The stock market is on the verge of a bubble: Economist – CNBC.com

The Federal Reserve does the stock market “no favors” by keeping interest rates low, according to one economist who says the market is on the brink of a bubble burst.

Charles Dumas, chief economist at London-based Lombard Street Research, wrote in a recent note that the low cost of borrowing has made corporate buybacks a more attractive, and feasible, option than in past years. Dumas says buybacks at these rates have led to to a stock market that appears to be reaching artificially high levels.

“And the reason this is profitable, of course, is that debt is ultra cheap at the moment, and the stocks on the other hand yield quite a bit so it makes sense even in a very short term way,” he said Friday in an interview on CNBC’s “Trading Nation.”

According to Dumas, corporate buybacks have become the “chief source of buying in the market,” not outside investment, and 8 percent growth in nonfinancial bank debt is fast enough “to sound the alarm.” He said the economy is healthy enough to withstand a rate increase but he fears the stock market is not prepared.

“When the Fed gets real and makes the necessary increases, this market could prove much more vulnerable than is traditional in the early stages of a rate-hike cycle,” Dumas wrote.

Buybacks are in fact down by one measure, according to Howard Silverblatt, SP Dow Jones indices senior index analyst.

Buybacks fell by 21 percent in the second quarter, and the decline indicates that companies have not increased “planned buybacks or rearranged expenditures to support their shares” through the end of the fiscal period. Discretionary buybacks, used to reduce share count and boost earnings per share, are “unknown,” according to Silverblatt.

But he points to the same reason as Dumas for high buyback levels.

“The combination of low interest rates, expected limited action from Yellen Co, and record cash levels ($1.37T) continues to give companies the ability to set record shareholder returns (as well a little push from outside investors),” Silverblatt wrote in a recent note.

The Fed will inevitably raise interest rates “pretty soon,” Dumas said, and he remains a long-term bull on U.S. equities.

“I’m not suggesting the stock market is headed for a bloodbath like in the crisis in 2008-9, but of course American rates do drive everything else in the world,” Dumas said.

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