- Explaining stock price movement in the post-Glass Steagall financially engineered universe.
- Why it is impossible to engage in long-term investment strategies in this financially engineered universe.
- Why organic economic growth won't happen, as the disparity in incomes between the 1% and the rest are so extreme that recession is inevitable.
- Why short covering has been the driver of stocks in 2014, and the significance of a short covering blow-off top.
By the middle of 2012, the stock market rally ceased to be logical based on the underlying fundamentals. Those who understood this chose not to participate in the market, choosing instead to sit back and wait for the inevitable sell-off - a sell-off that still hasn't arrived two years later.
Those choosing to stand aside did so on the basis that playing the long side of the market throughout this period was nothing more than speculation and certainly not long-term investing. Some will argue that point, of course, but the evidence seems to support that view regardless of those who would argue otherwise.
When considering how to invest one's money a distinction needs to be made between investing and speculating or gambling. Perhaps one of the best ways for differentiating between investing and speculating is to think in terms of a coin toss. When using an honest coin, the odds are 50-50 that a head will come up. Over a large number of flips where you always bet on the head, and always bet the same amount, you will succeed in wasting your time, as you end up with no loss and no gain.
Using the coin toss to distinguish between investing and speculating or gambling, one might think of it as betting on a coin that is not honest. In other words, the coin is designed to produce a higher percentage of heads than tails. In that situation, if you bet on heads, you will end up making a lot of money over time. Perhaps the coin is designed in a way that 60% of the flips produce heads and 40% tails. You can certainly run into a string of tails and lose money in the short term, but over time, if you stay with the strategy, you will come out a big winner.
The stock market is not unlike that dishonest coin. There are a number of factors that work to create an outcome that is not random. For instance, good managers make wise business decisions that grow sales and maintain good profit margins. And government policy makers do all they can to produce a climate that creates the demand for the goods and services produced by these companies. Over time, these efforts on the part of corporate managers and government policy makers should produce the intended results, and one's money should grow in spite of the short-term fluctuations in the market.
That is the premise behind the idea that long-term investors should depend on the continuation of a biased outcome over time and just keep on investing. The game is rigged after all, in a good way of course, and even if you have to weather the storm in a short-term sell-off, those in charge will do what is needed to keep the game rigged in favor of the long-term investor.
The question we must ask, though, is this - can government policy makers really implement policy that works to insure high demand for the goods and services that corporations sell? The answer is, yes they can, but there is a caveat we need to consider - do they know what should be done, and will they do what needs to be done?
The pundits who continue to tell us that stocks are the only place to be are operating with a great deal of faith in the idea that they will know what to do and they will do it. Experience tells us that our policy makers are not as omnipotent as those pundits would have us believe. Perhaps the best example of the flaw in that omnipotent premise is the Nikkei:
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Certainly, it is hard to make a case for the effectiveness of policy makers in keeping the game rigged in favor of the long-term investor as it relates to Japan. The Nikkei peaked 25 years ago, and sits today at levels 60% below that 25-year old peak. So much for long-term investing in that situation.
By comparison, we can look at the US stock market. The chart below of the S&P 500 (NYSEARCA:SPY) suggests we have done a much better job of keeping the game biased in favor of the long-term investor:
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The question one must ask is this - are we really doing the things needed to sustain this trend in the US, or are we succumbing to policy initiatives that only exacerbate the problem in the long term? The answer, unfortunately, is that we are not on a sustainable path, and the evidence of that is observable for those willing to abandon their bias and look.
The sad truth is that our policy makers are not omnipotent, and in fact, seem clueless on what needs to be done to ensure that the demand for goods and services continues to be high enough to absorb the potential production capacity of the labor pool. Over the last several decades, policy makers have succumbed to the demands of those who produce the goods and services, and to the detriment of those on the other side of the equation who consume them.
The income and wealth disparity that has arisen as a result of the political class giving in to the capitalists' demands has become so significant that extraordinary policy measures have been implemented to ensure a continuation of the status quo. Our government policy makers are doing all they can to keep the game rigged in favor of the long side of the stock market, but the sad truth is they are not attacking the problem at its root, and only producing the seeds of what will end up being a catastrophic outcome.
Capitalist/socialist hybrid economy
What we have in the US - and for that matter in most of the world - is a hybrid system that combines capitalism and socialism. It is a system that won't work in the end. The means of production are controlled by fewer and fewer large conglomerates, and so all the money ends up flowing to the few who control these companies.
For an economic structure to work, a balance must be maintained between those who buy goods and services and those who produce those goods and services. When either side of the equation is out of balance, we end up with problems. And the system is out of balance, and in fact, not unlike that period in our history just prior to the Great Depression.
The root of the problem is really quite simple - those in the 1% group simply can't spend the money that flows to them to buy goods and services. Consider, for example, Mark Zuckerberg. He is one of the most recent additions to the Forbes richest people list, coming in at #21, with a net worth of $28.5 billion according to the excerpt below, and most recently registering a net worth of $30.1 billion:
The ranks of the world's billionaires continue to scale new heights-and stretch to new corners of the world. Our global wealth team found a record 1,645 billionaires with an aggregate net worth of $6.4 trillion, also a record, up from $5.4 trillion a year ago. We unearthed 268 new ten-figure fortunes, including 42 new women billionaires, both also records. In total, there are 172 women on the list, more than ever before and up from 138 last year.
The year's biggest dollar gainer was Facebook's Mark Zuckerberg, whose fortune jumped $15.2 billion, to $28.5 billion, as shares of his social network soared.
The problem is really quite simple - those in the wealthiest category simply can't use their money to support GDP growth. If Zuckerberg were to earn a mere 2% on his net worth in the coming year, he would earn $600 million on the year, or converted to a daily average, $1,643,835.62. What do you do with $1.6 million a day in earnings? If Zuckerberg were to buy goods and services and simply give them away, he would be stimulating demand for goods and services and contributing to economic growth. On the other hand, if he invests those funds in stocks, he is simply inflating an already inflated asset bubble.
That is the problem. Compare Zuckerberg's wealth gains with the real per capita income for the United States:
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The per capita income was $37,021 as of the end of the 1st quarter of 2014. That works out to be $101.43 per day per person. Rest assured, those earning $101.43 per day spend almost all of it for goods and services in order to exist. Zuckerberg, assuming a 2% return on net worth, earns 16,308 times the per capita figure. What do those of Zuckerberg's ilk do with their money? The answer is that most of it must go into risk assets, as it is simply not possible to spend it on goods and services.
Those who control the means of production of goods and services continue to expand their wealth and continue to invest that wealth in risk assets, not goods and services. Our policy response to this dynamic is akin to socialism in that our government simply borrows and spends more and more money into the economy. When they do that, the money flows from the Treasury to those who would spend it buying goods and services. When they spend it, though, it simply flows back to the capitalists, who invest it in risk assets, not goods and services.
Perhaps the best way to see this is to look at total federal debt and M2 money supply:
What we see in the chart above is that 25 years ago, federal debt was actually $127 billion less than M2. Today, we see federal debt at $6.494 trillion higher than M2. What policy makers have done is simply exacerbate what is already a very problematic imbalance in income and wealth through bad policy. They have produced a short-term fix with massive fiscal stimulus that has worked to drive demand for goods and services in the short term, but the imbalance between the capitalists and the consumers has gotten worse, not better.
We need that money created by an expansion in federal debt to stay in M2. It is M2 money that drives GDP growth. What we see, instead, is that the money created by the increase in federal debt flowed through to the big corporations, who have invested it in risk assets.
The difference between M2 and federal debt can be accounted for in M3 - a metric the government no longer calculates. For the most part, the difference between M2 and M3 is represented by money market funds - funds used to support the shadow bank credit intermediation process of securitizing various debt obligations, such as mortgage-backed securities and other collateralized debt obligations.
To attempt to better understand the nature of the shadow banking system, we will cite a Federal Reserve Bank of New York staff report authored by Zoltan Pozsar, Tobias Adrian, Adam Ashcraft, and Hayley Boesky, simply entitled Shadow Banking.
We will start with this excerpt from the introduction of the paper:
Over the past decade, the shadow banking system provided sources of funding for credit by converting opaque, risky, long-term assets into money-like, short-term liabilities. Arguably, maturity and credit transformation in the shadow banking system contributed to the asset price appreciation in residential and commercial real estate markets prior to the 2007-09 financial crisis. During the financial crisis, the shadow banking system became severely strained and many parts of the system collapsed. Credit creation through maturity, credit, and liquidity transformation can significantly reduce the cost of credit relative to direct lending. However, credit intermediaries' reliance on short term liabilities to fund illiquid long-term assets is an inherently fragile activity and may be prone to runs.
Continuing on, the paper explains the multiple-step credit intermediation process that converts junk debt to high-grade investment status:
1. Loan origination (i.e. auto loans and leases, non-conforming mortgages, etc.) is performed by finance companies which are funded through commercial paper (CP) and medium-term notes (MTNs).
2. Loan warehousing is conducted by single- and multi-seller conduits and is funded through asset backed commercial paper (ABCP).
3. The pooling and structuring of loans into term asset-backed securities (ABS) is conducted by brokerdealers' ABS syndicate desks.
4. ABS warehousing is facilitated through trading books and is funded through repurchase agreements (REPO), total return swaps or hybrid and repo/TRS conduits.
5. The pooling and structuring of ABS into CDOs is also conducted by broker-dealers' ABS syndicate desks.
6. ABS intermediation is performed by limited purpose finance companies (LPFCs), structured investment vehicles (SIVs), securities arbitrage conduits and credit hedge funds, which are funded in a variety of ways including for example repo, ABCP, MTNs, bonds and capital notes.
7. The funding of all the above activities and entities is conducted in wholesale funding markets by funding providers such as regulated and unregulated money market intermediaries (for example, 2(a)-7 MMMFs and enhanced cash funds, respectively) and direct money market investors (such as securities lenders). In addition to these cash investors, which fund shadow banks through short-term repo, CP and ABCP instruments, fixed income mutual funds, pension funds and insurance companies also fund shadow banks by investing in their longer term MTN's and bonds.
Point 7 above explains that the whole process is funded by "money markets". It is well beyond the scope of this essay to go into a detailed dissertation on this, but one does need to understand the money we have created through massive levels of borrow and spend economics has only had a very short-term impact on GDP.
Even more disturbing is the fact that the money that is reflected in M2 is increasingly held by those who don't spend it on goods and services. We see that in the M2 velocity chart:
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The chart above shows that M2 velocity has plummeted since the political class surrendered the economy to the big banks with the repeal of Glass Steagall. Today, these big banks facilitate the process of creating assets that the wealthy can invest in through the process of transforming bad debt into good investments. To fully understand the process, one needs to recognize the need for derivatives such as credit default swaps and short-term funding provided by money market funds. Again, the process is well beyond the scope of this essay, but suffice it to say that the process does very little to create organic economic growth.
It is no coincidence that M2 velocity began a precipitous fall at the same time we agreed to repeal Glass Steagall. But to the point, if M2 velocity had remained at 2.0, the level it was at just prior to the onset of the Great Recession, the GDP would be $22.214 trillion today, not $17.601 trillion. The calculation is a simple one - just multiply the money supply turnover reflected by the M2 velocity. At 1.59 and a money supply of $11.107, we get $17.660 trillion. With an M2 velocity number of 2.0, we get $22.214 trillion.
The reason for the low M2 velocity is that a substantial portion of the money held in M2 is held by those who simply don't spend it to buy goods and services. And unfortunately, it won't get better until our policy makers address the problem at its root. That will require a number of legislative actions that strengthen the position of the working class and weaken the position of the capitalists. The following is a very short list of the things we could consider:
- A very progressive tax rate on corporations that provides them the incentive to pass profits through to wage earners.
- A very progressive tax rate on high-income earners.
- Strengthening the ability of the working class to engage in collective bargaining.
- Changing the dividend tax rules that would incentivize higher levels of dividend distributions of corporate profits.
As hard as it might be for many of us who grew up hearing the virtues of capitalism, it is particularly difficult to listen to ideas that cast capitalism in a negative light. That said, it still makes a lot more sense to raise tax rates at the upper end of the income bracket, not lower them. A look at the chart below, courtesy of the National Taxpayers Union, shows the history of the tax rate at the upper end of the income scale dating back to the beginning of the income tax:
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What we see in the chart above is that at the upper end of the income scale, the tax rate was at its lowest just prior to the onset of the Great Depression. Today, we are once again at the lower end of a multi-decade decline in the tax rate at the upper end of the scale. More importantly, we are seeing the very same market dynamic today that we saw in that period leading up to the Great Depression.
Capitalism's virtue is that it allows for those who would assume risk in a society to profit, by providing funds to those innovative geniuses who create products that improve our lives. They provide the funds needed to build production and distribution systems to deliver those products to the masses, and they would not do so if they weren't allowed to profit from these investments.
Capitalism gave us the automobile, the personal computer, and the smartphone, for example. On the other hand, the negative aspect of capitalism can best be defined by understanding the inherent conflict articulated by Karl Marx. The following excerpt on the matter of the Marxist Conflict Theory is useful in explaining the negatives of a capitalistic system:
According to Karl Marx in all stratified societies there are two major social groups: a ruling class and a subject class. The ruling class derives its power from its ownership and control of the forces of production. The ruling class exploits and oppresses the subject class. As a result there is a basic conflict of interest between the two classes. The various institutions of society such as the legal and political system are instruments of ruling class domination and serve to further its interests.
To the extent that the political class strives to achieve an equitable balance between the two classes, capitalism's virtues can be realized while avoiding the consequence of efficient capitalists that choose to exploit all things in order to gain more and more of the wealth of a nation. Absent that effort to maintain balance, at some point, the capitalist becomes so efficient that they undermine and eventually collapse the system. We saw that in the era leading up to the Great Depression, and we are seeing it again today.
The steps involved in creating the current stock market bubble
To understand the current bubble, it is useful to understand the last bubble. The following chart helps us in that regard:
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What we see above is that mortgage debt took on an accelerated rate of increase in the mid 90s. For a time, that new debt drove housing starts higher, but by the first quarter of 2006, housing starts seized up and began a precipitous decline, while mortgage debt continued to climb higher. After housing starts peaked and began to decline, the increase in new mortgage debt no longer drove GDP growth, rather the new debt simply churned around in the marketplace, driving the price of existing house prices higher.
We all know the outcome of that folly, but all we did after the crash was engage in a brand new exercise in futility in an effort to bring us back from the depths of the Great Recession - at least as it relates to real organic economic growth - in that we began the process of unprecedented fiscal stimulus to pick up the slack in GDP growth through deficit spending. The following chart of the federal surplus/deficit explains how we managed to keep GDP growth positive:
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What we see in the chart above is a huge increase in the federal deficit - money that was borrowed and spent into the economy in an attempt to push GDP back into positive territory. It worked, as we can see in the GDP chart below:
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Anyone who thinks this chart exemplifies good policy or that the chart can be ignored as the pundits continue to explain why we are now on the verge of real economic growth is in abject denial of reality. Granted, the massive increase in deficit spending did work to prop GDP up for as long as we continued the policy. The problem is that since we've slowed down on the rate of deficit spending, we have also seen one of the worst real GDP prints in the last 30 years, exceeded only by the low print in 1990 and two quarters in 2009 at the height of the Great Recession.
This fiscal stimulus initiative was the first step in creating the current stock market bubble. We can see from the chart below that corporate profits, as reflected by the S&P 500, soared higher as the government flooded the system with fiscal stimulus money.
Stocks climbed out of the Great Recession trough based on corporate earnings growth. Earnings then peaked temporarily in the 1st quarter of 2012 and began to decline, only to surge higher throughout 2013 and peaking in December of 2013, before falling off by .73% through the end of the 1st quarter of 2014:
Some would argue that the incredible correction-less climb in stocks throughout 2013 was irrational, but that argument can't be made based on earnings alone. Earnings did climb higher throughout 2013. Still, the question one must ask is, why? Was it a function of the economy catching fire or something else?
In March of this year, the WSJ weighed in on the matter with the following comments from an article entitled Will Stock Buybacks Bite Back?:
Last year, the corporations in the Russell 3000, a broad U.S. stock index, repurchased $567.6 billion worth of their own shares-a 21% increase over 2012, calculates Rob Leiphart, an analyst at Birinyi Associates, a research firm in Westport, Conn. That brings total buybacks since the beginning of 2005 to $4.21 trillion-or nearly one-fifth of the total value of all U.S. stocks today.
There has been a lot of talk in the past few years about how index funds, which buy and hold stocks regardless of whether they are cheap or expensive, might be contributing to an overvaluation of the U.S. stock market. But the companies that make up the U.S. stock market might be contributing even more. And, if you wanted a signal of when to get in and out of the market, doing the opposite of whatever companies themselves are doing would serve you pretty well.
To be sure, corporations should favor a buyback when shares are trading below the total value of their future cash flows and when capital expenditures or acquisitions don't appear likely to offer a higher rate of return. And investors ought to welcome a repurchase, since it should increase earnings per share-so long as the company isn't overvalued and can finance the buyback cheaply.
Yet companies tend to exhibit the same perverse timing-buying high and selling low-as individual and institutional investors. As the market hit a then-record high in the third quarter of 2007, corporations bought back more than twice as much of their shares-$214.3 billion worth-as they did in the depths of the bear market. In the final quarter of 2008 and first quarter of 2009 combined, repurchases totaled only $97.3 billion.
To sum it up, stock prices climbed higher out of the recession trough based on fiscal stimulus that drove GDP sharply higher. Stock earnings stalled out in the first quarter of 2012, meaning that those gains realized through 2012 were based on multiple expansion only. Then, in 2013, we saw a steady increase in earnings that is best explained by the ramp-up in corporate stock buybacks in 2013.
Not only did the increased interest in stock buybacks create upward pressure on the price of stocks, it also ended up creating the impression that the market move higher was predicated on increased earnings. Unfortunately, in this case, it ends up being a "cart before the horse" situation in that the only reason profits moved higher was because those profits were dispersed over a smaller number of shares.
Profit growth has stalled out again in 2014, and yet, the market has managed to add another 7% to the value of stocks this year. Trade volume has fallen significantly, implying that there is little interest on the buy or sell side in the market in recent months.
Of course, the real question is this - are we in a bubble? The answer to that question is yes, and is based on the fact that the underlying economy cannot support an expansion in GDP absent a ramp-up in fiscal stimulus. And, for the moment, at least, we are doing the opposite - that is, we are reducing, not increasing, deficit-financed fiscal stimulus.
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What we see in the chart above is a lagging impact to the reduction in fiscal stimulus, but an impact nonetheless. The arguments the pundits make is that we are going to see a rebound in second-quarter GDP and all is well. Stocks are the only place to be, they tell us, and those who have been sounding warnings for the last several years have been wrong, and therefore, will continue to be wrong. Just get in, they say.
Well, if the economy is going to grow on its own, we should see some evidence of that in the way of an improvement in the condition of the consumer. The charts below suggest little has changed for the better:
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What we can infer from the foregoing analysis
What we can infer from the data and the analysis above is that organic economic growth will continue to elude us. We can also present a credible thesis in support for the fact that the sharp drop in deficit spending is the reason for the drop in first-quarter GDP. Certainly, there is nothing in the analysis above that suggests consumer health has improved and that the consumer will be able to ramp up demand for goods and services on their own.
We can also conclude that there are separate policy dynamics in play here. Fiscal policy has attempted to flood the economy with needed money to drive demand. On the other hand, monetary policy has worked in the shadows by providing high levels of cash that has been used to fund high levels of leverage by the wealthy in risk assets.
Perhaps the market can continue to move higher from here purely as a function of monetary policy, but it seems doubtful at this point, as the Fed seems committed to ending their asset purchase programs by October. As long as interest rates remain low, those invested in leveraged carry trades will be able to hold those trades, but the fact that money creation is slowing and the Fed's efforts to supply system liquidity are ending means the prospects for continued leveraging into risk assets are not likely and takes away a significant driver of the bull market going forward.
None of this analysis is particularly useful in the very short term, as we could see an acceleration in price purely as a function of short covering as speculators enter the market on the short side attempting to time a market top. And make no mistake, the final phase of a short covering blow-off top can add a lot to the price of stocks in the short term. What ends this final blow-off phase is when those who are inclined to pick the top by shorting stocks finally surrender. At that point, the boat is fully loaded on one side.
It is at that point where the only orders in the market are liquidation orders, and as long as the market makers are willing to stand in the gap and buy what the sellers want to sell, the sell-off will be modest. However, if the market makers recognize that we are in the final stage of a blow-off top, then they are not likely to stand in the gap for long.
The bottom line is this - we really are in a bubble, and the idea that buying at these levels is anything akin to long-term investing is simply wrong. Furthermore, a close look at the Nikkei chart suggests that when this market finally does collapse, it may be a very long time before we see these price levels again. Make no mistake on this point - since the end of the Great Recession, we have followed the same flawed policy that Japan has been engaged in for a long time now. Given that, it is hard to think we will see a different outcome.
On July 30, we get the first estimate for the 2nd-quarter GDP number. Most are expecting a sharp rebound in GDP. Maybe we get it, but the risk is that we won't. And it is not unreasonable to expect a negative 2nd-quarter print signaling the beginning of a new recession. If that were to occur, we could see a major rush to the exit, and one wonders who will be willing to stand in the gap and buy stocks at all-time highs as we enter a recession.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am long SPY puts.