THE STOCK MARKET SOAP BUBBLE

derivatives-bubble

CDOs (collateralized debt obligations) were financial derivatives which caused 2008 banking crisis. CDOs were only a small fraction of a global financial derivative  bubble.This graph shows that before 2008 crisis, derivative bubble reached almost $700 trillion (for comparison world GDP in 2008 was $63 trillion).

Monetary easing (QE) is forced monetary policy that followed as a consequence of the global banking crisis in 2008. QE successfully flooded with cash banks, increased their liquidity, covered their losses ( removed toxic derivatives from bank’s balance sheets ) and caused historically low-interest rates. The positive effect of this is relieved refinancing and interest payments for Governments, citizens and the private sector.

However, QE has not stimulated the desired aggregate demand and inflation. Central banks have long been in a liquidity trap, not because they can’t influence the interest rates, but because they have a limited impact on aggregate demand, due to stagnating real wages and credit bubble. We could say that the central banks by printing money have saved the banking sector, in order to avoid a financial collapse that could have taken, like a stone around the neck, the whole economy into the abyss. However, the truth is that the taxpayers rescued banks. In fact, central banks took the shortcut, they might as well done it in a straightforward way- initially to fill the state budgets with that printed money, and then banks could have been saved from the state budgets, so that it would be absolutely clear that banks are saved with the taxpayer’s money. Each additional creation of money puts downward pressure on the value of existing money in circulation. The fact that this has not triggered hyperinflation or inflationary taxation caused by rising consumer price index (CPI), does not mean that the delivered bill sooner or later will not be paid (there is no free lunch). Savers and pension funds first paid the bill. The next who might pay the bill are the owners  of shares (among them pension funds and savers again) listed on the stock exchange. Forced monetary policy has created a side-effect – abundance of cheap money that can easily be used to create bubbles in financial and real estate markets. Undeployed money can’t lie for long  in the banks and the only question is where and how it will be directed and which category will be inflated. Without the support of a regulatory policy which will minimize risks and adequate fiscal policies that will take advantage of the positive effects, such isolated monetary policy will only postpone the inevitable.

In individual countries, there is a cry for investments in infrastructure, because of the long period of neglect. That can stimulate aggregate demand, but the question is who will finance these investments? Of course, the state can always borrow the money, especially when it is at such low interest rates as it is nowadays. But we should take into consideration: a) at some point interest rates will start rising, and refinancing of accumulated debt will mean new debt with higher interest rates, b) some states are already over-indebted, c) there are also effective additional sources of financing– progressive tax on corporate incomes, progressive individual income tax (tax on capital gains included) on those who benefited the most in past period  (effective rates should be raised) and d) the best result would be if these investments start globally,  because of spillovers through trade.

Economic models and abstractions when assuming the rational behavior of actors in economic relations, facilitate access to consistent and logical conclusions. Rational behavior is a relative term. If there is weak aggregate demand, significant productive investments in real economy are becoming unrealistic for private sector, generated profits and abundant  cheap money somewhere eventually will be deployed and directed, and that place can easily become a stock exchange casino  that always offers the illusive hope that the stock indices do not know the law of gravity. In such institutional and macroeconomic environment, an orientation of the shareholders and managers for immediate enrichment obtains characteristic of rational behavior. From the standpoint of long-term prospects of companies, a significant buybacks and dividend payments, reduce capacity for capital investment, research and development (R & D), training and development of employees and improvement of product quality. (I)Rational economic behavior depends on the assumptions that are involved in or excluded off the model. Abstract-rational in the short term becomes irrational in the broader long-term perspective. The macroeconomic view should not ignore the structure and behavior of the constituent elements of the economy because their dynamics are affecting general dynamics.

Cash in S&P 500 companies

Cash deployment S&P 500

Charts show that the largest US corporations that are tracked by the stock exchange index S & P 500 (excluding banks), accelerated borrowing in order to pay buybacks and dividends. In their balance sheets, for example in 2 quarter of 2016, there is free cash in the amount of     $ 1.45 trillion, which is used about 60% for buybacks and payment of dividends and only about 40% for capital investments. Currently, the PE (price / earnings) ratio of S & P 500 companies, is about $ 25, and in 1999 just before the Tech bubble that ratio has reached      $ 34. This ratio indicates what share price an investor is willing to pay for a dollar of earnings (profit after tax). This ratio inverted shows a potential profitability- when the whole profit of the company is paid to shareholders. Currently, this inverse relationship is  1/25 or 4% that tells us that stock prices are overvalued (especially taking into account the risk of the stock exchange). Therefore, based on PE ratio, we can conclude how costly stocks are  on the stock market and whether there is a stock bubble. Some stocks in the US stock market have incredibly high PE ratio: Amazon.com Inc. (AMZN) $ 169.30, Netflix (NFLX) $ 310.22, Salesforce.com (CRM), inc. $ 230.22, Boston Scientific Corporation (BSX) $ 405.66. At the beginning of 2008, S&P 500 price to book value indicator was 2.77 and in the second quarter this year it is 2.84.

S & P 500 index grows faster about 3 times compared to sales growth of companies that are components of the index and nominal GDP growth in the United States, from 2010 to 2015. During this same period, the S & P 500 index has harmonized rate of growth only  with the growth of EPS (earnings per share) due to buybacks.

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