by David Robertson, CFA
August 2016
In the early 1980s the scientist and college professor, Carl Sagan, became famous for hosting a television series called, Cosmos, A Personal Voyage. Throughout the series, Sagan explored topics related to astronomy and the universe and popularized science to such a degree that according to Wikipedia, "As of 2009, it [Cosmos] was still the most widely watched PBS series in the world". His hallmark expression of "billions and billions" helped acclimate his audience to a universe of really big numbers and became an iconic bit of American culture.
Investors may be experiencing the same sense of awe and wonderment with recent market behavior as Sagan's viewers did with the complexity and vastness of the universe. Despite high valuations, eroding fundamentals, and risks around almost every corner, with the exception of an occasional bout of volatility, the market just keeps hanging in there. While the observed effects may seem otherworldly, the primary cause is all too earthbound and human: Central banks are buying billions and billions of dollars' worth of stocks.
While most investors probably understand that the value of an investment is directly related to its underlying cash flows, it's price can be driven by other forces. Ebbs and flows among different investor groups often affect the demand for that investment and when they do, prices can deviate substantially from intrinsic value.
When such deviations occur, they can present a challenge to investors who follow the markets, but who may not have the resources to dive deep down into the financials and discount the cash flows. As a proxy, many look to market behavior for signals as to the worthiness of various investments. The process of watching and inferring can work when the composition of market participants and activity is balanced because fairly accurate price signals are sent. But when market behavior becomes correlated, imbalances arise, and signals get mixed up. In these situations, prices may not only convey little information, they may convey completely misleading information.
Normally this happens in fairly isolated instances, but occasionally incentives and behaviors coalesce into bigger movements that can materially impact markets. We've noted [here] and [here] that one of the investor groups that is large enough that it can upset the balance of the markets and affect prices is that of companies themselves - through share repurchases.
The latest data by Factset [here] reveals that "Dollar-value share repurchases amounted to $166.3 billion in the first quarter (Feb-April), which represented a 15.1% increase year-over-year and a 15.6% gain from Q4. This marked a new post-recession high for quarterly buybacks in the S&P 500." We have also noted that historically, companies have been terrible at timing their repurchases - which is highlighted by another statistic from Factset: "Since 2005, only Q3 2007 produced a larger amount of buybacks ($178.5 billion)." Companies made their largest allocation to repurchases exactly as the market peaked just before the financial crisis.
Over the last few years, central banks have also emerged as an investor group that is sizable enough to affect prices and that is largely insensitive to prices. This development is under appreciated because it slips under the radar for a couple of reasons. Namely, it is easy to assume that since the Federal Reserve is not allowed to buy stocks that any other purchases of stocks by central banks would be either immaterial in size or so far removed from US markets as to be irrelevant. Both assumptions are wrong.
The issue of direct central bank stock purchases first started creeping into the news a few years ago. Bloomberg posted a story [here] in 2013 that identified the emerging trend: "Central banks, guardians of the world’s $11 trillion in foreign-exchange reserves, are buying stocks in record amounts." The story also suggested that these purchases were not one-off or idiosyncratic in nature: "In a survey of 60 central bankers this month by Central Banking Publications and Royal Bank of Scotland Group Plc, 23 percent said they own shares or plan to buy them." A zerohedge story [here] updates the situation by revealing "a surge in net global central bank asset purchases to their highest since 2013."
Paul Craig Roberts revealed a sense of the breadth and interconnected nature of such activity in a blog post last August [here]. He noted, "It turns out that the Swiss central bank, in addition to its Apple stock, holds very large equity positions, ranging from $250,000,000 to $637,000,000, in numerous US corporations — Exxon Mobil, Microsoft, Google, Johnson & Johnson, General Electric, Procter & Gamble, Verizon, AT&T, Pfizer, Chevron, Merck, Facebook, Pepsico, Coca Cola, Disney, Valeant, IBM, Gilead, Amazon."
Jim Grant addressed this very subject in a presentation to the CFA Society of Washington, D.C. He asked, "Did you know that the Swiss National Bank files its own 13-F form, that it owns shares in 2,600 American companies, that its portfolio was worth $54.5 billion at last report and that it contained, among other items, 14.5 million shares of Apple, 11.6 million of Exxon-Mobil and 4.5 million of Wal-Mart?" (For a glance at the SNB's 13-F holdings list see [here]).
While Switzerland stands out for global reach, Japan, which faces tremendous deflationary pressures, has been the leader of the pack in terms of the scale of stock purchases. As noted by zerohedge [here], "in April the BOJ was revealed to already be a top 10 holder in about 90% of all Japanese stocks." In addition, "the BOJ is already an owner of more than half of all Japanese ETFs." That's right; the BOJ is already an owner of more than half of all Japanese ETFs. As Michael Schemacher of Wells Fargo Securities reported to the Financial Times [here], "The Bank of Japan is buying everything not nailed down, and the ECB is also acting very aggressively."
Noting that the impact of this activity on "equity fund flows is non-trivial," is an understatement. Further, it's not done yet. According to the story, "Over the next year, BoJ is scheduled to purchase ¥6t ($58b) in ETFs, and $116b over the next two years. By June of 2018, BoJ is likely to hold ¥20.5t ($200b) in ETFs."
By means of comparison to the US market, which is five times bigger than that of Japan's, the new stimulus "can be viewed as equivalent of the Fed purchasing $580b in ETFs over the next two years, and the Fed holding $1t in ETFs." These are clearly huge numbers.
Even this doesn't capture the full scale of central bank buying. According to a New American story [here], "By far the largest overall central bank-controlled investor is the Communist Chinese dictatorship’s 'State Administration of Foreign Exchange (SAFE), which is part of the regime’s central bank known as the 'People’s Bank of China' ... SAFE has almost $4 trillion under management, including massive stakes in publicly traded European companies."
The implications of central bank purchases of stocks, then, are profound. What has already been done blows away any assumptions that the amounts may be immaterial or that the activity won't impact US markets. The implications go even further though. The whole idea that markets are fairly efficient and therefore fairly good at arriving at reasonable prices seems to be going right out the window.
Paul Craig Roberts asks a fundamental question: "If central banks purchase stocks in order to support equity prices, what is the point of having a stock market? The central bank’s ability to create money to support stock prices negates the price discovery function of the stock market."
Jim Grant continues the line of thinking: "The SNB creates money from the thin air—in its case, Alpine air. In this it is no different from the Fed. The Swiss create francs with which to buy euros in order to beat back unwanted strength in the franc. With those euros, it buys dollars, and with those dollars it buys American stocks. Which is to say it buys equity interests in real companies with money it whistles into being. I will call that something for nothing."
The conclusion, according to Ed Yardeni [here] is that, "The major central banks are no longer just the Banks of Last Resort. They are turning into Investors of First Resort. In the long run, it’s hard to imagine that having the central monetary planners buy corporate bonds and stocks with the money they print can end well. In effect, the central banks are turning into the world’s biggest hedge funds."
One can reasonably ask, “If central banks are playing the role of ‘greater fool’ by buying my stocks at attractive prices whenever I want to sell them, why should I be in any hurry to sell them?” It's a valid question and many investors are pursuing exactly that course of action. As Ben Hunt observes [here], "In 2016, the $10 trillion asset class of negative rate sovereign bonds is entirely based on the Common Knowledge that there is no limit to the greater foolishness of Central Banks." John Hussman makes similar comments [here], "The urging of central banks, which has become nearly a form of propaganda, is that there will always be a lower rate, a higher price, and a greater fool."
Hunt describes such an investment approach using an analogy with poker and the strategy of "playing the player". To be fair, there is a body of knowledge around game theory that can guide one in analyzing strategic options of various players and improve one's chances at "winning" that game. With nearly every country in the world having a central bank, though, there are an awful lot of "players" to keep track of. Further, it is extremely difficult to discern to what degree they might act in concert and under what conditions they may not, and whether they continue stock purchases or perhaps even start selling. In other words, it is largely a crapshoot.
This is the point where many long term investors should take a step back, take a deep breath, and re-evaluate exactly what they are trying to accomplish. If the thinking is something like, hey, I wanted to put some money aside to take advantage of the better long term returns that generally accrue to stocks, and this sounds more like gambling now, you would have an excellent point and should seriously consider reducing your exposure. If you're a good poker player with a deep knowledge of central banks and don't mind wagering your retirement money, then there may be some opportunity for you. Either way, though, this is not investing as usual. Central banks have changed the game.
Being exposed to new things that are so different from anything you know or have seen before can be exhilarating and mind-expanding. Carl Sagan brought exactly this type of experience to countless viewers of Cosmos. Central banks are bringing an entirely different type of experience to investors, however. By taking such an active role, they are undermining the capital markets that have served investors so well. Under these conditions investors should be forewarned against inferring much of anything regarding the economy or underlying cash flow streams: Billions and billions of dollars’ worth of stock purchases by central banks have severely distorted those signals.
August 2016
In the early 1980s the scientist and college professor, Carl Sagan, became famous for hosting a television series called, Cosmos, A Personal Voyage. Throughout the series, Sagan explored topics related to astronomy and the universe and popularized science to such a degree that according to Wikipedia, "As of 2009, it [Cosmos] was still the most widely watched PBS series in the world". His hallmark expression of "billions and billions" helped acclimate his audience to a universe of really big numbers and became an iconic bit of American culture.
Investors may be experiencing the same sense of awe and wonderment with recent market behavior as Sagan's viewers did with the complexity and vastness of the universe. Despite high valuations, eroding fundamentals, and risks around almost every corner, with the exception of an occasional bout of volatility, the market just keeps hanging in there. While the observed effects may seem otherworldly, the primary cause is all too earthbound and human: Central banks are buying billions and billions of dollars' worth of stocks.
While most investors probably understand that the value of an investment is directly related to its underlying cash flows, it's price can be driven by other forces. Ebbs and flows among different investor groups often affect the demand for that investment and when they do, prices can deviate substantially from intrinsic value.
When such deviations occur, they can present a challenge to investors who follow the markets, but who may not have the resources to dive deep down into the financials and discount the cash flows. As a proxy, many look to market behavior for signals as to the worthiness of various investments. The process of watching and inferring can work when the composition of market participants and activity is balanced because fairly accurate price signals are sent. But when market behavior becomes correlated, imbalances arise, and signals get mixed up. In these situations, prices may not only convey little information, they may convey completely misleading information.
Normally this happens in fairly isolated instances, but occasionally incentives and behaviors coalesce into bigger movements that can materially impact markets. We've noted [here] and [here] that one of the investor groups that is large enough that it can upset the balance of the markets and affect prices is that of companies themselves - through share repurchases.
The latest data by Factset [here] reveals that "Dollar-value share repurchases amounted to $166.3 billion in the first quarter (Feb-April), which represented a 15.1% increase year-over-year and a 15.6% gain from Q4. This marked a new post-recession high for quarterly buybacks in the S&P 500." We have also noted that historically, companies have been terrible at timing their repurchases - which is highlighted by another statistic from Factset: "Since 2005, only Q3 2007 produced a larger amount of buybacks ($178.5 billion)." Companies made their largest allocation to repurchases exactly as the market peaked just before the financial crisis.
Over the last few years, central banks have also emerged as an investor group that is sizable enough to affect prices and that is largely insensitive to prices. This development is under appreciated because it slips under the radar for a couple of reasons. Namely, it is easy to assume that since the Federal Reserve is not allowed to buy stocks that any other purchases of stocks by central banks would be either immaterial in size or so far removed from US markets as to be irrelevant. Both assumptions are wrong.
The issue of direct central bank stock purchases first started creeping into the news a few years ago. Bloomberg posted a story [here] in 2013 that identified the emerging trend: "Central banks, guardians of the world’s $11 trillion in foreign-exchange reserves, are buying stocks in record amounts." The story also suggested that these purchases were not one-off or idiosyncratic in nature: "In a survey of 60 central bankers this month by Central Banking Publications and Royal Bank of Scotland Group Plc, 23 percent said they own shares or plan to buy them." A zerohedge story [here] updates the situation by revealing "a surge in net global central bank asset purchases to their highest since 2013."
Paul Craig Roberts revealed a sense of the breadth and interconnected nature of such activity in a blog post last August [here]. He noted, "It turns out that the Swiss central bank, in addition to its Apple stock, holds very large equity positions, ranging from $250,000,000 to $637,000,000, in numerous US corporations — Exxon Mobil, Microsoft, Google, Johnson & Johnson, General Electric, Procter & Gamble, Verizon, AT&T, Pfizer, Chevron, Merck, Facebook, Pepsico, Coca Cola, Disney, Valeant, IBM, Gilead, Amazon."
Jim Grant addressed this very subject in a presentation to the CFA Society of Washington, D.C. He asked, "Did you know that the Swiss National Bank files its own 13-F form, that it owns shares in 2,600 American companies, that its portfolio was worth $54.5 billion at last report and that it contained, among other items, 14.5 million shares of Apple, 11.6 million of Exxon-Mobil and 4.5 million of Wal-Mart?" (For a glance at the SNB's 13-F holdings list see [here]).
While Switzerland stands out for global reach, Japan, which faces tremendous deflationary pressures, has been the leader of the pack in terms of the scale of stock purchases. As noted by zerohedge [here], "in April the BOJ was revealed to already be a top 10 holder in about 90% of all Japanese stocks." In addition, "the BOJ is already an owner of more than half of all Japanese ETFs." That's right; the BOJ is already an owner of more than half of all Japanese ETFs. As Michael Schemacher of Wells Fargo Securities reported to the Financial Times [here], "The Bank of Japan is buying everything not nailed down, and the ECB is also acting very aggressively."
Noting that the impact of this activity on "equity fund flows is non-trivial," is an understatement. Further, it's not done yet. According to the story, "Over the next year, BoJ is scheduled to purchase ¥6t ($58b) in ETFs, and $116b over the next two years. By June of 2018, BoJ is likely to hold ¥20.5t ($200b) in ETFs."
By means of comparison to the US market, which is five times bigger than that of Japan's, the new stimulus "can be viewed as equivalent of the Fed purchasing $580b in ETFs over the next two years, and the Fed holding $1t in ETFs." These are clearly huge numbers.
Even this doesn't capture the full scale of central bank buying. According to a New American story [here], "By far the largest overall central bank-controlled investor is the Communist Chinese dictatorship’s 'State Administration of Foreign Exchange (SAFE), which is part of the regime’s central bank known as the 'People’s Bank of China' ... SAFE has almost $4 trillion under management, including massive stakes in publicly traded European companies."
The implications of central bank purchases of stocks, then, are profound. What has already been done blows away any assumptions that the amounts may be immaterial or that the activity won't impact US markets. The implications go even further though. The whole idea that markets are fairly efficient and therefore fairly good at arriving at reasonable prices seems to be going right out the window.
Paul Craig Roberts asks a fundamental question: "If central banks purchase stocks in order to support equity prices, what is the point of having a stock market? The central bank’s ability to create money to support stock prices negates the price discovery function of the stock market."
Jim Grant continues the line of thinking: "The SNB creates money from the thin air—in its case, Alpine air. In this it is no different from the Fed. The Swiss create francs with which to buy euros in order to beat back unwanted strength in the franc. With those euros, it buys dollars, and with those dollars it buys American stocks. Which is to say it buys equity interests in real companies with money it whistles into being. I will call that something for nothing."
The conclusion, according to Ed Yardeni [here] is that, "The major central banks are no longer just the Banks of Last Resort. They are turning into Investors of First Resort. In the long run, it’s hard to imagine that having the central monetary planners buy corporate bonds and stocks with the money they print can end well. In effect, the central banks are turning into the world’s biggest hedge funds."
One can reasonably ask, “If central banks are playing the role of ‘greater fool’ by buying my stocks at attractive prices whenever I want to sell them, why should I be in any hurry to sell them?” It's a valid question and many investors are pursuing exactly that course of action. As Ben Hunt observes [here], "In 2016, the $10 trillion asset class of negative rate sovereign bonds is entirely based on the Common Knowledge that there is no limit to the greater foolishness of Central Banks." John Hussman makes similar comments [here], "The urging of central banks, which has become nearly a form of propaganda, is that there will always be a lower rate, a higher price, and a greater fool."
Hunt describes such an investment approach using an analogy with poker and the strategy of "playing the player". To be fair, there is a body of knowledge around game theory that can guide one in analyzing strategic options of various players and improve one's chances at "winning" that game. With nearly every country in the world having a central bank, though, there are an awful lot of "players" to keep track of. Further, it is extremely difficult to discern to what degree they might act in concert and under what conditions they may not, and whether they continue stock purchases or perhaps even start selling. In other words, it is largely a crapshoot.
This is the point where many long term investors should take a step back, take a deep breath, and re-evaluate exactly what they are trying to accomplish. If the thinking is something like, hey, I wanted to put some money aside to take advantage of the better long term returns that generally accrue to stocks, and this sounds more like gambling now, you would have an excellent point and should seriously consider reducing your exposure. If you're a good poker player with a deep knowledge of central banks and don't mind wagering your retirement money, then there may be some opportunity for you. Either way, though, this is not investing as usual. Central banks have changed the game.
Being exposed to new things that are so different from anything you know or have seen before can be exhilarating and mind-expanding. Carl Sagan brought exactly this type of experience to countless viewers of Cosmos. Central banks are bringing an entirely different type of experience to investors, however. By taking such an active role, they are undermining the capital markets that have served investors so well. Under these conditions investors should be forewarned against inferring much of anything regarding the economy or underlying cash flow streams: Billions and billions of dollars’ worth of stock purchases by central banks have severely distorted those signals.
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