How Long Will Stock Buybacks Fuel the Bull Market?
by the Curmudgeon with Victor Sperandeo
The markets fixation on the Fed is incredible. This past week, stock prices rose sharply - attributed to anticipation Fed Chairwoman Janet Yellen wouldn't hint at raising interest rates anytime soon in her Jackson Hole speech. She didn't and the S&P 500 closed at an all-time record high on Thursday. But gold prices moved the other way and declined on reported fears that the Fed would raise rates sooner than expected. What gives? Honestly, we don't know and don't want to hear any explanations for the capricious and contradictory market action.
One of the dumbest and contradictory editorials I've ever read was this Sunday's NY Times piece titled: Why Interest Rates Need to Stay Low. Here's the most contentious part IMHO: "The Fed’s loose policies have pushed up stock, bond and real estate prices — which is, in fact, the point of a low-rate policy (Really? I thought it was to stimulate investment and loans to benefit the real economy?). There is legitimate debate about how overvalued assets may be. But low rates, by fostering investments with borrowed money, invariably create the conditions for bubbles."
We dismiss the above as a new low in the newspaper I've read regularly since 1957. Instead, let's examine and analyze what was said by the Fed Chairwoman at the central bankers’ gala conference in Jackson Hole, WY.
Yellen Has Spoken:
Janet Yellen’s Jackson Hole speech didn't give any hints at when short term interest rates will be increased or when Fed Monetary policy will be normalized. The only thing really new is the Fed says the unemployment rate doesn't fully describe the current "slack" in the labor market.
The headline unemployment rate has fallen from more than 8% -- when the Fed started the current phase of its QE/asset-purchase program -- to 6.2% in July 2014. Yet that headline unemployment rate is not capturing what is truly happening in labor markets, which are quite a bit weaker (i.e. the large number of discouraged workers that have left the labor force, people forced to retired early, temporary and part-time workers, etc.).
To pursue its second mandate of full employment, the Fed will be following "a labor-market conditions index (LMCI)," consisting of 19 individual indicators, to gauge the actual state of the labor market. Ms. Yellen addressed important labor market issues and how they impact the FOMC’s assessment of current market conditions. She gave more weight to possible structural changes in the labor market and pointed to the danger of raising rates too late as well as too early. She seemed to take a neutral position on the level of under-employment in the economy, but was quite vague
Related subjects Ms. Yellen addressed included: labor market slack and difficulties in measuring it; the recent changes in the labor market participation rate; the problem of the chronically unemployed; the role of people who are employed part-time but want full-time jobs; labor market flows in terms of quits and hires; workforce demographics and the impact of an aging workforce; the disappearance of so-called middle-skill jobs; the impact of disability rates, retirements, and school enrollments; and finally, the effects of the recession on wages and productivity gains. Here's a quote we especially liked:
"Likewise, the continuing decline of middle-skill jobs, some of which could be replaced by part-time jobs, may raise the share of part-time jobs." Do you think the ACA might have something to do with that remark as it doesn't apply to part time workers?
Ms. Yellen emphasized the goal of promoting full employment in a way that broadly improves labor market conditions, rather than just seeking to lower the unemployment rate (which as noted above is often misleading).
“With the economy getting closer to our objectives,” Ms. Yellen said, “the [Federal Open Market Committee’s] emphasis is naturally shifting to questions about the degree of remaining (labor market) slack, how quickly that slack is likely to be taken up, and thereby to the question of under what conditions we should begin dialing back our extraordinary accommodation." Yellen’s bottom line seemed to be: "under-utilization of labor resources still remains significant."
Apparently, Yellen believes that accommodative (AKA ultra-easy) Fed monetary policy can continue without stoking the fires of inflation. She said that the current slack in labor markets, combined with an economy growing at or slightly below trend, is evidence that inflation is not a near term problem, nor is likely to become one anytime soon (Hyper-inflation forecasters, where are you? John Williams forecasts hyper-inflation to commence this year).
Besides raising the Fed funds and discount rate, what other actions might the Fed take to normalize monetary policy? Based on Yellen and other FOMC member speeches, there is no consensus as to how policy should be normalized. For example, when should the Fed stop rolling over its maturing U.S. Treasury and mortgage securities, how the four relevant policy rates (Discount rate, interest rate on reserves held at the Fed, Federal Funds rate, and Reverse Repo rate) should be set relative to each other, what role forward guidance (to pre-announce monetary policy) will play what will be the timing of any or all of the above. In fact, the FOMC has just formed yet another committee to consider its communications policy with the public. And it's yet to clarify exactly how it will use Reverse Repo's to control bank reserves and the money supply.
Peter Boockvar, managing director at the Lindsey Group, said, “Bottom line, the speech was an academic discussion that was a non-event in terms of gleaning any clues to when future policy moves, past the end of QE, will occur.” We don't agree as explained below.
Fed Policy Takeaways & Implications:
With inflation not perceived to be a problem it's almost certain that short term interest rates will remain at zero (0 to 0.25%) until greater labor market improvement (including wage increases) is evident. Moreover, there appears to be NO TIME TABLE for Fed rate hikes at this time. The labor market and other incoming economic data will dictate that event which will likely be pre-announced via "forward guidance."
Given the lack of Fed consensus and clarity, we think it highly unlikely that the Fed will raise rates or even normalize monetary policy in March (or anytime in Q1) 2015, as many bullish economists expect (that's largely based on GDP forecast north of 3% accompanied by accelerating wage increases). Even if there were a consensus amongst FOMC members, there is great uncertainty as to how financial markets would react to any policy move or even to a hint that a policy move is imminent. Remember last summer's "taper tantrum?"
We believe a sharp market reaction would follow, with holders of large portfolios of (now) low-yielding junk and emerging market bonds dumping them abruptly to avoid capital losses. That could destabilize other financial markets, especially overvalued global equities, precipitate an across the board lack of confidence, and derail the now fragile (main street) economy.
One Federal Reserve Board President isn't worried about inflation getting out of control or any fallout in the financial markets from Fed guidance on a rate rise. Atlanta Fed President Dennis Lockhart is instead more concerned about a potential spillover from financial markets into the broad economy.
In conclusion, we don't think a return to normal (let alone tighter) Fed policy will be the catalyst that ends the bull market in financial assets. As Victor has pointed out in numerous Curmudgeon posts, it will likely be an "unexpected event" that the market hasn't anticipated and the Fed can't control. What else might spoil the "free money party" on Wall Street?
Will Reduction in Stock Buybacks Kill the Bull Market?
Could there be a significant reduction in stock buybacks- the major driver of U.S. stock prices in recent years? Share buybacks have tallied $1.56 trillion since the start of 2011, according to S&P Dow Jones Indices. During this period, buybacks peaked during the first quarter of 2014 at $159.28 billion. They were estimated to be $120.21 billion for the second quarter.
Economist magazine's August 16th Buttonworth column:
“In a sense stock markets have defied gravity . . . another factor has been companies’ use of their spare cash to buy back their stock. This makes earnings per share rise faster. American firms announced buy-backs worth $671 billion last year, or about 3.9% of GDP, and have made plans for nearly $300 billion this year, according to TrimTabs, a data service. That is more than four times the money placed into equity funds by retail and institutional investors. Like a snake swallowing its own tail, the corporate sector is absorbing its own equity. How long this can continue is anyone’s guess. The peak year for share buy-backs was 2007, just before the debt crisis. That is not a great omen."
Indeed, the equity market now ignores any comparison with 2007, when third-quarter buybacks reached $171.95 billion and the S&P 500 rallied into what was record territory in October- just as the financial crisis was getting started. We think a reduction in stock buybacks would remove a very important prop for U.S. equities. We wonder who else will be doing the buying besides U.S. corporations buying back their own shares.
Victor's Assessment of Fed Policy, the Economy & the Markets:
On August 22nd, Reuters reported: "U.S. labor markets remain hampered by the effects of the Great Recession and the Federal Reserve should move cautiously in determining when interest rates should rise, Fed Chair Janet Yellen said on Friday in a defense of her policy approach."
Why didn't Queen Yellen also blame Herbert Hoover as someone to also blame for the weak labor market? It's never the failed polices of any government official(s) currently in office to blame for the current economic malaise. Rather, it's the overhang/aftershocks from past recessions or previous policy mistakes.
The causes of the Great Recession (which Yellen indicated the U.S. hasn't recovered from yet) included the allowance of a huge buildup of subprime mortgage backed securities that resulted in distortions in housing. Where were the government regulators, gatekeepers and watch dogs? Also, permitting Lehman Brothers to fail had a huge avalanche effect on credit markets (think "buried alive"). Yet the big banks are blamed for the Great Recession and are still being fined (e.g. Bank of America this past week). No one blames central planning or the government and no government official is ever fired. Why not? Is it all a government propaganda game to obtain more power?
In addition to the Fed's dysfunctional monetary policies, the weakness of the U.S. economic "recovery," has also been caused by the failed fiscal policies of the Obama administration and the gridlocked Congress.
As to the current attempts to decipher Yellen's comments on when the Fed will raise rates -- forget it. Randall Forsyth in this week's Barron's: "Instead of the proverbial two-handed economist, she more resembled a Hindu goddess with half-dozen or more appendages." Evidently, Yellen does not know herself when rates will rise. As long as the Fed can continue to steal savers/depositors interest (by keeping short term rates at zero and long term rates exceptionally low -- due to QE) they will continue to do what they are doing.
How much is the "interest rate theft?" Using Ibbotson Associates (now owned by Morningstar) data from 1926 to date:
1. The CPI or an equivalent government
inflation measure compounded at 3.01% to 2008
2. 30 day T-Bills compounded at 3.71% or 70 bps more than the CPI. Note that Fed Funds are generally 25 bps above the T-Bills rate.
Accordingly, with the last year- over- year CPI at 2%, 30 day T-Bills should be 2.71%, and Fed Funds 3%. However, the reality for the last 5.58 years (from 2008) was that T-Bills compounded at only 7 bps (currently 2 bps), while the official CPI was 2.28% (if you believe the BLS which many say understate the inflation rate to make real GDP higher than it actually should be). Compare that with the fair value of 30 day T-Bills today which is at 3%. That's a difference of 293 bps per year or 16.35% during the last 5.58 years. But that actually understates the amount of interest rate "theft" savers have experienced.
[Prior to Sept 2008, annual CD interest rates were a few percentage points above the 30 day T bill rate. Therefore, savers have been deprived of much more than 16.35% in additional interest since 2008. That's been a huge blow to retirees living off interest on savings.]
To listen to the words of the Fed is like playing "picking the pea under the three walnut shells" game. The Fed is actually a private corporation owned by the banks (i.e. a cartel). It has the name to sound like a government entity, whose owners are secret, whose polices are hidden (unless they want to make investors do what they wish),who won't allow an audit, and who won't deliver a small portion of the gold to Germany it has held in trust. Like any other government representative agency, the Fed lies, misleads, and distorts to accomplish its agenda and pursue its own rewards.
Instead of changing its policies when they fail to produce the desired outcome(s) or results, the Fed persists and usually does more of the same (e.g. QE), which is effectively "pushing the envelope."
A new article in the very influential Foreign Affairs magazine titled: "Print Less but Transfer More“ by Mark Blyth and Eric Lonergan, makes the case for "cash transfers" of money to everyone -- AKA the "Helicopter Ben" theory of stimulating growth. It doesn't suggest that inflation may occur as a result. Here's a very revealing excerpt from the article:
"Rather than trying to spur private-sector spending through asset purchases or interest-rate changes, central banks, such as the Fed, should hand consumers cash directly. In practice, this policy could take the form of giving central banks the ability to hand their countries’ tax-paying households a certain amount of money...Cash transfers stand a better chance of achieving those (central bank) goals than do interest-rate shifts and quantitative easing, and at a much lower cost. Because they are more efficient, helicopter drops would require the banks to print much less money. By depositing the funds directly into millions of individual accounts -- spurring spending immediately -- central bankers wouldn’t need to print quantities of money equivalent to 20 percent of GDP."
We don't think that's the answer! What should be done instead? Reduce burdensome regulations on business, decrease income and capital gains taxes and provide tax credits or incentives (such as Puerto Rico has done1). There is no capital gains tax and only a 4% tax on export service income for established residents of the U.S. Commonwealth of Puerto Rico.
Note 1. Enacted in 2012, Puerto Rico’s Act 22 allows investors and traders with bona fide residence in Puerto Rico to exclude 100% of all short-term and long-term capital gains from the sale of personal property (including stock) accrued after moving there. The Act 20 tax incentive is a 4% flat tax rate on export service net income.
I'm waiting for a government official to propose something like that for the entire U.S. I'm giving odds of 1,000 to 1 that no one will. Any takers?
Till next time......
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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.
Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.
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