How High Can the Stock Markets Go?

By: Paul_Petillo

Not so long ago a triple point gain, like the one that occurred last Wednesday or a similarly sized loss, a healthy correction that hasn't happened in far too long was serious news indeed. The math suggests why. A 100 gain/loss when the Dow was at 8000 represented a 1.25% move whereas a similar gain in the 13,000 point range coughs up half as much of a move but twice the chatter. 

With the Dow setting new daily records and the S&P 500 now in the same territory, one wonders what kind of news will move traders do change course. What economic tidbit will convince them to pile in with ever greater abandon or take their money and head for the exits? 

It seems as though nowadays, market-moving news is almost a non-event.

Yet, there are some interesting contrasts at work in today's marketplace. 

Liquidity is very much at play in the stock market. And not the kind of liquidity that allows all investors to jump in with the same advantage as the institutional big boys and girls.

No, this liquidity has an entirely different ring to it. Long time readers of this column will already know how I feel about stock buybacks, the single most disruptive force at play in the markets today.

For those who have not been following this trend and the S.E.C. seems to be among those who either are unaware or who have chosen to look the other way, buybacks work like this. Companies give guidance to analysts. Analysts determine a target price for the stock depending on where the equity is at the moment and where it might go in the future.

Investors, mostly the institutional types take the info and buy or sell the stock accordingly. But should those companies miss that number for one reason or another, the analysts gets skewered, the stock drops and the company is left explaining what went wrong.

But suppose the company has some cash in the coffers (we'll assume the reason may be just as simple as having a good year profit-wise). Suppose that company, understanding the simple math of price/earnings ratios – an equation that take the stock price and multiplies it by the total number of shares available at any one time to purchase, decides to use the cash to buy back some of those shares.

The stock doesn't go away but it is no longer available to the investor for purchase. In other words, the liquidity of the stock has just been diminished. 

There are numerous scenarios a company can pursue with those missing shares but the move has a net result: an increase in the share price the next time the P/E calculation is done.

This leaves two investors on the short end of the equation: the investor who may be eyeing the company as a potential investment and the investors who are already in it. The potential shareholders are looking at a stock whose price is now artificially inflated. The shareholder, who is the technical owner of the company, will not receive the portion of the profits they rightly deserve.

The second half of the liquidity problem comes from overseas. The foreign investor, flush with cash from trade deficits, oil prices, and outsized growth has few places in which to invest. Pouring money into a market that rises on whatever news, good or bad, weak or poor is simply a problem of choice. 

Henry Paulson, the US Treasury Secretary, who has been attempting to loosen the regulations at play in the US markets, should take note. There are few places to go other than Wall Street with huge amounts of cash.

For now. If and when bond yields head towards 5% and that possibility looks very real, this whole scenario might unravel. As the Fed waffles on its economic stance – housing is bad one day and not so bad on another; inflation is contained but not as much as the bankers would like; the economy is weak but may not be for long or may be weaker than anticipated, the markets rise. They may start out weak but have rarely ended so.

With so many cheerleaders, so many companies involved in these types of legal stock price manipulations, and so little reliable news, the market will go higher. Tomorrow and the next day.

Until…

By Paul Petillo
Managing Editor
http://bluecollardollar.com

Paul Petillo is the Managing Editor of the http://bluecollardollar.com and the author of several books on personal finance including "Building Wealth in a Paycheck-to-Paycheck World" (McGraw-Hill 2004) and "Investing for the Utterly Confused (McGraw-Hill 2007). He can be reached for comment via: editor@bluecollardollar.com

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