More than meets the eye (of a storm)
In a week that saw NAFTA agreed with Mexico but delayed with Canada, increased Chinese trade tension, some relief on Brexit and a record US GDP, US indices continued their surge to and maintain new highs. Although part of this move has been fueled by perma bear buying back their shorts, it will require more than just shorts leaving the market to cause a stock market top. We need to see a continued trend in the corporate buyback, the subject of this week’s newsletter. But It is the central bank buy back – in the form of US balance sheet reduction and the tapering of global QE programmes – that will fashion the eventual top – the subject of next week’s article on liquidity.
You cannot be reading our newsletters if you do not know we see the consolidation for much of 2018 as setting up the very final aggressive blowout in US stock markets at least. Given our FITS approach such a rally leaves the fundamentals behind, sees intermarket relationships break down even further and challenges most forms of technical analysis. It is increasingly if not purely sentiment driven. Clearly our template also remains the 1929 and 1987 finales.
Two strong features of this period and the very final leg in fact was a collapse in liquidity not just in financial markets but also in the corporate sphere where increasing numbers of the companies bought either their own shares back or indeed other companies. Perhaps the most eloquent testimony of a final sentiment driven leg that cannot be justified fundamentally. Companies see a better return from holding either their or other companies’ shares rather than investing in real assets to expand their production.
Today’s newsletter explores what has been happening in market liquidity and indeed the corporate sector to see whether the aggressive gains we expect into the final quarter of 2018 represent the last hurrah. Or whether, like the increasing number of public predictions, this is merely another leg of uptrend into 2019 if not 2020.
Buybacks are set to surge this year with Goldman Sachs’ estimate for 2018 repurchase authorizations reaching a record $1trn, representing a 46% rise from last year.
Despite the rally in US yields, corporate debt is still very cheap and it can make financial sense for many companies to use debt to fund the purchases.
Much of the recent surge in activity is driven by Trump’s tax cuts and will be funded by repatriated cash.
This will give many stocks a tailwind for the rest of the year, especially the Tech sector. As GS notes, Tech has accounted for 40% of 2018 repurchase authorizations, but so far represents only 21% of actual executions. This means there is a lot of buying still to be done.
Buybacks not only boost prices, but inflate EPS, making many traditional fundamental metrics irrelevant or unreliable. Incredibly, EPS has grown nearly 300% for the S&P 500 since 2009 while actual revenue has grown just 30%. So while PE ratios are nowhere near the peaks of 2000, price to sales are comparable, and even far in excess if we consider the median S&P 500 stock’s price-to-sales ratio.
Buybacks not only massage earnings, and valuations based on earnings, they also have a much longer-term detrimental effect on the economy. Trillions of dollars have poured into stock buybacks and dividends instead of business spending and investment. Core capital goods orders, a proxy for business investment, has remained flat in nominal dollars dating back to the late 1990s. Short-term fixes are much more desirable than long-term sacrifices.
Buybacks were actually made illegal after the 1929 stock crash. President Franklin D. Roosevelt decided at the time to appoint a “fox to guard the chicken house” and appointed a seasoned stock manipulator to lead the new U.S. Securities and Exchange Commission. Joseph Kennedy Sr. saw ending repurchases as among the SEC’s four key missions. Yet the regulation was rescinded (or more accurately tweaked) by Ronald Reagan in 1982 and was one of the triggers for the stock blow out into the 1987 top. Throughout the 1980s the amount of buybacks ballooned and by 1987 the media questioned whether record buybacks were a good idea after huge gains. On March 5, 1987 the New York Times reported
“The soaring stock market, which has lifted many stocks to record highs, has not cooled corporate America’s love affair with that one sure-fire way to bolster share prices and please investors: the buyback. The announcement by the General Motors Corporation earlier this week that it would repurchase more than $5 billion of its stock over four years – the largest announced buyback ever – was greeted warmly by investors, and sent the stock whirling up $3.875 yesterday, to $79.50.”
Kimberley Clark were also ramping up buybacks.
“A Kimberly-Clark spokesman conceded that many buybacks are ”a kind of a quick fix for a stock.” But he explained that his company’s objective was to add leverage to the company’s balance sheet. He said Kimberly would like to raise its debt to between 28 and 32 percent of its total capital, from 22 percent, where it is now.”
Leverage is rising again in 2018 as this debt to equity (yellow) chart shows.
As Barclays notes:
“A prominent feature of extended bull markets is higher levels of leverage, as measured by the ratio of debt to equity. We found that the debt-to-equity ratio went up during every late-cycle bull market since 1980. Advances in debt and more efficient use of capital structures are obvious ways for companies to offset the economic malaise that sets in toward the end of business cycles and continue to drive stock prices higher.”
This is illustrated well by a chart of debt as % of US Nominal GDP, which is making a new peak and has accelerated into all significant tops of the last 30 years.
Why the default rate is defying the trend is another matter, but I think we can safely say there is evidence that stocks are late cycle, comparable to 1987, but also positioned to ramp further. Excess debt has (wrongly) been a narrative for the bears during much of the bull market, and whilst numbers are high, it will only become an issue for the stock market when the conditions are right.
These conditions are never easy to specify exactly. While many articles about 1987 and 1929 will neatly fit the causes and triggers into a brief paragraph, the reality is often much more complex. The same conditions may have been developing for several years (during which time stocks have seen huge percentage gains) into a top.
Yet we can say a rise in buybacks are another piece of the puzzle and fit into the general context of a late cycle driver of prices. When combined with over leverage, over valuation and tightening financial conditions, the outcome is not likely to be much different than other major tops.
This tightening of financial conditions comes not only from rate hikes, but the Fed’s quantatitive tightening (QT) program, which essentially takes money out of the system.
The effect is even more pronounced when we look at US True Money Supply – or the US monetary inflation rate – which hit 2007 levels before recovering in early 2018 (probably due to repatriated funds).
The squeeze on liquidity has some parallels with other periods of history, but we will cover this fully in next week’s article.
Here’s to making the very best. Good luck and Good Trading
Ed Matts, Founder, and Andrew McElroy, Chief Stocks Analyst
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