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.

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.

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.


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.

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.

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.

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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