The Fed's Unspoken Partners
The primary force driving this stock market is the same force driving the bond market. It’s not earnings or the economy, it’s Fed monetary policy and all the financial games and leverage its allowing. We know the Fed, by their continual purchase of treasury and mortgage bonds, has kept long term interest rates low. They just indicated they will continue with this activity. But they are also getting important assistance in this - and the Fed is encouraging it - from hedge funds and big market players in a rather unique way.
It's All About Leverage - The Fed's Implied Guarantee
You can buy Treasury bonds with 10% margin – you put up 1 million dollars and you can buy 10 million. The interest or Margin rate you pay to borrow the money to do this are short term rates and, as everyone knows, basic, short term rates are being held near zero. Because of this Hedge funds and big players can probably borrow money near 1%. They therefore buy T-bonds yielding 2.5% using money they pay 1% on – and at 10% margin – make 15% on the cash flow per year.
With the Fed supporting prices and announcing their plans to continue this, there is very little risk that prices of T-bonds will go against the hedge funds. It’s like money in the bank; almost a sure thing. As more and more big players see what's happening and do this, it adds to or reinforces the Fed’s buying actions, and long term rates go unbelievably low and are continually held there by the combined action of these two forces.
It's the Same Game for Stocks
Stocks get caught up in the same leverage game. Many big institutions and hedge funds can get past the 50% margin requirement for stocks. So they do the same thing with high dividend paying stocks. They borrow at 1% and buy huge quantities of stocks with high dividend yields like 3% or 5%. They lock in these huge cash flow yields built on this extreme leverage.
As more and more see and play the game, prices continue higher. Again, as long as the Fed telegraphs their willingness to continue buying and holding both long and short term rates low, more players do it and it becomes self-reinforcing. This action can carry prices to extreme levels. This activity adds to the normal buying of stocks because of a good economy or improving earnings and you get a kind of “positive double whammy” to stock prices.
Note: This additional activity has nothing to do with normal stock matters like earnings growth, etc. It's just buying using leverage with the Fed taking away the normal risk associated with this. In any event, prices react in the same they do to any buying - they go up.
What's the Fed's Real Purpose
I don’t think it will be a shock if I say I personally don’t think the Fed is telling us exactly why they are doing what they are doing. The reason they give in statements has some truth, but it’s not the real reason. To me it’s like the Fed is opening up a huge window and holding it open for as long as they can. This huge window will allow corporations and individuals to refinance their huge debt pools at unbelievably low, long term interest rates. Then, with lower debt payments locked in, more of corporate earnings or personal salaries can be spent on the economy for jobs and growth.
(I tried to explain some of this two months ago with my article Why This Is a Sustainable Rally and We Are in a Bull Market but didn’t do a good job then. Hopefully this is better.)
