Barriers to a bear market recovery

Reading time: 2 – 4 minutes

Stock price indices have been rising rapidly since early March 2009, but are still about 30% down from levels of mid-2008.

It would be nice if this trend were to continue and we could all return to July 2008 and get on with our lives as before.

Unfortunately, analysis of Federal Reserve flow of funds data indicates three formidable barriers to a happy recovery:

Flood barriers on the Thames

1. Executive stock options: Perhaps a trillion dollars in executive stock options are sitting out there, waiting to be exercised once they again become “in the money”.The precise amount is unknown, but judging from the level of net equity sales by the household sector (essentially executive stock options), prior to August 2008, a trillion dollars give or take, seems like a good guess.However, because of persistence of the banking crisis, corporate stock buybacks will not be there to catch the ball. Executive stock options, alone, are enough to brake any recovery in stock prices.
2. TARP repayments: Commercial banks are anxious to escape the trap of TARP money and pay back the US Treasury.However, the total amount needed to do this, including equity needed as a result of the “stress tests”, is in excess of $272.2 billion. As prices rise, banks will be issuing equity into the market in amounts greater than new money flowing in, blocking further increases, and covariance will take care of the rest.
3. Baby boomers’ flight to safety: The huge generational cohort about to enter retirement has been scared witless by the horrible depletion of their life savings since mid-2008. Some may stick with equities and continue to believe in the Common Stock Legend as prices recover.But it seems reasonable that many will switch into bonds and income producing assets, as is more appropriate for one’s “golden years”. This move can hardly be positive for equity prices.

These three barriers to stock price recovery will be there, at least for several years, even if earnings recover and unemployment falls.

There is, of course, the possibility that foreign money (from the trade deficit) now tied up in fixed income securities could switch into equities, perhaps out of fear of inflation.

Equities, to some degree, do offer some protection against inflation — sometimes. And foreign money tied up in US fixed income securities is certainly of an order of magnitude that could really help equity prices if it were to move in that direction.

But there are other alternatives for winding down the trade deficit: real estate, private acquisitions, or export goods.

We’ll see.

Do you think this is a suckers rally?

Photo credit: Flood barrier, flickr by 10b travelling.