The Real Story Behind the Market’s Rise

The global bull market shook off the late February jitters and resumed its charge with renewed vengeance. Once again, it is being led by the speculative frenzy in Shanghai and Shenzhen. Just to show you the enormity of the speculation in stocks traded in Renminbi in the mainland exchanges, the Shenzhen Composite increased threefold over the last 12 months. In comparison, the “hottest” U.S. index, currently the Dow Jones Industrial Average, gained a rather paltry 15% over the same period.

The 15% gain was enough to decisively take the DJIA above the major top of January 2000. In the recent months, the same feat had already been accomplished by the NYSE Composite, while the more racy indices such as the Russell 2000 made new all-time highs back in late 2004. On the other hand, a few major U.S. indices are still either marginally or substantially below their 2000 all-time highs, namely the S&P 500 (3.8%), the NASDAQ Composite (50%), and the NASDAQ 100 (60%).

Whether a given global market or particular index already bettered the historical 2000 highs or has still more to go, the gains following the 2000-2002 collapse have been worldwide and immense. Even more amazing and unusual is that the huge gains in stocks were racked up concurrently by commodities, real estate, and collectibles — essentially hard assets that do best during inflationary periods rather than during periods of low and declining inflation like 2002-2007.

During the previous explosive boom in commodities, which took the CRB Commodities index from 185 in August 1977 to nearly 335 by November 1980, the DJIA gained only 8.5% and the S&P 500 gained a more respectable 43%. Trying to justify or explain


the world’s broadest ever bull market in virtually all tradable assets, both optimists and sceptics agree on one thing — it has been driven by the global liquidity in borderless markets and economies.

The credit, and eventually the blame after this bubble bursts, must go to the major central banks led by the U.S. Fed and the Bank of Japan (BOJ). Facing the prospect of the 2001-2002 recession turning into a depression, they hammered down the risk by setting interest rates close to the zero level. In fact, the BOJ still keeps it benchmark interest rates below 1%, offering institutions no-brain trades of borrowing in Japan and investing in countries with much higher interest rates.

Cheap and easy money probably revived the global economy more vigorously than the central bankers had expected. The result has been strong multi-year growth in earnings and operating margins across a broad range of industries, in contrast to the narrow based boom in the “new economy” industries of the late 1990s.

Growing cash hoards on balance sheets triggered unprecedented growth in private leveraged buyouts (LBO) and corporate acquisitions. Managements of cash rich companies, trying to fend off buyout barbarians, added to the frenzy by massive share repurchases, often enlarged by new borrowings. Reducing the number of outstanding shares has provided an extra kick to per share earnings growth, boosted share prices and P/E ratios, making re-leveraged public companies less enticing for LBOs.

The latest statistics on private LBOs, mergers, and corporate share repurchases suggest that 2007 will probably exceed the record breaking 2.7 trillion worth of LBOs and mergers done in 2006. The resulting shrinkage in public share float, more than anything else, is the reason why the stock market is capable of climbing the proverbial wall of worry. The wall created by the collapsing housing and related sectors, the meager 1.3% growth in GDP, while inflation remains stubbornly above the Fed’s target, and other long ignored factors such as doubling of the U.S. deficit and the war in Iraq.

It would be hard to argue that LBO partnerships, hedge funds, or conventional mutual funds are much worried by developments in the U.S. economy that would normally deflate high stock valuations. As an example, the U.S. Equity Mutual Funds as a whole now hold only 3.7% of their assets in cash, the lowest ever cash reserves held!