Bank Reserves Will Tip Start of Market’s Fall
Forced to choose between bad news from Brazil, which stopped interest payments on its debt, and good news from Paris, where the finance ministers of the major industrial nations came up with an agreement to stabilize the dollar, the stock market declined Monday. Has Brazil written the ending to the incredible bull market?
Probably not. The market is likely to recover from Monday’s fall because the currency agreement will encourage even more foreign investment in U.S. common stocks, and foreign money has been one of the driving forces behind the market’s strength.
In fact, though it sounds overly simple, the real reason stock prices have risen so high this year is that more money is buying common stocks. That is, money that used to be invested elsewhere, in bonds perhaps, or bank certificates of deposit, or even in other countries, has flooded into the stock market.
Plenty of Foreign Funds
Foreign money is coming in at a furious rate--between $25 billion and $30 billion last year, up from roughly $5 billion in 1985 and $3 billion the year before that.
This year? So far, it’s running at a $40-billion annual rate, and the weekend agreement in Paris--by lessening the risk of a declining dollar--should encourage even more.
But the stock market lives on more than foreign money. Domestic savings are the real power behind the market. Americans are pouring money into mutual funds, seeking the returns the stock market promises, because returns elsewhere are low.
At 5.5% or less on money-market funds or bank certificates of deposit, the rate of return after inflation is now less than 4.5%. And that’s based on last year’s inflation, which is likely to be lower than this year’s. So the mutual funds are taking in money at an unprecedented rate--almost $16 billion a month in 1986, and even more than that in January of 1987.
Some Mortgage Homes
Admittedly, the action is getting frantic. Like the poor wretch in the old Western movies who bet the homestead at the poker table, some people are taking a second mortgage on their home to put money in the stock market.
Such people are overlooking the fact that the market historically has promised only a 6% net return--nothing near the 18% gain the Dow Jones industrial average has made since the first of the year. And of course the market is notorious for not keeping its promises.
So how will we know when the bull market really is ending? Once again, follow the money--the money the Federal Reserve leaves sloshing around in the banks, available for lending.
Lately the Fed has been allowing that basic money supply to expand at a 19% annual rate, in an economy where business would do well to expand 2.5%. Obviously there’s an excess of money around, and that excess is what has been fueling the stock market.
When the Federal Reserve turns around and starts taking some of that excess back from the banks--which it would do if it saw renewed inflation--you can bet that the stock market will decline. And you can follow Fed policy, says Charles Clough Jr., director of investment policy for the Cowen & Co. brokerage firm, by keeping track of the category called “non-borrowed reserves” in the Federal Reserve Bulletin.
That’s one of the banking terms broadly indicating how much banks have available to lend. When non-borrowed reserves start seriously declining, it means the Fed is tightening up on money and the stock market could be headed south.
It could be a long way down, because the market is way up there by such traditional measures as the ratio of stock prices to company earnings.
The average company in the Standard & Poor’s 500-stock index, for example, is selling at more than 19 times earnings per share--which means investors are paying a hefty premium for anticipated growth in company profits.
But the growth may not be there. Business really isn’t strong anywhere, but prices of some basic commodities, such as paper and chemicals, have been rising, and this has made basic U.S. industries look more solidly profitable than they really are.
Ominously, those rising prices mean inflation may get a little higher this year, and so might interest rates--which will go up when the Fed feels the need to rein in money supply. And that could really stall the stock market.
A Fool’s Errand
When will it happen? Don’t even try to guess; predicting the market’s timing is a fool’s errand. But watch the money supply and keep your savings handy either for higher interest rates or to buy bargains when the market does decline.
And meanwhile, don’t worry overmuch about the U.S. economy or the world’s.
As in Paris this weekend, the hopeful thing is in the collaboration among nations, not the arguments; in the Brazilian debt negotiations, not the disruption; in the doughnut, not the hole.
