Cash Crash Coming

Less than three months ago global markets teetered on the news that the U.K. had voted to exit the European Union. Talking heads fretted that the already struggling European economy would grind to a halt.

But on Monday a survey showed a powerful rebound in the U.K. service sector, surprising investors and economists alike. The Purchasing Managers’ Index (PMI) rose to 52.9 in August, up from 47.4 in July. A reading above 50 indicates an expanding economy. This level of PMI accounts for 80% of the country’s output.

The FTSE, the index representing the U.K. stock market, is now up 9.3% for the year. The British pound is at a seven-week high. And the U.K. is not alone. The S&P 500 is up 9% year-to-date despite tepid earnings growth.

What gives? Are economists so out of touch that they imagined a Brexit blowout?

They simply didn’t put enough stock in low interest rates, which are the cocaine of the stock market.

As investors witnessed in the period following the 2008 crash, a market flooded with capital (thanks to low rates) lifts all boats. The abrupt turn in the U.K. PMI may simply be due to demand, suppressed after Brexit, finally returning in earnest, but the buoyant market, strong British pound and the S&P’s levitation are certainly linked to lower rates.

Economists expect low borrowing costs will encourage investment in factories and other expensive purchases that require loans. In theory, low rates spur companies to invest while demand is ramping up. This demand for services and supplies from companies then boosts the greater economy, creating demand from employed, confident consumers who see their wages rising.

The problem is that when there are low interest rates and low demand, money doesn’t go into business expansion but is pushed into unintended places. Right now companies are using a lot of cheap money to buy back their own shares.

Quarterly buy-backs for S&P 500 companies soared 15% in the first quarter of this year and are now at post-recession highs. In a perfect world corporations use cash only to buy back shares when those shares reach bargain basement levels. A company making efficient use of its capital should be weighing a buy-back against other investments like making acquisitions, expanding its workforce or building more factories.

But buying back shares when they are pricey, as they are now, creates risk for that company. It is true that earnings per share will be boosted because the number of shares outstanding drops, pushing up stock prices. That’s a dangerous high, and all but guarantees a crash, like snorting cocaine. Share buy-backs using cheap money provide instant euphoria to shareholders (and to company insiders sitting on stock and options), but leave a company cash-strapped when that money is needed for more important investments.

While I’ve never experienced a cocaine crash, I know one too many glasses of Zinfandel can ruin a whole morning–and just imagine the hangover when rates rise, cash is cut off and companies looking to expand are caught flat busted.

That scenario scares me, so I make sure the companies in my Profit Catalyst and Growth Stock Strategist portfolios haven’t been binging on stock buy-backs and have cash ready for expansion.

 I’ve also been issuing bearish option trades for Profit Catalyst subscribers to take advantage of companies that have overindulged.