If the market is never wrong, according to the old Wall Street maxim, then why does the stock market keep rallying despite worries about North Korea, U.S. policy uncertainty, Federal Reserve tightening and concerns over runaway valuations?
Simple. It is because public pension funds keep flooding the credit markets with cash at a record pace, and companies keep using that money to buy back their stock, says Brian Reynolds, asset class strategist at Canaccord Genuity.
Reynolds said he believes the credit boom could continue for at least three years, and maybe even five. That would make the current bull market the longest in history by a wide margin. A bull market is defined by many as a rise of 20% or more off a bear-market low, without a 20% decline.
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See also: Here’s the ‘best reason to be bearish’ in the final quarter of 2017.
Unlike so-called smart investors, who worry about fundamental influences including the economy, politics and even natural disasters, the nation’s public pensions trustees only care about one thing:
“Their sole focus is on making 7.5% through the credit market,” Reynolds wrote in a recent note to clients. “They are going to focus on that whether the economy speeds up or slows down, whether there is tax reform or not and whether the Fed raises rates more or has to bring them back down.”
As Reynolds explains, 7.5% is generally what pension trustees have to earn on assets to cover the gap between what pensions have promised to pay out and what they actually have.
The general perception among pension trustees is that equities are too risky, and safe 10-year Treasury notes are currently yielding just 2.31%. And since their biggest worry is to not be too careful, pension funds have been gobbling up higher-yield corporate debt and credit instruments.
Through August, high-yield bond issuance reached $1.21 trillion, already just shy of the full-year record of $1.23 trillion in 2016, according to data provided by Fitch Ratings. Institutional leveraged loan issuance hit $1.07 trillion through August, already breaking the 2016 record of $973.1 billion.
Assuming the pace of flows remains the same, the puts high-yield issuance on track to exceed $1.8 trillion and leveraged loan issuance to top $1.6 trillion.
Companies have used that cash to be the primary buyers during the current bull market, while what Reynolds described as the “main investors” have been net sellers. “Main investors” include mutual funds, insurers, hedge funds, households, foreign buyers, broker dealers, pension funds and exchange-traded funds. Read how the ‘great central bank unwind’ could ignite the next financial crisis.
Since the S&P 500 index
hit its bear-market bottom in March 2009, it has soared nearly fourfold, even though “main investors” have sold a total of $9.89 billion worth of stock, Reynolds said, using Bloomberg data. That’s because the cumulative total of corporate stock repurchases has been about $3.2 trillion, he said.
And since the credit market has grown by $3.3 trillion since the credit crisis, Reynolds sees it as nearly a one-to-one correlation between the credit boom, share buybacks and the bull market.
Investors should get a clearer view of corporate stock buyback plans as the third-quarter earnings-reporting season gets under way in mid-October.
One thing that might stop these trustees from investing in aggressive credit funds is having leverage undercut by an inverted yield curve, or when 10-year Treasury yields fall below 2-year yields.
Yields on 10-year Treasurys were 86 basis points (0.86 percentage points) above 2-year yields through Thursday, compared with a 100-basis-point spread six months ago, according to Treasury Department data. See the U.S. Department of Treasury’s yield curve chart.
Even if that flattening continued, Reynolds said he believes it would take at least a year for the curve to invert. And the two previous times since 1991 that pension trustees were forced to sell credit to meet margin calls were in 2000 and 2007, or roughly two years after the yield curve inverted, Reynolds said.
“We believe the yield curve inversion scenario will eventually repeat itself,” Reynolds said. “Absent that, we think it is more likely that the credit boom will intensify in the coming years, rather than come to a premature end.”
In other words, the bull market in stocks couldn’t just continue, but accelerate higher, even if investors believe the market is wrong.