The Coming Stock Market Rout

Several days ago, IM Vronsky wrote that the big banks are in deep trouble. Since the financial reporting of these companies leave out much of the data necessary to evaluate these companies, he pointed to the price history (and technicals) of several bank stocks.

While stock prices reflect only the collective market sentiment based on the incomplete reporting, it does indicate that all is not well in River City.

Looking at the overall market first, we find that prices peaked about a year ago and since have turned down. Let’s look at some factors affecting stock prices.

Earnings: The reason most people invest money is to make a profit. The larger the company’s earnings, the greater the potential for bigger payouts down the road. To compare different stocks, one method is to view earnings compared to the price of the stock – or the PE Ratio. Historically, the “average” PE has been around 14, with 7 denoting ultra-cheap, 21 indicating high stock prices, and 28 showing bubble territory. Currently, the S&P500 sports a PE over 23, richly price.

Alternatives: Stocks are one among several investment possibilities, the main alternative being bonds. Half a century (and more) ago, analysts such as Dan Dorfman noted a pattern relating bond yields and stock prices – low interest rates foster high PEs and vice versa, and this makes sense. If the alternative investment carries a lower yield, more people will invest in stocks, pushing up the price. Our current interest rate environment decidedly is one of low rates.

Chicanery: Companies can use cash to buy back their own shares – even borrowed cash. With low PEs, this could make sense, but with high PEs, buybacks are hard to justify. Many (most?) companies pay their employees (and Directors) with stock options. Since buybacks provide artificial demand, stock prices usually wind up higher than they would have been, so buybacks together with stock option grants are a conflict of interest. I have written several times that I think the practice should land the officers in jail. This is blatant stealing from the shareholders!

Estimates vary, but stock buybacks for 2015 likely were between $600 and $1,000 Billion. With total US stock market cap around $18.7 Trillion, buybacks were 3½% to 5½% of the whole stock market in 2015. Said another way, stock market cap fell around 4½%. Without buybacks, stock prices would have fallen about that much – that’s over 750 points lower on the DOW.

Government: Politics reigns in government. High CPI and Unemployment reports are a No-No in DC (see www.ShadowStats.com for real numbers). BLS and other agency lying tends to support higher rather than lower stock prices.

A reduction in any of these factors can provide the pin to bust the stock market bubble, as we started to see with the FED’s 0.25% rate hike.

Banks are especially vulnerable today because the FED has become immobilized due to no good policy choices. Keeping rates and money supply stable will allow a continuation of deflation of the Economy and of the stock markets. Raising rates further will bring home to roost all the mis-allocations of funds (including massively out of control federal spending). Crash! (I favor a gradual – 0.01% at a time – increase until rates reach try market levels, perhaps in 2 years or so.)

Going to NIRP – negative interest rates – is the FED’s worst option. It would eliminate all but FED buying of Treasuries at a time when Budget Deficits are expected to skyrocket once again. NIRP would cheapen the Dollar on FOREX markets, just as the FED would be flooding the Economy with new Dollars. Such savers as still exist would face a strong incentive to become spenders.

Prices would rise so fast that even the bogus official numbers would start to take off. Businesses, starved of capital and facing escalating cost increases, would continue to shrink. Larger numbers would default on loans / bonds.

Such an environment is not conducive to banking success. Banks likely will be harder hit than many other kinds of businesses.

Stocks, especially banking stocks are in for a large downturn – I expect a decline of -50% and more (a 23 PE falling to 7, with falling earnings suggests a possible -70% drop) for stocks in general over the next couple of years. Furthermore, several banks (even Too-Big-To-Fail Banks) will go belly up.

After the forth-coming stock market rout, there will be much reason for optimism…but that’s a story for another day.