It's The Central Banks, Stupid

| About: SPDR S&P (SPY)


The BIS recently reported the extent of central bank stock holdings.

Low bond yields also are motivating official stock purchases.

The unpredictability of central bank purchases leave equity markets in a very dangerous position.

Why are equity markets hovering at insanely high levels? Why does each time the S&P 500 (NYSEARCA:SPY) dip near 2120 the index then shoots up? It will not be a scoop to learn there are official institutions intervening to prop up equities. The Bank of International Settlements recently quantified the extent to which central banks are becoming more active in the equity markets. According to the BIS, the proportion of central banks investing in stocks in 2007, just before the Financial Crisis, was just 17%. By the Spring of 2012, of the 64 world central banks, 9 institutions were investing their reserves capital in stocks. By 2016, 12 central banks, including half of the central banks in large developed nations, were actively buying stocks. Moreover, 30 other monetary authorities are considering today investments in long-dated assets. Note that the U.S. Federal Reserve is not allowed to buy company stocks directly, however many market observers speculate that the Fed is using indirect methods to prop up the U.S. equity indexes.

The reason for the move into stocks by world central banks is to diversify their holdings out of fixed income investments which offer paltry yields. Ironically, it is central bank policy itself which is responsible for the paltry bond yields today. Among the central banks with disproportionally large equity holdings are the Bank of Russia, the Bank of China, the Swiss National Bank, the Bank of Japan, the Hong Kong Monetary Authority, the Bank of Israel, the Czech Central Bank, the Bank of Denmark. This year Thailand voted in favor of a new law that allows the Bank of Thailand to invest in the stock market. On average, central banks are holding 9.6% of this reserves in the stock market, with some central banks (notably the Bank of Japan) at almost 20% of their reserves in company stocks.

Not surprisingly, central banks investing in equities are not active stock pickers. Rather, central banks use exchange-listed ETFs, which passively track a major equity benchmark index. In this way, central banks remain "neutral", not favoring one company over another or obtaining voting rights in company general assemblies. The central banks' choice to use ETF explains the success of passive investing recently, as their purchases "lift all boats". Similarly, the outperformance of expensive large cap stocks can also be attributed to central bank equity purchases, as ETFs track generally market-cap weighted indexes. For example, each day the Bank of Japan buys shares in the Nomura Topix ETF fund, the BoJ is buying 3.6% of Toyota (NYSE:TM), 2.01% of Mitsubishi (OTCPK:MMTOF), etc. In addition, foreign central banks are also engaging in cross-border stock purchases, as seen with the National Bank of Switzerland's holdings.

Many investors have been confounded by the disconnect between stock price and valuation. Central banks are value agnostic, indiscriminate buyers of equities. Most market observers would agree with us that the signal factor supporting equities today is central bank official purchases. Discriminating, value-conscious investors are reasonably petrified to buy and hold a fully-invested equity portfolio today. Indeed, as the rules of the game have changed (at least in the short-term), it becomes increasingly difficult for the traditional value investor to break from his/her investment philosophy and hold over-valued equities. Those buying equities today on -2% to 3% dips are demonstrating a blind faith in central banks to continue augmenting their proportion of reserves in stock investments. It is unlikely today that Congress would authorize the Federal Reserve today to begin buying directly (and openly) company equity. Fed governors may still attempt to make the argument that official stock purchases would further increase consumer confidence, household spending, and help lift inflation above the Fed's target. There is no doubt that the over-reaching Fed would like to "add to their toolkit". Mere rumors of Congressional discussion for approving Federal Reserve direct stock purchases would set the stage for another leg higher in this increasing tired bull market. In the meantime, and in the absence of increased central bank equity purchases, we expect U.S., European, and other developed equity benchmarks to continue churning as fundamental forces pull the markets down while official central bank actions drag equity prices back higher. We continue to recommend avoiding a long-term buy-and-hold outlook today as the unpredictable mix between poor fundamentals, slowing earnings growth, and central bank behavior is creating an explosive cocktail that will eventually trap the majority of investors wrong-footed.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.