Friday, 15 March 2013

Calling The Top

Last week the Dow Jones Index hit an all time. I asked the question DOW Hits All Time High, Then What?. Well, the answer, so far has been that it has continued rising. In fact, today, as I write, not only is the DOW at another all-time high, but the much wider S&P 500 Index, is only 4 points away from an all-time closing high too. The technology rich NASDAQ Index, is however, still at only 60% of its all time high reached in March 2000.

That equity markets are at these high levels is odd for a number of reasons. Firstly, although these levels are only marginally above the highs reached in 2007, the fact remains that in 2007, those markets were themselves at very elevated levels pumped up on an ocean of cheap money that had been pumped into the system during the 1990's, and particularly in the early 2000's, to counteract things like the crash of 2000, 9/11 and so on. That cheap money, had found its way into a huge array of very speculative financial vehicles, such as the Mortgage Backed Securities, that packaged together home loans made to large numbers of sub-prime borrowers. In addition, as was the case in 2000, when the Stock Markets crashed, this cheap money had gone into large amounts of leverage i.e. borrowing for speculative purposes.

In terms of investing, for example to buy shares, leverage works like this. Suppose you want to buy some shares whose price is £1. If I have £10,000 to invest then, obviously I can buy 10,000 of these shares. But, in fact, I can buy these shares on margin. That means I only have to pay a fraction of that cost say 10%, agreeing to pay the balance at some future date i.e. borrowing the other 90% I owe. This, of course, is very similar to what happened with house prices. People who could not afford to buy the houses they took mortgages out for, were lent money, on the basis that as the price of the house went up, they could borrow more money against it, to cover the debts they were racking up elsewhere. The other way this worked with houses was that so called “flippers” people who bought houses with such loans, could sell them within a few months, when the price had gone up, and thereby pay of the loan, having made a capital gain in the process.

Leverage as far as buying shares works on precisely this latter basis. The £1,000 I have, with leverage actually allows me to buy not 10,000 shares, but 100,000. If the share price rises by 1%, before I get the margin call to pay the other 90% I owe, then I have made £1,000 capital gain. I can sell the shares, for £101,000, pay off the £90,000 I owe, and pocket the £1,000 gain. Now, as with the sub-prime crisis, this is all very well so long as share prices are steadily rising. Where the shit hits the fan, is where they start falling, especially if they fall across the board, suddenly and by large amounts. If I've laid out £10,000 to buy 10,000 shares, if the share price falls by 20%, on paper, I've lost £2,000. I might not be happy, but its not the end of the world, and its money I actually had to lose.

However, if I've bought 100,000 shares on margin, and the price falls 20%, then I'm down £20,000, but things are worse than that, because I have to meet the margin call. I have to find £90,000, and even if I sell all the shares, I will only get £80,000. If I can't raise the other £10,000, then I've defaulted on my debt. That is bad for me, but if thousands of other people also default under such conditions, its even worse news for the banks and financial institutions to whom the money is owed! What is more, the majority of these deals on margin will not be for £10,000, but for millions of pounds!

The reason this is important is that latest figures show that the amount of leverage in the equity markets is at the same high levels it reached in 2000 and in 2007, before the Stock Markets in those years crashed. That is not surprising. For one thing, with interest rates so low, leverage is cheap, so it encourages borrowing for speculation, at a time when borrowing for productive investment is not very profitable. But, its also not surprising because sentiment in the markets is very optimistic at the moment. An indication of that is given by the VIX, volatility index. It measures the degree by which share prices move up and down. When people are very optimistic, share prices continue to move higher, without much in the way of pull backs, so volatility falls. In 2008, the VIX went to over 40, today it is around 13, anything below 20 is low.

So, in this sense its not odd that stock markets are at these new highs. But, the question then is, why is optimism so high. Listening to market traders and commentators, comments like there is an expectation that there will be a pull back, a correction, that there is nervousness that prices have risen too far and for too long, that the market rally is tired etc. are common. But, they are usually accompanied with the sentiment that any such correction is merely a temporary, necessary move, before the market rises higher. But, why is there this confidence that this must be the case. Partly, of course, its self-interest. The stock market traders tend to make more money when share prices are rising, than when they are falling, because at those times, more retail investors i.e. Joe Public, tends to buy shares. And, the media commentators on Bloomberg and CNBC, are also cheer leaders for market rallies, because for similar reasons, they get much better viewing figures when markets are rising than when they are stagnating. Also, many of these commentators, have an ideological commitment to capitalism, and so see rapidly rising markets as a vindication.

But, looked at from the perspective of facts, there seems little reason for markets to be hitting new highs, certainly highs that equal the bubble highs of 2007. Western economies have picked up from the crisis of 2008, but not by that much as to justify a doubling of share prices. As I pointed out a while ago, in Britain we have a Zombie economy. As I set out there we have about 150 retailers about to go bust, and we have 150,000 zombie companies employing about 2 million people, unable to repay the capital on their loans.

Share prices are at inflated levels, but the economic reality seems to suggest that the potential for companies to increase their profits are limited. That is certainly the case in Britain, because the economy is shrinking. In the US, the economy is growing at around 2%, but that is way to low to generate the kind of profit growth that would be necessary to justify current projections. In fact, to justify current projections for company earnings, US GDP would have to be rising at 7% p.a.!!! In fact, according to recent projections, the p/e/ ratio on future earnings for the S&P 500 is now in the low 20's, which is historically high.  Across Europe, Spain is in a 1930's style Depression and getting worse.  Greece is bankrupt, Portugal is reduced to vassal status, and Ireland's economy is still crippled by the debts caused by bailing out the banks following its property bubble.  The other European economies are also in recession, and even Germany is in recession as it depends on the rest of the EU market to sell into.  The Eurozone as a whole is mired in a massive debt crisis, that the Eurozone politicians refuse to tackle by taking the necessary political decisions to establish a European State, with a fiscal union, and mutualisation of the debt via Eurobonds.  Yet, European stock markets are at all time highs too.

There is another reason the high share prices are odd, that is that they coincide with very high Bond prices. That is odd, because, usually, when share prices are rising strongly and consistently, money comes out of bonds, in order to buy up shares. Money comes out of bonds, because it can make more money in shares, and because, as money comes out of bonds, their price falls. But, Bond prices fall also, because generally if share prices are rising, it is a sign that the economy is see to be strengthening, and so interest rates will rise. As interest on bonds rises, so their price falls, because one is an inverse of the other. So, it is odd that money continues to move both into bonds and equities, or at least to be moving into equities without coming out of bonds.

The main reason for that is because of Financial Repression. There is so much money in the system that although it has flooded the bond markets, there is still a superfluity available for investment in other assets. That is not accidental. The US Federal Reserve owns about a third of US Government Bonds, as the Bank of England owns about the same proportion of UK Government Bonds. As the US Government, and the UK Government issue Bonds i.e. borrow money, the Federal Reserve and the Bank of England step into to buy via Quantitative Easing. So, essentially any money going out of Bonds into equities is replaced by money from the Central Bank.

The reason given for this is to stimulate the economy, but its clear that it is doing no such thing. What in fact it is doing is keeping interest rates down at unsustainable levels so as to prevent the housing market and the share market collapsing. It is doing that for purely political reasons. The US, and Ireland showed that not only is a collapse of the housing market not the end of the world, but it is in fact, healthy. It means that people who currently cannot afford to buy a house can do so, and it means people who own a house and want to buy a more expensive house, but currently can't afford it, will be able to do so. But, a house price crash in Britain, would collapse the banks, who are currently trying to frantically shore up their own inadequate capital reserves. Similarly, a share price collapse would collapse US Banks.

But, there is a limit to everything. Many Bond Funds have already said they are moving out of Bonds, because they are too expensive. The Financial Times the other day warned that the UK is heading for stagflation, as happened in the 1970's. Inflation is bad for bonds, because it means their real value is eroded. Whenever there is a hint of inflation rising too sharply, there is a sell off in Bonds, for that reason. If there is a big Bond sell-off, it would be difficult for Central Banks to make up the difference without printing so much money that it would threaten hyper inflation.

Central Banks have been trying to avoid a sell-off in Bonds, because it means an increase in interest rates, and in Britain, that would mean the housing market would collapse, and it would mean all those zombie companies would not be able to repay the interest on their loans, sending them into bankruptcy too.

But, if share prices continue to rise, then the inclination of the Bond Funds to sell up and shift into equities will become unstoppable. The investors in those funds will demand they move, because otherwise they are losing money. That will send more money into equities sending share prices higher still. The final bit of the jig-saw is the retail investors. For the last 5 years, the ordinary man in the street, has been afraid to put their money into the stock market, after the crash of 2008. In large part, they have missed out in the near doubling in share prices that has occurred. The rise in share prices has been driven by institutional investors that I'll come to shortly. But, in the past, when share prices have risen for a considerable period, and particularly when they hit new highs, that is precisely the time, when the man in the street starts buying shares again, or putting money into an ISA and so on. That gives the stock market its final twist higher, before it collapses.

For the last four years, most of the money going into equities has been from institutional investors. That means that a lot of the money has simply been recirculating within the system. Its a bit like with house prices, or anything else where the price is bubbled up. Generally, prices of things rise because either the cost of producing them has risen, or else because the demand for them has risen faster than the supply can be increased to meet it. But, where prices are simply in a bubble, that can happen without demand rising at all. Suppose, there are three people who own houses, each worth £100,000, the price of these houses can rise to £200,000 without there being any additional people demanding them, or the three people demanding additional houses. All that is required is that the three people decide to value the houses at double their original price. A could then buy B's house for £200,000 on paper, whilst C buys A's house for the same amount, and B buys C's house at £200,000. In reality, there has been no change in the value of any of the houses, the owners and buyers have simply decided to stick a different price label on each of their houses! But, a similar thing can occur, if the price rises, and the people buying them are allowed to borrow more money to buy the house at the higher price. That in fact, is what has happened over the last 30 years or so with house prices. There has been no real change in the value of the houses, if anything the value is less today, but the market price is higher simply because people have been encouraged to go into more debt to buy them.

The same is true with share prices. The real value of the shares, which is based on the real value of the companies underlying the shares has not changed much, but the share prices has because the owners of the shares like the owners of the houses have simply decided to stick a different price tag on them, and so long as they continue to exchange these shares amongst themselves at these mutually inflated prices the spiral can continue. A sells their shares in Microsoft to B at twice their original price, B sells their shares in Apple to C, at twice their original value, whilst C sells their shares in IBM to A at twice their original value. Its just a paper chase, or to give it its another name, a Ponzi Scheme. The fact, that they have been able to do this with borrowed money using leverage, simply inflates the process, and provides the basis for the increased prices.  One of the indications of that is that we are now seeing again, the return of those unsafe financial derivatives.  Speculative investors have begun to buy up cheap US housing, pushing prices back up rapidly.  But, now also in the US a new financial derivative has been developed based on sub-prime car loans!  In other words, people who cannot afford to pay back the loan are being lent money to buy a car.  Then, as with the sub-prime mortgages, they are bundled together, and sold as a derivative to banks and other financial institutions!  That should be setting off alarm bells to anyone.

There is another part of the explanation. In the post referred to earlier, I pointed out that another consequence of low interest rates is that, companies are able to borrow money themselves, and then use this money to buy back their own shares. Company Executives like this, because the fewer shares there are, the fewer shareholders there are for them to be responsible to. Moreover, buying back shares raises their price, which keeps the other shareholders happy. But, also, many Executives are provided with share options. That is an option to buy a large amount of shares in the company at some point, at a given price. If they buy back shares, and drive the share price higher, that means they can buy their allotted shares at their option price, and automatically make a capital gain on the difference with the market price.

But, reducing the amount of the company's financing provided by share capital, and increasing the amount provided by borrowing, known as gearing, can be very risky. If the company hits a bad patch, it can always save money by not paying a dividend to shareholders, but if it has borrowed a lot of money, the banks and bond holders will still want to be paid their interest. It can then cause the company to suffer a cash flow problem, and even to become insolvent.

Not only is leverage at the same inflated levels it reached in 2000 and 2007, but the level of company buybacks is also at the same level it hit in 2007. Large companies in particular have being accumulating large cash piles. Apple has more than $100 billion of cash sitting on its balance sheet. That is because they have been making large profits, but have not been prepared to invest it all in productive investment, because they are not confident that there would be a market for the additional production this would lead to. Modern large companies, as Engels pointed out 100 years ago, plan their production rather than simply respond to the market. But, even these companies with huge amounts of cash, have taken advantage of record low interest rates to borrow more.

Some of that huge cash pile has gone into buying back their own shares. 2007 was the record year for share buybacks, and it preceded the collapse of share prices in 2008. Similar trends have been seen in other years when shares have hit a peak. But according to Birinyi Associates, last month there was $118 billion of buybacks authorised in the US, and that is the largest amount on record. 2013, appears to be heading for the largest amount of share buybacks since 2007, and probably exceeding it. The only other time there was such a level of share buybacks was 2000, and that too was followed by a big stock market crash.

Jim O'Neill of Goldman Sachs has argued that stock markets are way over extended, and that the old adage “Sell in May and go away, don't return until St. Ledger Day”, could be the spark for such a sell-off. He may be right, as I said previously, there is a 13 year cycle for Stock Market crashes, and in that cycle, 2013 is the next year, when such a major sell-off is due. My guess is that once the retail investors begin to buy, that will mark the top of the market, leading to a major sell-off some time between May and October.

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