Pricey US stock market poised for historic reversal

By Yin Zhongli Source:Global Times Published: 2018/10/28 22:33:39

Illustration: Luo Xuan/GT


The US stock market plunged again on Wednesday after several major drops, erasing almost all gains since the beginning of this year. The three major US indexes showed signs of ending their bullish run and contracting, even before the end of September.

The quantitative easing policies supporting this extended bullish run have been gradually phased out. As the Federal Reserve has accelerated the pace of raising interest rates, the way companies use leveraged buybacks to drive up share prices will be constrained. 

Since US President Donald Trump came into office, the US stock market has been on an upward trend and renewed its highs after small dips. The dates when Trump became president and new records began to be set are seemingly in line, although there may not necessarily be a causal relation. But Trump took the credit and called himself the greatest president in US history.

But the good times seem to be gone.

Share prices are pushed up by market forces, which have little relationship with Trump being the president. Before him, US stocks had been rising for almost eight years. Stock prices can be self-reinforcing - more money comes in, pushing up share prices every time there is a strong uptrend in the market. The longer the stock market keeps going up, the more power there is to drive up stock prices.

However, the stock market has highs and lows, and it fluctuates according to its own rules and laws. Drawing connections between stock market and presidential performances could be an embarrassment when the stock market slides. If a politician wants to take credit for a stock market surge, it will only prove that he or she does not understand the stock market.

The US stock market rally is near an end and it may collapse at any time, since the bull market was boosted mainly by quantitative easing policies. Now, the policy fundamentals have seen major changes. The stock market will soon come back to bite Trump since he has been tying his performance with the stock market.

According to stock valuation models, if long-term interest rates decrease, it means a drop in the risk-free return rate, which is a plus for higher stock valuations. This is the basic reasoning for quantitative easing policies to drive up the stock market.

From the US stock market performance in the past few years, we can identify another effect that quantitative easing policies had. In the context of low market interest rates, many listed companies issued bonds and repurchased their own shares with the money. This kind of leveraged buyback helped contribute to a continuous rise in the stock market.

Leveraged buybacks are seldom seen in the Chinese stock market, but they are quite popular in the US stock market. The abundant liquidity in the market allows companies to enjoy low-cost financing. In this case, the cost of capital is quite low when using debt to obtain financing and the interest will be tax-deductible. With low-cost capital to repurchase their stock, the companies are conducting a de facto arbitrage by taking advantage of the spreads between stock dividends and the interest rate. Corporate bonds have grown into a $3 trillion market since 2009 and US corporate debt has reached a historic high of $13.7 trillion.

Nonfinancial companies have repurchased $3.3 trillion worth of outstanding stocks. The amount of corporations' bond issues is equivalent to their stock repurchases.

Goldman Sachs calculated the cash flow of listed companies in the S&P 500 and forecast that the repurchase scale is likely to keep.

Apparently, to continue the leverage buyback game, the financing cost has to stay low. As the Federal Reserve hit the accelerator in raising interest rates in the past couple of years, the game will face huge challenges.

Another fact is that more people have warned about the risks of the US stock market despite the upbeat trend. In a letter to Berkshire Hathaway shareholders, Warren Buffett implied that US stocks are overvalued and there is no point to maintain repurchases. Therefore, he has increased the amount of cash he is holding. Robert Shiller, professor at Yale University, has also warned that this is a risky time in the market since investors are no longer skeptical enough about corporate earnings, and this has made the US stock market the most expensive in the world.

The US stock market has been gaining for about nine years. But the market will eventually make a U-turn when it reaches its peak. Any subtle factor could trigger the conversion from uphill to downhill. It looks like the tipping point has been reached.

The author is researcher at the Chinese Academy of Social Sciences and research fellow at the National Institution for Finance & Development.


blog comments powered by Disqus