March 26, 2014
What can possibly go wrong with stocks these days? Consumer confidence in March leaped to the highest level since January 2008, just before the financial crisis annihilated it. Institutional investors’ risk appetite, as measured by State Street’s confidence index, backed off only a smidgen in March to the second highest level in the data series going back to 2005, down from February’s record high.
“Geopolitical risk in Ukraine, Turkey, and other emerging markets has yet to have a significant negative impact on institutional investor behavior,” is how State Street explained the phenomenon where all risks are irrelevant.
And IPOs are flying off the shelf. Cloud-storage startup Box filed for an IPO today. At its last round of funding, it was valued at $2 billion, on the hope that it could be dumped into the lap of retail investors at several times that. It’s in a crowded field with low barriers to entry where all comers from Cisco to startups like Dropbox (valued at $10 billion!) fight it out mano-a-mano, and where the NSA has been deploying its dragnet. In 2013, Box had $124 million in revenues, spent $166 million on sales and marketing, and sported a net loss of $169 million. It’s but one of 32 US startups with valuations of $1 billion or more, lined up to go public while the feeding frenzy lasts.
Five years of the Fed’s QE and zero-interest-rate policy – and look what happened: Risks no longer exist; they’ve been priced out of the equation.
But the illusion is ending.
Last year, the Fed’s taper cacophony, which markets finally took seriously in May when bonds plunged and yields soared, led to the expectation that the Fed would start backing off its bond purchases in the fall. Scared witless by market gyrations, the Fed chickened out, only to initiate a watered-down version of the taper a couple of months later. Despite those on Wall Street who’d bandied about the meme that the Fed would forever inflate asset prices with its money printing binge – they’d longingly dubbed it “QE Infinity” – that binge is now scheduled to be tapered out of existence by October. Stocks became jumpy. Rather than rallying as they’d done last year and the years before, they’ve since gone nowhere.
Now the Fed cacophony has switched to interest rates, and it might sideline the biggest stock buyers of all times, buyers that insist on buying at peak prices and ridiculous multiples: corporations buying their own shares.
It was kicked off in earnest by FOMC Chair Janet Yellen during her post-meeting press conference last week. As she saw it, the Fed might start raising rates “around six months” after QE ends. Suddenly there were visions of ZIRP dissolving into thin air just like QE is dissolving before our incredulous eyes. Markets plunged.
She’d put a time stamp on ZIRP.
Soothsayers immediately ascribed her statement to a rookie mistake, that she hadn’t meant it, that it was her first press conference as newly anointed Chair. She, a well-known dove, couldn’t possibly ever want to raise rates. Word got around and markets recovered on the consensus that she’d misspoken.
Two days later, St. Louis Fed President James Bullard dashed those hopes. The six-month time stamp wasn’t unexpected at all. “The surveys that I had seen from the private sector had that kind of number penciled in as far as I knew,” he said. Markets ignored him.
On Monday, San Francisco Fed President John Williams also dashed those hopes in a circuitous interview where the reporter was trying to nail Jell-O to the wall. Rate hikes were coming in the second half next year, he said. “As we get toward the end of 2016, sure, we’re maybe normalizing monetary policy out there a little bit more than people thought in December.”
And on Tuesday, Philadelphia Fed President Charles Plosser too dashed those hopes. It was “puzzling” that the market “reacted the way it did” – that it sold off – in the wake of Yellen’s six-month comment, he said. The timeframe didn’t surprise him. There’d been “a lot of evidence … that six months wasn’t a wildly unexpected timeframe.” And he didn’t think Yellen had made a “mistake.” He saw short-term rates at 3% by the end of 2015 and at 4% by the end of 2016.
Now the dreadful thought is out there: 4% for short-term money!
Under ZRIP as the law of the land, corporations have loaded up their balance sheets with cheap debt to fund anything from payroll to M&A and buy back their own shares. This debt will have to be rolled over at higher rates, and the ballooning interest expense will hit their earnings. Highly leveraged companies with junk credit ratings will have trouble rolling over their debt at rates they can live with. There will be defaults.
These things will blow up one at a time, here and there. But the impact of higher rates on share buybacks will hit the market as a whole, and in a big way: In 2013, the companies in the Russell 3000 stock index bought back $567.6 billion of their own shares, up 21% from 2012. That unrelenting corporate buying helped drive up the index 33.5%. So far this year, buybacks are on a similar trajectory.
Since 2005, share buybacks totaled $4.2 trillion, nearly a fifth of the total value of all US stocks today, the Wall Street Journal reported. And companies were buying at peak prices: during the third quarter in 2007, just before the bubble blew up, share buybacks hit $214.3 billion. For the year, buybacks set an all-time high of $728.9 billion “when banks binged on buying back their own shares right before they collapsed….”
Conversely, in Q4 of 2008 and Q1 of 2009, during the worst of the crash when prices were way down, buybacks for both quarters combined dropped to a measly $97.3 billion. Massive share buybacks are part of the self-reinforcing loop that drives stocks to dizzying heights. And when buybacks fizzle, that lack of demand pulls the rug out from under the already teetering market.
If the Fed pulls through, buybacks will get more expensive. The risky game of loading up the balance sheet with cheap debt to buy back shares, rather than invest in productive assets, will balloon interest expenses that will hit iffy earnings. That’s when the appetite for buybacks turns into nausea and a bout of stock-market vertigo. These are among the “unintended consequences” of the Fed’s ingenious QE and ZIRP policies.
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