What Happens to the Market When Stock Buyback Programs Stop

The International Monetary Fund (IMF) expects the global economy to increase by 2.9% this year and 3.6% in 2014—forecasts which I believe are too optimistic. Why?

First of all, we have the Japanese economy, the third-biggest in the global economy, suffering an economic slowdown. Tertiary industry activity (activity in the service businesses) slowed in September from a month ago. (Source: Japan Ministry of Economy, Trade and Industry, November 12, 2013.)

Then there’s Germany, the fourth-biggest economy in the global economy. Once believed to be immune to the economic slowdown in the eurozone, seasonally adjusted manufacturing output in the country declined 0.8% in September from August. As of September, year-to-date manufacturing output in the German economy has increased only 1.2%—a much slower growth rate than in the same period of 2012. (Source: Destatis, November 8, 2013.)

Earlier this month, in a statement about its monetary policy decision, the central bank of Australia said, “In Australia, the economy has been growing a bit below trend over the past year and the unemployment rate has edged higher. This is likely to persist in the near term… Public spending is forecast to be quite weak.” (Source: “Statement by Glenn Stevens, Governor: Monetary Policy Decision,” Reserve Bank of Australia, November 5, 2013.)

To fight the economic slowdown in the country, the Reserve Bank of Australia is using easy monetary policy measures. The central bank has reduced its benchmark interest rate in the country by more than 40% since the beginning of 2012. The cash rate, the overnight money market interest rate, sits at 2.50% compared to 4.25% in early 2012. (Source: Reserve Bank of Australia web site, last accessed November 12, 2013.)

Dear reader, I’ve only mentioned three countries in the global economy that are displaying a sharp economic slowdown. I haven’t mentioned that the U.S. and China—the two biggest economies in the world—are both displaying signs of an economic slowdown as well.

With all this happening in the global economy, I don’t see companies in key stock indices continuing to post the same corporate earnings as they have been doing since 2009.

The fact is U.S.-based companies have significant exposure to what happens in the global economy. Almost half of all revenues of the S&P 500 companies come from the global economy. Once American companies run out of money for their stock buyback programs, the economic slowdown in the global economy will result in lower revenues translating into weaker profits. Stock market participants beware!

Michael’s Personal Notes:

The strong jobs market report last week started the chatter again that the Federal Reserve would start to reduce the pace of its quantitative easing program. Some have said the Fed will reduce the amount of its asset purchases as early as December, while others are saying the quantitative easing will start to diminish by March 2014.

I have a different opinion: I believe the Federal Reserve can’t stop quantitative easing, because the market has become so dependent on it. If the Fed does go ahead with a pullback on money printing, the consequences will not be pleasant.

I made a very similar prediction last time when we heard a significant amount of “noise” about the Federal Reserve pulling back on its asset purchases. My predictions were right, and nothing has changed since then. The Federal Reserve continues to buy $85.0 billion worth of U.S. bonds and mortgage-backed securities (MBS) a month.

Please see the chart below to see why I believe the Federal Reserve just can’t walk away from quantitative easing without causing massive damage.

Chart courtesy of www.StockCharts.com

In May, when the Federal Reserve hinted it might be reducing the pace of its asset purchases, we saw a spike in bond yields with the 30-year U.S. Treasury rising from about 2.8% to as high as 3.9% in a very short period of time. Then we heard the Fed would not be tapering as was expected and bond yields settled and started trading in a range. Now, with the jobs market report perceived as good (first time we created over 200,000 new jobs in months), bond yields started rising again.

The issue is very simple: the Federal Reserve has become a huge buyer of. bonds through its quantitative easing program. Last time I looked at the Fed’s balance sheet, it was closing in on $4.0 trillion. And the Fed is still buying more U.S. bonds and mortgage-backed securities.

At the very core, the problem at play here is that as a massive buyer of both U.S. bonds and mortgage-backed securities (and it’s vastly known what the Fed holds in its portfolio), if the Fed tried to unload its holdings, this action could cause severe pressures on the bond market—prices will fall further and yields will soar, which will result in an increase in lending rates.

I remain very critical of quantitative easing; I think it has created more problems than benefits. Unfortunately, we will not know the outcome of those problems for months and maybe years to come. It’s a similar situation to the easy mortgage policies of 2004 to 2006, when it was so easy for home buyers to get a mortgage for a home they couldn’t really qualify for…and we know how that ended.