and Operation Twist produced liquidity that flowed into equities. Some experts say that caused the equity markets to be manipulated.  This year, the Fed will be purchasing $40 billion of U.S. government bonds and $40 billion of mortgage-backed securities each month means that the Fed will be pumping an additional $1 trillion dollars into the economy.


It's important to note that expectations about the future crucially affect todayís asset prices. For example, stock prices reflect expectations of future dividends. Long-term interest rates are influenced by expectations regarding future short-term interest rates. But when risk (as measured by stock market volatility or the VIX) is low, institutional investors take on more risk. We believe this is what caused global equities to post double digit gains in 2012- not fundamentals or improved earnings! 


However, we cannot ignore the steady rise in corporate earnings as per the chart below.   



But the crucial question for main street remains: if corporate earnings have done so well since the great recession, why hasn't GDP growth been way below trend rate of 3% and why has unemployment not come down to below 7%? The answer is that profit growth was mostly due to cost cutting, rather than large increases in top line growth (i.e. revenues)! We don't think that trend can continue in 2013.

Corporations are using their profits to mostly hoard cash, buyback shares, or (in some cases) increase dividends on their common stock. According to JP Morgan, the S&P 500ís combined cash holdings rose 14% through the first nine months of 2012, to $1.5 trillion. Because the uncertain global economy companies are holding cash instead of spending on capital equipment, increasing inventories, or hiring new employees.

But as we said in an earlier post we don't believe that earnings drive stock prices anymore. So what to expect for 2013?  Expect uncertainty and a huge increase in volatility from the relatively calm market experienced in the past year.  This is due to no real progress on Congress agreeing to reduce the U.S. federal deficit which has been running at over $1T for the last four years.  As most have already opined the fiscal cliff deal didn't really resolve anything.  The tough negotiations lie ahead and this time, that cannot be kicked further down the road!


Till next time......


The Curmudgeon

Curmudgeon is a retired investment professional.  He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996.  He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.