Can These "Tricks" Keep the Stock Market High Much Longer?

Remember the famous words of Mark Twain: “Whenever you find yourself on the side of the majority, it’s time to pause and reflect.” As readers of Profit Confidential know, it was this kind of mentality that lead me to: 1) turn bullish on gold in 2001; 2) turn negative on housing in 2006; 3) turn bearish on stocks in late 2007; and 4) turn bullish on small-cap stocks in 2009 (when the talking heads on the TV were saying “we are heading lower—sell, sell, and sell”).

Fast-forwarding to today, when I look at the key stock indices, I see something similar happening, but the chants I hear now are “buy, buy, and buy even more.” It seems the majority consensus is bullish. They believe the key stock indices will continue to march higher. Even the worst-case scenarios look overly optimistic. Outright euphoria? Maybe not, but we are getting there.

From January to August of this year, the key stock indices have significantly increased in value. The S&P 500 has increased a little more than 14% in the first eight months of this year, and the performances of other key stock indices have been in a similar range. But historically, since 1970, the S&P 500 has risen only about 8.2% per year on average. (Source: “Past Data,” StockCharts.com, last accessed September 10, 2013.)

Some argue that the rise we have seen in key stock indices so far this year, we have seen in the past. However, those times were truly different. For example, in 1997, the S&P 500 increased 31.6% because our economy was booming that year. U.S. gross domestic product (GDP) increased almost 4.5% in 1997. (Source: Federal Reserve Bank of St. Louis web site, last accessed September 10, 2013.) Today, we have no real economic growth.

According to the Bureau of Economic Analysis (BEA), U.S. GDP is growing at an annual rate of 2.5% this year.

I’ve heard some say that the key stock indices are forward-looking and investors are pricing in next year’s economic growth. Saying the very least, since the end of the financial crisis, we have seen our central bank be very accommodative. Now, the Fed is talking about ending those policies. And interest rates are aggressively rising. The yield on the 10-year U.S. Treasury is up 71% from a year ago. The interest rate on the popular 30-year fixed mortgage is approaching five percent.

And when looking at corporate earnings of companies in the key stock indices (the most important reason for stock prices to rise or fall), they give me another reason to be skeptical.

To offset declining earnings, companies are resorting to buying back their stock to boost per-share earnings. It’s outright “financial engineering” to increase corporate earnings.

The share buybacks are massive. We are not talking millions, but multi-billion-dollar share buybacks at a time. Take Halliburton Company HAL, for example; on July 25 of this year, it said it would buy $3.3 billion worth of its own shares at a price between $42.50 and $48.50. (Source: Halliburton Company, July 25, 2013.) I equate that to 12.6% of its outstanding shares—which translates to about the same increase in its per-share earnings. (Source: Yahoo! Finance, last accessed September 10, 2013.)

Aside from reducing the number of shares they have outstanding, companies in the key stock indices are resorting to cost-cutting to show better corporate earnings.

There’s a new trend emerging among public companies. To reduce the healthcare costs of retirees, companies in key stock indices are moving them to “health insurance exchanges,” where they have to create their own plans. This way, companies save on administrative costs. Famous names in the key stock indices that are taking this step include Time Warner Inc. TWX, International Business Machines Corporation IBM, Sears Holdings Corporation SHLD, and Darden Restaurants, Inc. DRI. (Source: Wall Street Journal, September 8, 2013.)

For the key stock indices to go higher, companies need to be increasing revenues and earnings the old-fashioned way—not by financially engineering the growth. “Tricks” to boost earnings can only go on for so long.

A stock market rally is justified when you hear that companies in the key stock indices are experiencing rising sales and earnings, when they are spending the cash they are hoarding to invest in their business expansion. None of that is happening right now.

With the back-drop of the Fed’s pulling back on paper money printing, interest rates rising, economic growth weakening, and global demand softening, the risks in the stock market are high. Investors should be cautious.

What He Said:

“Over-built, over-speculated, over-financed and over-done. This is the Florida real estate market right now. For those looking to buy for personal use or investment, hold off! The best deals are yet to come. I continue with my prediction that the hard landing in the U.S. housing market, which is now affecting lenders, will have significant negative effects on the U.S. economy.” Michael Lombardi in Profit Confidential, April 3, 2007. Michael started talking about and predicting the financial catastrophe we started experiencing in 2008 long before anyone else.