OOPS! A Bear!
(c) Can Stock Photo

Approximately eight years ago,  progressives were screaming that capitalists had with their avaricious, dishonest and selfish behavior thrown us into another Great Depression. The reaction of a Democratically controlled Congress was the Dodd-Frank Act, which has bedeviled the U.S. economy ever since. Yet noting this just barely scratches the surface of all the misdeeds of the executive and legislative federal government branches that are progressively weighing down our economy. One of the major effects of government discouragement of economic activity has been the inflation of a stock market bubble.

In my last post I discussed the extent to which the Federal Reserve has been responsible for our present stock market bubble. In this post, I will point out how the executive and legislative branches have been complicit.

The Culpability of the Executive and Legislative Branches in Creating the Stock Market Bubble

Counterintuitively,  all of the federal government’s discouragement of economic activity has, together with Federal Reserve easy money, driven the inflation of a U.S. stock market bubble. Normally, one would expect bad economic policies hurting the economy to cause the stock market to fall. Yet what we have seen over the past eight years is a disconnect between the health of the economy and the performance of the stock market. Even as growth has been stunted, the stock market has risen to ever higher highs, as shown in the plots of the S&P 500 index and the GDP growth rate below.

From the end of the Great Recession to the latter half of 2014, growth has been relatively stagnate with annual averages around two percent. Then, GDP growth trended downward, as demonstrated by the red line fit in the GDP plot above. Yet despite this uninspiring performance, the growth of the S&P 500 index forged ahead to ever higher highs until the second quarter of 2015. Since then with the exception of a couple of small corrections, the index has remained at a very high plateau.

To rub the lesson in even further, consider the development in recent years of the Federal Reserve’s Labor Market Conditions Index (LMCI), one of the most perfect coincident indicators ever invented by the mind of man. More precisely, it is the monthly change in the LMCI that is the perfect coincident indicator.

If this is not enough to create wonder, consider the fact we have been in a corporate earnings recession for five or six quarters, depending on whether or not companies’ earnings fell in the just concluded quarter.  So while GDP trended downward for the past two years, labor market conditions deteriorated during those same two years and show no signs of improving, and while corporate profits have fallen for a year-and-a-half, stock indices have been reaching ever higher altitudes in the atmosphere? How can such a disconnect of stock prices with the underlying economic conditions take place?

The answer comes in two pieces. The first piece comes from all the discouragement the federal government gives companies from continuing any economic activity at all. Both taxes and economic regulations have become so burdensome that many companies have decided to abandon the United States altogether and relocate their headquarters in foreign countries (the United Kingdom and Ireland appear to be the favorites) through a process called corporate inversion.

To see the problems corporations have with taxes, consider the following posts:

• Beware BEPS!
• Economic Effects of Current Tax Policy
• The Ideal Tax Regime – 1

As for economic regulations hamstringing business, consider the following posts:

• The Burden of Economic Regulations
• The Debilitating Effects of Obamacare
• Economic Effects of the Dodd-Frank Act
• The EPA. CO2, Mercury Emissions, and “Green” Energy

Because of the resulting unpromising prospects for earning profits, many companies have held off on making investments that increase their productive capacity. My favorite proxy for corporate investment is the time series for manufacturers’ new orders for nondefense capital goods, shown in the plot below.

Notice that manufacturers’ new orders for capital goods have been trending downward during the same two to two-and-one-half years as the downtrends for GDP and for the monthly change in the LMCI. By now you should see a pattern developing. The economy is deteriorating, corporate earnings are declining, government is making economic life impossible for the producers of new wealth, and the corporations can not find a way to profitably invest in their own operations. What’s a company supposed to do?

In fact, this economic environment presents corporations with two problems. The first is what to do with the profits they do make if they choose not to invest in their operations, nor to pay them out in dividends. The second is how to keep the value of their stockholder’s stock afloat in the face of falling earnings. Actually, many corporations are paying out more in dividends, but many companies are employing a strategy, either in addition to paying more dividends or in place of it, that kills the two birds with one stone. The idea is to take the money they would otherwise use for investment and use it to buy back their own stock. This is a strategy that has been popular with companies for some time now, as demonstrated by the Wall Street Journal plot of buybacks below.

By buying back their own stock they reduce the number of their shares outstanding, which if they bought enough shares back would increase their earnings per share even if their earnings had actually fallen! Also, the increased earnings per share would simultaneously decrease their price to earnings ratio, making their stock more attractive to other investors. When you add to this incestuous stew almost free money to borrow provided by a compliant Federal Reserve, you have a recipe for causing people and institutions to bid up stock prices and to create a stock market bubble.

Why the Bubble Bursting Will Hurt Even Those Who Are Not Investors

What I described above can not continue forever, and indeed there is evidence the pace of corporate buybacks is abating. Anthony Mirhaydari, posting on TheFiscalTimes website, makes the following observation.

Research from Goldman Sachs shows that 90 percent of S&P 500 companies will report earnings by Nov. 4 — meaning they are in a stock buyback blackout period. According to Ray Dalio of Bridgewater Associates, the “biggest force in the stock market right now is the buybacks and mergers and acquisitions.” Dalio adds that those lines of activity account for “something like 70% of the percent” of the buying action in the stock market. That could be just the thing to push the Dow back under the 18,000 level for the first time since July.

He also quotes analysts at Barclays Capital as saying shareholder dividends and buybacks are currently exceeding company cash flow at a $115 billion annual rate.  “Unless profitability and revenue growth return soon, companies will be forced to scale back these capital returns, and thus, remove a major source of buying demand from the stock market.” As evidence that corporate buybacks are already falling beginning with the second quarter of 2016, Mirhaydari offers the following plot.

At some point, if stock price increases are not justified by actual increases in company earnings, even the companies will have to judge their own stocks too pricey for purchase. At that point, unsupported by either economic fundamentals or corporate buybacks, stock prices should fall off a cliff until they reach prices giving a Shiller CAPE at or below its historical mean of 16.7. That will be an historical, memorable crash of approximately 60 percent off the S&P 500. There will be much weeping and wailing and gnashing of teeth among investors. It will not end well.

But it will not just be investors who are grievously hurt. Seduced by low interest rates created by the Federal Reserve, U.S. corporations have doubled their debt since the Great Recession to $6 trillion. That load of corporate debt is approximately 32 percent of the US GDP, and far beyond any cash or near cash they might have on hand. Should the stock market crash to more realistic levels, many companies may not have the means to pay back for the bonds they sold, and may be forced into chapter 11 bankruptcy or worse. Those who bought those bonds, who are mostly retail and foreign investors who bought the debt through bond funds or ETFs, will have to take military style haircuts. If that is the case, we shall all suffer greatly.

Just remember when this happens, it will be the fault of the federal government that left companies with no other alternative.

Views: 1,559

GO TO HOME

Sharing is caring!