If there’s one thing we’ve learned about the financial markets over the last year, it’s that things have changed quite a bit. Last year at about this time, some hedge fund managers were practically chomping at the bit for the momentum rally to finally end. Several managers told investors in their quarterly letters that the markets were doing the opposite of what they “should” have been doing.
So what’s behind the dramatic changes? One analyst has offered up a very interesting view. He suggests pension funds may be to blame for the extremes we’ve witnessed in recent years.
Bill to limit stock repurchases introduced
In a recent note, Canaccord Analyst Brian Reynolds weighed in on a bill to limit share repurchases introduced in the U.S. Senate this month. The legislation would limit share repurchases, and he said some investors were concerned because debt-fueled buybacks have been a major catalyst for the bull market over the last 10 years.
Reynolds thinks the share buyback bill probably won't be enacted for at least a few years, but if it ever is, he believes it would "contribute to a record strong of LBOs that would propel stocks higher until the next financial crisis." However, that isn't his biggest concern with the legislation. Instead, he criticized lawmakers for addressing only the symptoms rather than the actual problem that's driving runaway market valuations.
It's looking more and more that the fourth quarter of 2018 was nothing more than a tiny blip on the market's overall radar. While stocks did technically dip into bear market territory by the end of the year, it was off to the races again in January—almost as if the December bear market never even happened.
The problem Reynolds believes should be addressed is the "essentially unregulated" pension funds, which have driven "repeated financial boom and bust cycles since the early 1990s."
Here's why he thinks pension funds are to blame
"The problem is that our nation's public pensions have become the dominant global investor, are grossly underfunded and thus have to reach for risk, and are essentially unregulated because of states' belief that they are sovereign," he argued. "Thus, they reach for yield and have generated repeated financial boom and bust cycles since the early 1990s."
He said because of how underfunded public pensions are, their demand for risk will continue unabated. They're going to keep stretching to try to catch up on the payments they're liable for. As a result, he predicts that pensions' demand for risk could end up morph[ing] into some form of shadow banking designed to produce the results that the pensions require."
Reynolds believes buybacks are merely a symptom of pensions' need for returns. As a result, even if lawmakers do end up limiting buybacks at some point, it wouldn't do anything to treat pension funds' need for outsized returns.
"Our pensions would likely still have the same demand for credit," he said. "If those flows were prohibited from generating buybacks, they would likely fund another outlet, which we think would be a record strong of LBOs."
Canaccord noted recently that pension allocations to credit continue to reach record highs.
A warning for what lies ahead
Reynolds expects the Treasury and Government Agency yield curves to invert within the next one to three years. When that happens, like other "modern credit cycles," the money banks have been pouring into the "carry" trade becomes unprofitable, so it will then be shifted toward financing a wave of leveraged buyouts which could last as long as two years. The result would be "a surge in stock prices before a run on the shadow banking system prompts another financial disaster," he warned.
Even before the buyback bill was introduced, he had already been predicting a record-setting wave of LBOs. If Congress ends up enacting the restriction on buybacks within the next three years, it would match up with his expected inversion timing, and if buybacks are restrained when the inversion occurs, he warned the number of LBOs could exceed even the large number he had already expected.
When Reynolds warned about the LBO book in July 2018, he was concerned that there wouldn't be enough surviving companies left to fill out the Russell 3000.
"An LBO boom coupled with a restriction on buybacks would likely mean even fewer surviving companies, higher stock prices at the end of this cycle, and an even worse financial disaster following the peak due to the added leverage," he warned. "Unless politicians and regulators can change the behavior of public pensions (which we think is unlikely until after the next financial crisis), we think another boom and bust lie ahead."
This article first appeared on ValueWalk Premium