The US stock market has enjoyed a spectacular rally from its lows of 666 on the S&P 500 in March, 2009. Since then the market has surged higher, surpassing 2,100 on that same index. Stocks are credited with the ability to forecast the economic future of their respective country. This is a pattern that explains why rallies may occur before substantive economic improvements are realized.
This time is different
Instead of fundamental economic improvement, the stock market has rallied largely because of cost cutting, earnings improvements, quantitative easing (QE) and share buybacks. The latter two phenomenon are of particular concern because they offer a glimpse in to catalysts that are a complete departure from normal stock market rallies. The economy itself has largely languished since the 2008 collapse. As an indicator of that the workforce participation rate is at multi-decade lows while US debt is at an all time high.
Enter QE 1 through 3
During QE the stock market experienced the majority of its gains. As you can see in the chart below QE 1 through 3 bolstered the US stock market from its lows to new highs.
This unprecedented accommodative monetary policy, combined with a backdrop of enormous share buyback programs (see chart below), seems to account for the majority of gains that US equities have experienced since 2009.
Share buybacks surge to 2007 levels (from 2010 until now)
Share buybacks engender an atmosphere where corporate earnings seem to be better than they really are delivering. This is because with each share purchased the earnings per share reported increases. That is to say, a corporate stock buyback takes the shares out of public circulation and by virtue of doing so makes price-to-earnings multiples appear to be healthier than they really are.
Margin speculation exceeds 2007 highs
As seen in the chart above, margin debt is now exceeding that of the previous bull market. This is a disconcerting trend as all three indicators (QE, buybacks and margin debt) seem to illustrate a stock market that is thrusted higher more by debt than fundamental macroeconomic improvement or by improvements in company financials. That isn’t to say that this is a universally applicable rule to every individual stock, but by and large it is having an enormous effect on US equity indices.
Where do we go from here?
Every investor would love a crystal ball that shows them tomorrow’s prices today. If such a device existed there would be no uncertainty in investments. Indeed, everyone would be a winner — and there would be no losing trades.
My personal take on these charts and the facts they bring to light is that we are currently in the midst of a bull market that has been driven more by debt than structural improvement. A market where more of the gains eked out have been contingent on monetary stimulus, share buybacks and margin-based speculation than what this country truly needs: a stable, growing economy.
Burst bubbles lead to bigger and bigger bubbles
With that in mind I feel as though the lessons of bubbles past have been largely missed. Each time there is a bubble (NASDAQ 1999, real estate and finance in 2007 and with just about every debt-based asset class now) the bubble itself becomes more dangerous due to the underlying amount of debt and leverage necessary to inflate it. This trend is made possible by ever increasing amounts of monetary stimulus, market intervention and debt-driven speculation being used as the remedy for each previous bubble bursting.
I do not believe we have ever been in a more dangerous bubble than we are now. Real estate, stocks and bonds are largely at inflated values that rely on debt-based expansion rather than economic expansion. As a result, it may be worth considering exiting from those asset classes that have benefited from outsized gains due to, at least in part, an incredibly unsustainable combination of supporting factors.
Once this current bubble pops, the very same one that financial media, talking heads and central bankers claim does not exist, we may see a return to 2008-like volatility — or worse — a total seize up of the financial system. But one truth is certain: the rally we have experienced to date across multiple asset classes has been built on nothing more than a house of cards. And when it tumbles, so too shall confidence in the financial system at large.