The Perils Of Remaining In An Overheated Stock Market

As the DOW passed the magic  22,000 mark,  millions of stock investors began salivating at the prospect of  continued humongous gains - filling their 401ks or IRAs.  But most are barely aware of the treacherous territory they've entered.  Most had never  seen or read Nate Silver's book, The Signal and the Noise- Why So Many Predictions Fail But Some Don’t  - especially where he warned (p. 347):

"Of the eight times in which the S&P 500 has increased at a rate much faster than its historical average over a 5-year period , five cases were followed by a severe and notorious crash, such as the Great Depression and the Black Monday crash of 1987”.

Interestingly, two of the largest stock market dives have followed two of the biggest bubbles: the first of 37.85 percent and on the heels of the bubble that formed from Jan. 14, 2000 to Oct. 9, 2002, and the second of 58.78 percent that formed (mainly due to the housing bubble) from Oct. 9, 2007 to March 9, 2009.

One indicator of a bubble, of course, is the rate of stock  share increase. But another is the rate of inflation related to the trailing P/E ratio.  This is the classic price to earnings which looks at the current price divided by the company's total earnings the past 12 months. .  This is perhaps the most common metric used by investors to value publicly traded companies. While it does not account for growth rates by default, it represents a simple metric that can be compared over long periods of time. Lofty P/E multiples can predict market declines when growth starts to slow down, since investors can no longer justify the higher valuations.

Well, we are in that territory now. For reference, three years ago (in September)  the P/E ratio was about 18.5. Today the P/E for stock in the S& P 500 index is just over 24.  That is, investors are paying $24 for each $1 in corporate earnings. Just before the 2008 crash and 2009 financial meltdown it hit 27.   

What about those profits? Back in September, 2014, the profits for all the companies in the S & P 500 index were about $106 a share.  Currently, we're in the midst of second quarter earnings reports for 2017 and the estimate is that the same S & P 500 profits will be coming in at about $105 a share. That means profits haven't grown at all in three years - and yet the price of the S & P 500 is up about 23 % over the same period.

What gives?   What gives is that there is no genuine support for the share increases or higher PE ratio.  In other words, people are basically being hosed. Let's also note the long term average pE ratio is about 16 and markets tend to revert to that average at some point.

The other aspect is there is no really solid backing to justify the spiking DOW or sizzling S & P 500. The corporate earnings, profits simply don't support it. This is also why there exists a divergence between what we ae seeing with the stock market, and the low growth and wage stagnation plaguing Main Street.

But we were warned of this before. As the authors (William Wolman, Anne Colamosca)  of The Great 401 k Hoax have noted, it is living in a fool's paradise to believe that if the companies you invested in are only increasing their profits at 2-3% a year, that you can be earning 7% or even 10%. In fact, what one has then is an aberration in which the gains are out of whack with reality. (This is one reason why real stock investors demand dividends, and refuse to forego them so fund companies etc. can use the money to do "stock buybacks" thereby artificially inflating the share price!)

Why is this perilous? Some might ask. Consider: though you may be exuberant now to be getting near 10 percent returns, what if the market suddenly reverts back to the more standard 7 percent?  Doing the math it means you would need to save 70 percent more money to get to the same place as you have with the 10 percent returns.   Translated to income saved to pay for mutual funds or stocks, this means if you are taking out 5 percent now - say $150 a month - you will need to shell out $255 in the 7 percent return environment.  Obviously, if the returns go even lower - say to 5 percent or less- the savings burden will increase as well.

Simply put, the notion that you can save less because the market will do most of the heavy lifting is a fool's errand and paradigm. It won't. In fact, you will be in a hell of a lot worse position if the market tanks - say in a 20 percent correction. To get down to even more severe (e.g. crash) cases, a stock – or mutual fund- that drops in share price from $20 to $10 has suffered a 50% loss. But for that $10 stock or fund share price to return to $20  (breakeven point) it must gain 100%, or double.  Those near retirement need to ask themselves if they can sustain such a loss, and to multiple stocks or funds.

The other phantom contributing to the inflated PE ratio accompanied by low corporate profits, is stock buybacks which I've written about before.  The question every investor ought to ask is: WHY should Company X or Y have to buy back its own stock to create an artificial rise in share price if your company is genuinely doing well? It makes no sense. If Company X or Y is going to use any extra money for anything it ought to be for paying dividends, not stock buybacks!

Columnist Jonathan Clements in his piece in the WSJ three years ago wrote:

"Many companies were big buyers of their own stock before the 2007-09 market decline, only to scuttle their buyback programs during the market crash. In recent years with share prices up sharply they have begun to voraciously buy back."

And indeed they are doing it now more than ever.  Why not, because they are then reaping the bounty of their own high share prices? Buy backs also make management's stock options more valuable - so what better way to compensate the Street's honchos?  Strangely, all this has selectively blinded investors to the lack of dividends. As Robert Arnott, quoted by Clements, stated:

"Dividends are reliable, You cut them at your own peril - but you can cut a buyback and hardly anyone notices."

There's one more reason U.S. stocks are soaring which people ought to be aware of: According to the WSJ European investors are buying them up at a rate 25- 30 % greater than historical averages. You may cheer that our friends across the pond are helping us to this extent, but wait. What if they suddenly pull their money out, redeem all those shares, for whatever reason? 

It's time to think now more carefully than ever just where you're putting your money and why.

How Corporations Are Inflating the Equity Asset Bubble By Share Buybacks

In a previous post (Sept. 9) I noted:

"Right now those in the stock market, especially in equities, are riding a huge asset bubble. The bubble has two components that are perilous but which too few - high on the nose candy of their share prices - ignore. One is the very excess price of equities, or more exactly, the high price to earnings (P/E) ratio of most of them. "


This ought to be of concern for us all, especially as Martin Feldstein has noted the role of such  mispriced assets in feeding the current asset bubble.  And one huge contributor has been the practice of stock buybacks by big corporations - which artificially inflates their share prices and P/E ratios. Columnist Jonathan Clements in a WSJ piece last year observed:

"Many companies were big buyers of their own stock before the 2007-09 market decline, only to scuttle their buyback programs during the market crash. In recent years with share prices up sharply they have begun to voraciously buy back."

And why not, because they are then reaping the bounty of their own high share prices? Buy backs also make management's stock options more valuable - so what better way to compensate the Street's honchos?  Strangely, all this has selectively blinded investors to the lack of dividends. As Robert Arnott, quoted by Clements, stated:

"Dividends are reliable, You cut them at your own peril - but you can cut a buyback and hardly anyone notices."

Why? Why aren't the little guys more aware of how they're being shafted?  Because generally they're happy just to see higher share value, unaware of the risk being taken in enabling mispriced assets.

This has been abetted by the Fed's ginormous QE (quantitative easing) program - purchasing over $4 trillion in the bond market. Now we know corporations have been taking advantage of this strategy to use bond sales for buybacks.

As noted in The Wall Street Journal (Sept. 22, p. C2):

"U.S. companies are increasingly using the bond market for the benefit of shareholders, a move that is starting to raise alarm among some debt investors.

Proceeds from some of the largest bond sales, including those from Microsoft Corp., Qualcomm Inc. and Oracle Corp., were earmarked for share repurchases...

Buybacks can boost stock prices by reducing the number of shares available. Some analysts warn that the tactic risks eroding corporate financial health by diverting cash that can be used to fund debt repayments and make investments that can boost corporate earnings power over time."

Thus share buybacks are in fact undermining corporate health for short term gain, even as they fuel the ongoing equity asset bubble to absurd proportions. This is now made worse as the Fed, instead of raising interest rates to temper borrowers' insanity,  has dispensed yet more borrower's crack. As Feldstein has also noted, while these same investors may have realized the rapid increase in share prices are a bubble waiting to pop - they still invested "on the mistaken belief they would know when to pull out".  But they were deluded, as the 2007- 08 financial meltdown showed.

To her credit, as the WSJ piece notes, Hillary Clinton has called for "greater disclosure of buybacks amid concerns they come at the expense of longer term investment"

She is spot on and the WSJ  points out that companies are effectively transferring capital from bondholders to shareholders without investing to expand their business. This cannot be right, and it shows again how the Fed's nose candy QE bond buying program is actually backfiring on bond buyers.

Hopefully, at its next meeting the Fed will do the right thing and raise rates. I'd like to see at least a raise of 50 basis points, not merely 25.