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President Donald Trump has predictably taken credit for the US stock market’s relentless rise, but success has many fathers. In reality there are a brace of well-known fundamental factors behind the bull market’s thunderous run. But some analysts suggest an intriguing, less-appreciated one: scarcity.
The biggest broad drivers are clear. Corporate America has become a phenomenal money machine over the past decade, with profits staying above 10 per cent of gross domestic product through the post-crisis era. In the first quarter, the post-tax profit of US companies rose to a record $1.81tn, according to data from the St Louis Federal Reserve.
At the same time, alternatives to equities look miserable. Andrew Sheets of Morgan Stanley notes that the average interest rate across the G4 countries is still 1.5 percentage point below the inflation rate, keeping bond yields pinned at historical lows. Indeed, nearly $11tn of bonds still trade at sub-zero yields.
The Fed may never have dabbled with negative interest rates and US Treasury yields look generous next to the miserly (or negative) returns offered by eurozone and Japanese bonds. But low global yields still mean elevated stock market valuations. As Mr Sheets argues, “with rates low and central banks taking great care to avoid surprises, the question isn’t why many assets are expensive. It’s why they aren’t richer.”
Passive equity funds have ‘morphed into a type of black hole. Money goes in and stocks never come out’
Still, there are two lesser-noticed factors that have helped propel equities to new highs by taking stocks out of the financial system: corporate share buybacks and — perhaps more controversially — passive investing.
Firstly, corporate buybacks have been the single biggest source of demand for US equities since the financial crisis. Although the pace has slowed — not least because tax reform has dragged on, failing to produce a buyback bonanza financed by repatriated overseas profits — Goldman Sachs estimates that companies will repurchase about $570bn of their stock this year, and another $590bn in 2018.
If these forecasts are correct, it will mean that US companies have bought back close to $5tn of their stock since the financial crisis. Without this pillar, the net demand for US equities would have easily been negative throughout the post-crisis years.
Aside from the direct support they offer for share prices, the repurchases reduce the number of shares floating around the market. Howard Silverblatt of S&P Global estimates that the number of S&P 500 shares outstanding stands at about 306tn, roughly the same as a decade ago despite the stock market nearly doubling in value during that period.
Christopher Harvey, a senior analyst at Wells Fargo, has offered another intriguing, complementary technical force that has contributed to US stock market’s rise: the tectonic shift towards passive investing, which has continued unabated this year despite the welcome turnround in stockpickers’ performance.
Superficially, this makes little sense. Over the past decade more than $900bn has seeped out of traditional equity funds and mostly gushed into passive exchange traded funds, according to EPFR data, but in practice, the money has largely been shuffled from one type of investment vehicle to another. This should have a negligible overall impact on the market. But Mr Harvey argues that the impact of passive equity funds is “beginning to resemble the footprint left by quantitative easing”.
Let’s unpick this a little. When the Fed bought up and held a big chunk of the Treasury market, it in effect reduced its free-float, making Treasuries scarcer amid still-healthy demand. The Wells Fargo analyst argues that a similar dynamic is happening with ETFs and the US stock market.
Given that inflows have been pretty much uninterrupted since the crisis, they hardly ever sell stocks, in practice reducing the free-float of shares available for traditional asset managers to buy. As Mr Harvey puts it, passive equity funds have “morphed into a type of black hole. Money goes in and stocks never come out.” In other words, the more money goes into ETFs the fewer natural sellers there are in the market, helping buoy prices.
This has lately been exacerbated by increasingly shallow dips whenever the stock market has quivered. Given that selling on these dips has proven foolish, fund managers are instead going on what the Wells Fargo analyst calls a “seller’s strike”, reinforcing inertia and stock scarcity as a powerful force in markets.
Of course, the scarcity theory — and it remains a theory — rests on uncertain foundations. Corporate buybacks have already begun to wane, and if the stock market ever does suffer a severe setback then money might flow out of ETFs. But the overall, long-term trajectory is clear, and the “black hole” of passive investing is likely to continue to soak up stocks for a long time to come.
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