We’re enjoying your comments and questions – especially one that essentially reads, “What’s holding these markets up with all the bad news out there?”
That’s the magic question. Here’s our answer:
There are basically three forces keeping the market’s head just above water, namely corporate stock buybacks, the proliferation of passive stock-index funds, and (of course) the Federal Reserve.
And as both math and history confirm, they are each highly dangerous and, together, they are treacherous.
Market Performance, Huh?
First, let’s be clear on exactly “what’s up.”
In Monday’s article, we reminded readers that despite all the bullish “surges” which bobblehead financial journalists and sell-side Wall Streeter’s headline on a near-daily basis, actual returns over the last two years of increased risk have been flat to minimal:
In short, from January 2018 to the last high of 2019, almost nothing has changed or been gained net/net, when all is said in done.
Again, this is not opinion but math. That total of 5.2% up was accompanied by a 20% downturn in the last quarter of 2018 – not what we call “fun.”
Stock Buybacks – An Invalid Market Force
Here’s some more math.
Since the alleged “recovery” in the U.S. equity markets began in 2009, corporations themselves purchased over 20% of the U.S. market cap at the very same time that the “smart money” institutional investors sold over 7% of that same corporate sector.
Stated otherwise, the wind beneath the U.S. stock market has come from the very companies that comprise that market. See for yourself:
This means that even the paltry gains witnessed by our markets in the last two years would be far, far lower today if it weren’t for these stock buybacks. In short, markets would otherwise be falling to record levels.
The math behind these stock buybacks is revealing in many important ways.
First, it just feels wrong.
After all, if I were to legally announce that I were a “best-selling author” based upon book sales, that would be impressive on its face.
But if I were to later admit that my rich uncle bought all those books and now warehouses them in his garage, my “best-selling” status would feel a bit tainted.
Well, it’s no different when considering the status of our “surging market highs,” for they are “high” only because publicly traded corporations like Cisco, Lowes, General Electric, and Apple have been “high” on their own Kool-Aid – i.e. “buying their own books.”
Secondly, such buybacks create equally tainted data points, most notably when the media brags about “impressive” earnings per share (EPS) data.
Here’s the rub: That EPS data is totally rigged.
When companies buy back their own stocks, the available number of shares is greatly reduced, and hence the earnings per those reduced shares make the data seem better than it actually is.
That is, we have the same earnings divided by a smaller number of shares, and hence a higher (yet fudged) ratio of earnings per share.
Putting numerical lipstick on a corporate pig is artificial. But there’s more…
Taking this a step further, think about this. Executives are often compensated by EPS stats, which we now know are inflated EPS stats. Which means they are enriching themselves even as their corporate performance sags.
Ah… what a “recovery,” eh?
There is also a matter of simple legality here, something former law graduates like myself cannot ignore or easily accept.
It’s worth noting as well that such buyback scams were a leading “proximate” and “direct” cause of the great market crash of 1929, and thus subsequently outlawed by no other than the former bootlegger and market-rigger-turned-SEC-Chairman, Joseph Kennedy.
After all, it takes a fox to catch a fox.
Unfortunately, and thanks in part to the unfettered, deregulatory “insights” of Milton Friedman and the Chicago School, such pesky legalities were later dismissed, and the stock buyback scam that crushed us in 1929 was reinstated.
So here we are again, heirs to a bad plan reborn in bad times.
Index Funds – Another Bad Plan
Bad plans don’t just develop because they occurred in the past. They are reborn, generation after generation. A completely new generation of equally bad plans has indeed emerged, including the modern index fund into which the majority of retail investors have been herded like cattle by their traditional (highly dangerous) wealth advisors.
By index fund, we refer to a simple mutual fund (MF) or an exchange-traded fund (ETF) that follows preset rules that track a specified basket of underlying investments. The most popular index funds track the major indexes, like the S&P 500 Index or the Dow Jones Industrial Average.
By parallel, the recent flood of funds into index funds mirrors the pre-’08 rush to buy into the subprime Collateralized Debt Obligation (CDO) bubble that brought our markets to their knees.
Now, as then, this massive inflow is poised for a reversal – i.e. an equally massive outflow. Of course, the longer this bubble persists in the interim, the uglier it will be when it reverses.
That’s because as in 2008, no one is taking the time to look beneath the hood of these indexed securities at the underlying balance sheets that comprise the basket of assets they hold.
Prices in these indexes are based on volume, not valuation. They rise with the market tide, not on individualized volume, earnings, profits, or losses.
The Russell 2000 index is a perfect (and mathematical) example of this distortion. The majority of the stocks beneath its hood trade at low volume and are valued at less than $5 million each, and almost half of those names trade at less than $1 million on any given day.
But when packaged together under a nice index ticker, these same stocks peddled by Wall Street and consensus-thinking wealth “advisors” trade at hundreds of billions of dollars.
The S&P is little better. Its index is comprised of the world’s largest stocks and trades at levels that reach trillions of dollars, but over half the names in that index trade daily at less than $150 million on their own.
In short, index funds are “like a box of chocolates,” most of which are crap, but trade at grotesquely overvalued prices merely because a few “good flavors” in that chocolate box are tasty enough to seduce investors to buy the whole box.
But as Forrest Gump further reminds, “stupid is as stupid does.”
Smart investors, however, see right through these risks and don’t buy in bulk via indexes, but handpick their chocolates carefully, typically looking for the few true value names in the small-cap growth space (mainly good technology stocks) which offer the most bang for the individual buck.
But even such sniper-shooting for genuine value has risks today, as even the good names (with good balance sheets) can and will go down when the market tide goes out.
Ironically, it will be the sudden outflows from the big index funds (and the many bad chocolates they hold) which will punish the few good chocolates trading outside the indexes.
All of this is my way of saying that risks continue to outweigh reward in these increasingly overvalued and distorted markets – made all the more so by such dangers as seen in stock buyback scams and index overvaluations.
Today, any number of foreseen and unforeseen events (drone strikes to repo market “glitches”) can make rising tides suddenly turn into falling tides driven by massive flows out of the above-described index vehicles, or rising tides in interest rates which end the current buyback scam.
Today, I therefore see a market stool held together by three shaky legs: 1) stock buybacks, 2) overvalued/crowded index funds, and, of course, 3) totally rigged Fed support.
Which leg will break first? When will it happen?
Does it matter? Well, yes and no. At this point, it’s smart enough to simply avoid sitting on a broken stool.
Simple math and common sense speak for themselves, and you have plenty of both to make the right decisions now.
20 responses to “Three Legs of a Broken Market Stool”
September 25 2019