What Is Driving the Stock Market Rally?

Ever-higher earnings are a large part of why some of the big tech stocks keep going up. But, in an interview with CNBC, Dallas Mavericks owner and billionaire Mark Cuban says it has to do with interest rates. You’ll know when the rally is over when rates start going up.

Mark Cuban, who made billions of dollars during the dot-com boom, said Wednesday that the stock market is not reminiscent of 1999.

“Interest rates were a lot different back then,” Cuban said on CNBC’s “Fast Money Halftime Report.” “And you saw a lot more people participating in the market. … You don’t see that now. That individual day trading really led the market to be frothy.”

The levels of day trading have receded and given way to the rise of index funds, creating a fundamentally different landscape, Cuban said.

“There’s so much money chasing index funds, so as long as those funds keep on growing the market is going to go up,” said Cuban, who sold Broadcast.com to Yahoo in April 1999 for $5.7 billion.

His argument is that there is a lot of money looking for investments and, so long as rates are low, the stock market and its derivatives art still where the best return lies.

How Abruptly Will the Market Change Direction if Rates Go Up?

Investopedia discusses the effect of interest rates on investments in an article about what can cause a significant move in the stock market.

Rising interest rates can place downward pressure on real estate investment trusts (REITs) and slow the housing market. Higher interest rates mean higher borrowing costs slowing down purchasing activity and causing stock prices to dive.

These factors will come into play a bit at a time as rates go up and earnings drop off. However, the stock market anticipates events as wells as reacting to them. Many investors, like Cuban, will make adjustments as soon as rates start to rise in anticipation of the bull market ending. We have often noted that Warren Buffet’s silent warning to investors is that (like before the dot com crash) is stockpiling cash!

What Else Could Stop the Rally?

The threats of war, societal chaos, and economic collapse can all drive the market down temporarily. For example, the Chinese coronavirus may be an opportunity for some pharmaceutical stocks, but a global pandemic like the Spanish Flu epidemic a hundred years ago that killed 500 million worldwide would have widespread effects on the economy, investments, and governments!

Who Is Buying Stocks?

CNBC published a useful article about who is doing all the buying that is driving the market up.

Given a series of new highs for the S&P 500, the Dow Jones Industrial Average and the NASDAQ, the obvious question is who is doing all this buying?

The author goes through the list of investor categories and come up with conclusions that should be of concern to regular investors.

The large investor groups for stocks include retail investors who own about 20% of US stocks. However, this group now has holding comparable to 2007 and is likely not the main culprit in driving up prices. Public corporations themselves are larger factors with money coming from the Trump tax cuts going to share buybacks. The same amount of investment capital (or more) is going to purchase fewer equities. That fact greatly skews the supply and demand curve!

And, hedge funds have become a huge factor in the markets. Money invested in hedge funds comes to a third to a half of that held by retail investors. But, the holdings in these funds are by definition more labile. Unfortunately for many hedge fund investors, the S&P 500 went up 31% last year while the average US hedge fund dealing in equities did about half that. The result is that the “rebalancing” of portfolios is impressive, especially as fund managers have attempted to make things look better at year’s end.

Quant funds, multi-strategy funds, and high-frequency traders add to the mix on the hedge fund side of things.

Why Does It Matter Who Is Buying Stocks?

It matters whose purchase are driving stock prices higher because it tells you a bit about their intentions. Success long term retail investors tend to follow an intrinsic stock value approach when investing in stocks. Hedge funds and short term traders are looking to time the market. If you are following the example of those who are looking for long term value, you want to emulate long term retail investors. If you are buying stocks because the hedge funds are driving up prices (temporarily) you may be in trouble as you prepare to stay the course and they are ready to bail out at a moment’s notice.

A common theme for folks promoting long term investing is to emulate Warren Buffet who only invests in companies that he understands and only buys when the intrinsic value is greater than the current stock price. That approach and following the purchases of hedge fund managers may make you money in the short term if you can respond fast enough but it does not put you in a position to sleep well at night with solid and dependable investments!

Stock Buybacks

Just a couple of months ago Forbes wrote about stock buybacks by Apple and other companies. The article is informative and helps shed light on one of the reasons that the market and especially the FANG stocks have not had a significant correction.

Stock buybacks were outlawed until 1982, when the SEC changed its rules to allow companies to repurchase shares on the open market, although doing so can artificially boost the stock price. CEOs and other corporate executives benefit the most from this behavior because their compensation, unlike that of rank-and-file workers, is closely tied to stock performance.

Between 2015 and 2017, U.S. publicly traded companies across all industries spent three-fifths of their profits on buybacks. The low-wage restaurant, retail, and food manufacturing industries spent 137%, 79%, and 58%, respectively. The restaurant industry borrowed money or used cash on its balance sheet to exceed the amount of its bottom line.

The argument that Forbes makes is that money which could have gone to higher wages or other employee benefits has gone to propping up stock prices. This disproportionately benefits upper levels of management. Our take on the practice is that buybacks are keeping the bull market alive by artificially inflating stock prices.

Stock Price versus Market Cap

When the market would normally take the price of a stock downward, stock buybacks prop up the stock price. However, this practice reduces the number of shares of stock available. Thus, if a company buys back 10% of its shares in order to increase the stock price by 9%, the market capitalization of the company, its total worth, is unchanged. If the company buys back 10% of its shares just to keep the stock price the same, the market cap of the company falls by 10%. If you have kept your shares in that company you now own a larger proportion of a company that is worth less than before. Stock buybacks are a common tactic used by old and successful companies with lots of cash that are now failing as their business plans become dated or simply because the economy is taking a downturn.

Buybacks and the Economy

The Forbes article goes on to note that when companies use buybacks to prop up stock prices and compensation for upper management the same buybacks rob workers of the pay increases or bonuses that otherwise would funnel into the economy and help everyone.

How Long Can Buybacks Prop Up a Stock Price?

Buybacks will continue so long as a company has the cash or credit to buy back its own stocks. How long that lasts is also determined by the needs of the company to simply run its business. As profits sag, a company will eventually need to use its resources to run the business and not prop up the stock price. At that time one might expect a more substantial correction than might normally have happened because the market forces poised to take the stock price down will be unopposed by the artificial action of buying back stocks. In other words, we might expect a stock to crash instead of correct when it has been supported artificially by buybacks for an extended period. Investors who are now leaving various stocks are likely looking at intrinsic stock value and not stock price to make their decisions.

Bad Technicals

Market Watch adds to the concern about a pending market correction or worse with an article about damage done to the stock market in recent weeks.

Acampora said he believed that the entire stock market itself would go into a bear market and said the current dynamic in the market was eerily similar to the stock-market crash of 1987, when the Dow slide a historic 22.6% in a single day on Oct. 19 of that year.

When we see the market fall on day and recover the next, one might think that solid long term investors are stepping in to take advantage of lower prices. However, it would appear that companies are using the downturns to buy back stocks at a lower price and especially to prop up the stock price. In this sense it would appear that buybacks are truly keeping the bull market alive and the time will come when sellers overwhelm the ability of the Apples of the world to buy back and prop up stock prices.

Are Buybacks Keeping the Bull Market Alive? PPT

Perennially bullish strategist Tom Lee believes the S&P 500 is set to rally 6 to 8 percent before the year is out.

That specific number is based on his analysis of prior market moves. Lee found that since 1940, the S&P ended the year higher in 27 of the 30 times it was up by 5 to 20 percent through mid-September.

One might think that election years, which threaten to bring a great deal of uncertainty to the end of the year, may hold something different. But out of the nine election years covered by the above stat, eight of them saw stocks gain in the final 3½ months, Lee says.

Many believe that the current market is overpriced. If that is the case what would drive it higher? One opinion is that many investors are still hurting from the 2008 market crash and have avoided stocks ever since. Some of these folks are finally becoming believers and will push the market up as they try to get back into the market. The problem is that some will probably come in for a slight gain before the market finally corrects!

Will the Market Correct or Crash?

Not everyone believes that a year-end rally is in the cards. Investopedia reports that James Dale Davidson, who predicted the 1999 and 2007 crashes, says a stock market correction is imminent.

James Dale Davidson is controversial economist who famously made accurate predictions of the financial crashes of both 1999 and 2007. Now, he and other leaders in market correction predictions are suggesting that signs are pointing to another impending correction in the markets, and possibly one that is of greater magnitude since any crash since the Great Depression.

Interestingly Mr. Davidson does not believe that sources of current economic and market concern will cause the correction. This is a technical prediction. Many of us would like to see the fundamentals that drive the market higher the 27 of 30 times that stocks were up in September and rallied for the rest of the year. And it would be nice to see what Mr. Davidson thinks will pull the market down if it is not overpriced stocks. With this sort of confusion about the market how should an investor proceed?

Investment Returns and Investment Decisions

The point of investing is to make money and not lose any. As we gain experience with the results of our investments we, hopefully, make better investment decisions. The Economic Times writes about incorrect assessment of returns leading to bad investment decisions.

For most investors, point-to-point return figures serve as the performance yardstick. This can be misleading. The current return profile of equity funds, for instance, is a case in point. The three-year returns of most equity funds comfortably outshine the five-year figures (see chart). Large-cap funds have clocked 13.5% CAGR over the past five years compared to 17.8% over the past three. Mid-cap equity funds have yielded 20.6% CAGR over the past five years against a whopping 34% in three years.

It is an interesting discussion and worth the read. The point is that staying invested, even through events like the Great Recession smooths out the peaks and valleys. You may want to get into the market for a year-end rally but a better choice is probably to pick stocks with high intrinsic value and invest for the long term.

Will There Be a Year-End Stock Rally? PPT