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Sunday, November 3, 2013

Artificial inflation in the market

Tony Paradiso

I often say that I see no reason for the stock market to be at record levels, but I realized my position needs clarification. There are reasons for record highs in stocks – just not any good ones. Naively, my definition of good includes only macroeconomic fundamentals and company execution.

The $85 billion a month that the Federal Reserve is pumping into the system is in search of a profitable home. Currently that home is stocks. The problem is that this incremental demand is not real but a fabrication by the Fed. ...

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I often say that I see no reason for the stock market to be at record levels, but I realized my position needs clarification. There are reasons for record highs in stocks – just not any good ones. Naively, my definition of good includes only macroeconomic fundamentals and company execution.

The $85 billion a month that the Federal Reserve is pumping into the system is in search of a profitable home. Currently that home is stocks. The problem is that this incremental demand is not real but a fabrication by the Fed.

And the Fed isn’t the only source of “artificial” demand. With the Fed intentionally inflating asset values, “existing” money naturally follows the Fed’s lead. Margin debt – created when stocks are bought on margin – is another source of demand.

Buying stocks on margin means that the stock itself is used as collateral and the purchase is made with a combination of cash and borrowed money. Today, the typical split is half cash and half borrowed.

We talked about margin levels during the financial crisis because, like today, in the bubble years, investors increasingly bought stocks on margin. And why not? If stock values increase beyond the cost of borrowing the money, investors generate profits using other people’s money.

Margin is great when stocks are rising, but when they fall, margin can accelerate the decline. Because the stock itself is used as collateral, if the value of the stock falls below a certain level, the investor becomes subject to a margin call. That means they either must sell the stock to cover the margin debt, or cover the margin in cash.

Why do I mention this? Because in September, margin debt on the NYSE hit a record high of $401 billion. Before the financial crisis, margin debt peaked at $381 billion. That happened in July 2007, three months before the S&P 500 hit an all-time high.

Needless to say, for me, leveraging low interest rates to buy stocks on margin because the Fed is inflating stocks prices, doesn’t constitute a good reason for stocks to hit record highs. But it’s a reason.

And there is another dynamic that is inflating stocks. That is corporate buybacks. From time to time companies will buy back their own stock. Typically this is done because they consider the stock cheap. By buying it back, the amount of stock in the market is reduced and the supply/demand curve shifts in the stock’s favor.

Such buybacks hit a record amount in February of this year. Since the markets started rebounding in 2009, the overall amount of stock purchased has now been pushed above $1 trillion.

There’s nothing wrong with a company buying back its stock if it views it as undervalued, or the company is confident in the stock’s ability to increase its value. It is no less a good investment than if an individual purchased the stock. The difference of course is that when a company buys its own stock, it “artificially” enhances the price/earnings ratio.

My issue with the level of buybacks is the impetus for the purchases. Again, it’s partly because of the upward momentum created by the Fed. But it’s also because corporations have a record level of cash on their balance sheets, and they have no better use for it.

A more desirable use would be investing in plants, equipment and people. The problem is that there isn’t sufficient demand to justify such investments. Given the lackluster economy, corporations currently benefit more from stock buybacks than from investing in growth.

Everyone who thinks that’s a good reason for stock prices to increase raise their hand …

One, two, I see three hedge fund managers with hands enthusiastically raised.

So how are the economic fundamentals? According to the Fed – the same as they have been for far too long. Emerging from its most recent meeting, Fed officials continued to describe the economy as “slow-growing” and expanding “at a moderate pace.”

The Fed left open the possibility that it could start tapering its $85 billion bond buying program at its Dec. 17-18 meeting, but there’s virtually no chance that will happen. You know why? Because of disappointing sales of candy corn.

Yes, the dreaded candy corn indicator is rearing its ugly head. Retail sales declined 0.1 percent in September, and the slowdown evidently bled into Halloween. Redbook Research reported that sales in the first three weeks of October were down from their September average, and discount stores started cutting prices on Halloween-related merchandise earlier than usual.

As the theory goes – if consumers cut back on candy corn now, they may curtail their purchases of candy canes later.

But not to worry. It’s a stupid theory. Comparing Halloween with Christmas is like comparing jack-o’-lanterns with garland.

Christmas is a deep-rooted holiday and parents usually find a way to buy their kids the things they want.

I’m not saying this holiday season will be robust, only that Halloween sales are irrelevant.

As for the Fed, the chance that it will play the Grinch and start its taper in December is somewhere between zero and none.

Author, professor, entrepreneur, radio and TV commentator Tony Paradiso can be reached at
tparadiso@tds.net.