Tag Archives: buybacks

Corporate Profits Are Worse Than You Think – Addendum

We recently published Corporate Profits Are Worse Than You Think to expose stock prices that have surged well beyond levels that are justified by corporate profits. 

A topic not raised in the article, but a frequent theme of ours, is the role that share buybacks have played in this bull market. Corporations have not only been the largest buyer of stocks over the last few years, but share buybacks result in misleading earnings per share data, which warp valuations and makes stocks look cheaper. Over the last five years, corporations have been heavily leaning on the issuance of corporate debt to facilitate share buybacks. In doing so, earnings per share appear to sustain a healthy upward trajectory, but only because the denominator of the ratio (number of shares) is being reduced as debt on the balance sheet rises. This corporate shell game is one of the most obvious and egregious manifestations of imprudent Federal Reserve policies of the past decade.

Given the importance of debt to share buybacks, we provide two graphs below which question the sustainability of this practice.

The first graph below compares the growth of corporate debt and corporate profits since the early 1950s. The growing divergence, especially as of late, is a clear warning that debt is not being used for productive purposes. If it were, profits would be rising in a manner commensurate or even greater than the debt curve. The unproductive nature of corporate debt is also seen in the rising ratio of corporate debt to GDP, which now stands at all-time highs. Too much debt is being used for buybacks that curtail capital investment, innovation, productivity, and ultimately profits.  

Data Courtesy St. Louis Federal Reserve

The next graph uses the same data but presents the growth rates of profits and debt since 2015. Keep in mind the bump up in corporate profits in 2018 was largely due to tax legislation.

Data Courtesy St. Louis Federal Reserve

Lastly, we present a favorite chart of ours showing how the universe of corporate debt has migrated towards the lower end of the investment-grade bucket. Many investment-grade companies (AAA – BBB-) are issuing debt until they reach the risk of a credit downgrade to junk status (BB+ or lower). We believe many companies are now limited in their use of debt for fear of downgrades, which will naturally restrict their further ability to conduct buybacks. For more on this graph, please read The Corporate Maginot Line.

The Market Soars As Corporate Profits Slump!

The SPX recorded new highs this week.  Investors appear to be excited about the U.S. – China Phase 1 trade agreement, which only goes so far in ending the trade war.  Plus, the Fed is cutting interest rates, injecting $100 billion in repo financing over the next month, and embarking on a new round of QE. So, is it clear sailing for corporate America? Maybe companies are not as financially viable as record SPX levels would indicate.

Let’s look at the lifeblood of a company, cash flow.  Goldman Sachs analysis of corporate cash flows shows that SPX companies are actually running, in aggregate, negative cash flow at 103.8% while keeping stock buybacks and dividends flowing to shareholders. Debt is up 8% squeezing corporate cash flow to the point where aggregate cash flows are down 15% versus the prior year.

Source: Goldman Sachs – 7/25/19

Cash is the lifeblood of a company, but a company can’t borrow money forever without being a viable profitable entity able to pay back debt.

Non-financial corporations have taken on record debt at 47% to GDP.  The last time corporations approached this level of debt was during the Great Recession.  Yet, default rates have not gone up.

Sources: Federal Reserve Bank of St. Louis, Edward Altman – 8/5/19

Is this time for debt payment defaults different?  It would seem this is a ‘benign credit cycle’ when defaults don’t rise.  However, a more likely cause is that corporate cash flows are being pumped up by low interest rate loans. This corporate financial cliff maybe one reason the Fed is moving quickly to keep overnight and interest rates low.  The Fed has said it is concerned about high levels of corporate debt.  What is wrong with corporate debt at 47% of GDP?

The issue is when profits sink due to the trade war or as consumer spending slows, companies will no longer qualify for low interest loans. Banks and investors will hesitate to take on risky loans to companies raking up continuous losses.  Without low cost loans to provide needed cash flows, sales decline will result in a freeze on hiring, the layoff of full time workers, and a closure of offices and plants. Management will take these measures to try to keep the company open until sales turnaround.

The profit margin squeeze has been happening over the past 4 ½ years, well before the trade war started.  Profits were flat for the past nine years, supported by a huge corporate tax cut from the Tax Cut Bill of 2018. The contraction in profit margins has been the longest one on record since WWII. Note how recessions usually follow steep declines in profit margins at 1 to 4 years.

Source: Oxford Economics, The Wall Street Journal, The Daily Shot – 10/28/19

Why have margins been contracting?  Margins can be increased by investing in automation, lowering material costs, deploying productivity enhancements, and other efficiencies. Instead of investing in margin increasing activities, corporate executives have been spending available cash from profits and debt on stock buybacks totaling $1.15 trillion in 2018.  Stock buybacks are a way to boost corporate stock prices thereby increasing the income of shareholders and executives. Executives have squandered over the past ten years the opportunity to use profits for investments in research, productivity enhancements, raising wages, or cutting costs.  Management has focused on short term stock gains at the cost of long term corporate viability. The chickens are finally coming home to roost.

In addition, profit margins are declining due to declining international sales. It is difficult to maintain healthy margins when sales are falling due to base spending for sales, support, and transportation to reach a certain sales threshold of profitability. Major corporations face increasing trade headwinds.  For most S & P 100 corporations 50 to 60% of their sales come from overseas with prior growth rates from 15 – 25% per year in emerging markets.  The Asia – Pacific region is the fastest growing sales region for many companies. Yet, the accumulating tax of trade tariffs and trade uncertainty is stifling sales growth.

Sources: U.S. Census Bureau, Tariffs Hurt the Heartland, USTR Office, The Wall Street Journal, The Daily Shot – 10/28/19

Since January of 2018, U.S. companies have paid about $34 billion in tariffs. To hold price levels and market share, companies largely paid tariff costs themselves rather than passing them onto customers. Taking tariff costs onto corporate ledgers has squeezed profit margins. The loss of decent margins in high growth markets is creating a huge profit challenge for companies. 

While the Phase 1 agreement with China may provide a pause to the trade war, breaking up into two major trade blocks.  Corporations will have to navigate selling into two opposing markets with focused sales, support, and product features and pricing.  For more details, see our post Navigating A Two Block Trade World to see how companies plan on changing supply chains, and the implications for investors.

Corporate executives see a loss of profits and margin tightening in the future. A recent CEO survey showed confidence levels of SPX CEOs at recession levels.  The survey results indicate a possible SPX decline beginning as soon as four months from now.

Sources: USA CEO Confidence Survey, Macrobond, The Wall Street Journal, The Daily Shot – 10/18/19

The concerns that CEOs see in revenue and profitability were borne out in 3rd quarter reports of 40% of S &P companies.  Companies with more than 50% of sales in international markets report a 9.1% decline in profits and a 2.0% decline in revenue.  All S &P companies report a 3.7% slip in earnings thus far for 3rd quarter of 2019.

Source: Factset – 10/25/19

Are equity markets recognizing the decline in profits for corporations?  The chart below shows the SPX rising despite flat national corporate profits since 2013, with a huge divergence emerging in the past four years. The SPX soaring to new heights tells us that stock market complacency is at record levels in appraising stock valuations versus actual corporate profits. The chart below shows how wide the gap has become which is about twice the gap size just before the Dotcom decline into 2002 from a peak in 2000.

Source: Soc Gen – Albert Edwards – Marketwatch – 10-28-19

The economic storm corporate executives see on the horizon is likely to be a future economic reality, and not liquidity fueled soaring valuationsExecutives are closest to economic reality because they have to make the economic system work for their company day in and day out. A reversion of equity valuations to the reality of falling corporate profits is coming.  The only question remaining is: when will the SPX reversion happen?

Patrick Hill is the Editor of The Progressive Ensign, writes from the heart of Silicon Valley, leveraging 20 years of experience as an executive at firms like HP, Genentech, Verigy, Informatica and Okta to provide investment and economic insights. Twitter: @PatrickHill1677.

Quick Take: IPO Surge

Pinterest, Zoom, Lyft and a host of other companies led a surge in Initial Public Offerings (IPOs) over the first four months of 2019. Totaling nearly $1 trillion in new offerings, 2019 is already closing in on the annual record set in 2000.  

The gray line in the chart above, courtesy Sentiment Trader, compares the S&P 500 to the annual amount of IPOs. The easy takeaway, given that two of the three prior high water marks in IPO issuance were 2000 and 2007, is that the current surge in IPOs bodes poorly for the stock market. Such logic follows that IPO’s, especially for companies with little to no earnings yet high growth expectations, are easiest to bring to market when investor complacency is high.

Comparing today’s IPO issuance to prior examples may prove wrong as it did in 2014. Investors must consider the overall supply of shares outstanding in the entire market before jumping to conclusions. The graph below, courtesy Ed Yardeni, shows net stock issuance, IPOs and share repurchases included, have been in decline over the past decade. It is possible that IPO issuance is just a small offset to the massive number of shares that corporations have bought back over the last few years and therefore it is not the warning sign some market prognosticators make it out to be.

Powell Keeps The Bond Bull Kicking

In a widely expected outcome, the Federal Reserve announced no change to the Fed funds rate but did leave open the possibility of a rate hike next year. Also, they committed to stopping “Quantitative Tightening (or Q.T.)” by the end of September. 

The key language from yesterday’s announcement was:

Information received since the Federal Open Market Committee met in January indicates that the labor market remains strong but that growth of economic activity has slowed from its solid rate in the fourth quarter. Payroll employment was little changed in February, but job gains have been solid, on average, in recent months, and the unemployment rate has remained low.

Recent indicators point to slower growth of household spending and business fixed investment in the first quarter. On a 12-month basis, overall inflation has declined, largely as a result of lower energy prices; inflation for items other than food and energy remains near 2 percent. On balance, market-based measures of inflation compensation have remained low in recent months, and survey-based measures of longer-term inflation expectations are little changed.”

What is interesting is that despite the language that “all is okay with the economy,” the Fed has completely reversed course on monetary tightening by reducing the rate of balance sheet reductions in coming months and ending them entirely by September. At the same time, all but one future rate hike has disappeared, and the Fed discussed the economy might need easing in the near future. To wit, my colleague Michael Lebowitz posted the following Tweet after the Fed meeting:

This assessment of a weak economy is not good for corporate profitability or the stock market. However, it seems as if investors have already gotten the “message” despite consistent headline droning about the benefits of chasing equities. Over the last several years investors have continued to chase “safety” and “yield.” The chart below shows the cumulative flows of both ETF’s and Mutual Funds in equities and fixed income. 

This chase for “yield” over “return” is also seen in the global investor positing report for March.

Clearly, investors have continued to pile into fixed income and safer equity income assets over the last few years despite the sharp ramp up in asset prices. This demand for “yield” and “safety” has been one of the reasons we have remained staunchly bullish on bonds in recent years despite continued calls for the “Death of the Bond Bull Market.” 

The Reason The Bond Bull Lives

Importantly, one of the key reasons we have remained bullish on bonds is that, as shown below, it is when the Fed is out of the “Q.E” game that rates fall. This, of course, was the complete opposite effect of what was supposed to happen.

Of course, the reasoning is simple enough and should be concerning to investors longer-term. Without “Q.E” support, economic growth stumbles which negatively impacts asset prices pushing investors into the “safety” of bonds. 

As the Fed now readily admits, their pivot to a more “dovish” stance is due to the global downturn in economic growth, and the bond market has been screaming that message in recent months. As Doug Kass noted on Tuesday:

“Which brings me to today’s fundamental message of the fixed income markets – which are likely being ignored and could be presaging weakening economic and profit growth relative to consensus expectations and, even (now here is a novel notion) that could lead to lower stock prices. That message is undeniable – economic and profit growth is slowing relative to expectations as financial asset prices move uninterruptedly higher.

  • The yield on the 10 year U.S. note has dropped below 2.60% this morning. (I have long had a low 2.25% forecast for 2019)
  • The (yield curve and) difference between 2s and 10s is down to only 14 basis points.
  • High-frequency economic statistics (e.g. Cass Freight Index) continue to point to slowing domestic growth.
  • Auto sales and U.S. residential activity are clearly rolling over.
  • PMIs and other data are disappointing.
  • Fixed business investment is weakening.
  • No country is an economic island – not even the U.S.
  • Europe is approaching recession and China is overstating its economic activity (despite an injection of massive amounts of liquidity).”

He is correct, yields continue to tell us an important story. 

First, three important facts are affecting yields now and in the foreseeable future:

  1. All interest rates are relative. With more than $10-Trillion in debt globally sporting negative interest rates, the assumption that rates in the U.S. are about to spike higher is likely wrong. Higher yields in U.S. debt attracts flows of capital from countries with negative yields which push rates lower in the U.S. Given the current push by Central Banks globally to suppress interest rates to keep nascent economic growth going, an eventual zero-yield on U.S. debt is not unrealistic.
  2. The coming budget deficit balloon. Given the lack of fiscal policy controls in Washington, and promises of continued largess in the future, the budget deficit will eclipse $1 Trillion or more in the coming years. This will require more government bond issuance to fund future expenditures which will be magnified during the next recessionary spat as tax revenue falls.
  3. Central Banks will continue to be a buyer of bonds to maintain the current status quo. As such they will have to be even more aggressive buyers during the next recession. The next QE program by the Fed to offset the next economic recession will likely be $2-4 Trillion and might push the 10-year yield towards zero.

As I have discussed many times in the past, interest rates are a function of three primary factors: economic growth, wage growth, and inflation. The relationship can be clearly seen in the chart below.

Okay…maybe not so clearly. 

Let me clean this up by combining inflation, wages, and economic growth into a single composite for comparison purposes to the level of the 10-year Treasury rate.

As you can see, the level of interest rates is directly tied to the strength of economic growth, wages and inflation. This should not be surprising given that consumption is roughly 70% of economic growth.

As Doug notes, the credit markets have been right all along the way. At important points in time, when the Fed signaled policy changes, credit markets have correctly interpreted how likely those changes were going to be. A perfect example is the initial rate hike path set out in December 2015 by then Fed Chairman Janet Yellen. This was completely wrong at the time and the credit markets told us so from the beginning. 

The credit markets have kept us on the right side of the interest rate argument in repeated posts since 2013. Why, because the credit market continues to tell us an important story if you are only willing to listen. 

The bond market is screaming “secular stagnation.” 

Since 2009, asset prices have been lofted higher by artificially suppressed interest rates, ongoing liquidity injections, wage and employment suppression, productivity-enhanced operating margins, and continued share buybacks have expanded operating earnings well beyond revenue growth.

As I wrote in mid-2017:

“The Fed has mistakenly believed the artificially supported backdrop they created was actually the reality of a bright economic future. Unfortunately, the Fed and Wall Street still have not recognized the symptoms of the current liquidity trap where short-term interest rates remain near zero and fluctuations in the monetary base fail to translate into higher inflation. 

Combine that with an aging demographic, which will further strain the financial system, increasing levels of indebtedness, and lack of fiscal policy, it is unlikely the Fed will be successful in sparking economic growth in excess of 2%. However, by mistakenly hiking interest rates and tightening monetary policy at a very late stage of the current economic cycle, they will likely be successful at creating the next bust in financial assets.”

It didn’t take long for that prediction to come to fruition and change the Fed’s thinking.

On December 24th, 2018, while the S&P 500 was plumbing it’s depths of the 2018 correction, I penned “Why Gundlach Is Still Wrong About Higher Rates:”

“At some point, the Federal Reserve is going to step back in and reverse their policy back to “Quantitative Easing” and lowering Fed Funds back to the zero bound.

When that occurs, rates will not only go to 1.5%, but closer to Zero, and maybe even negative.”

What I didn’t know then was that literally the next day the Fed would reverse course. 

The chart below shows the rolling 4-week change in the Fed’s balance sheet versus the S&P 500. 

The issue for the Fed is that they have become “market dependent” by allowing asset prices to dictate policy. What they are missing is that if share prices actually did indicate higher rates of economic growth, not just higher profits due to stock buybacks and accounting gimmickry, then US government bond yields would be rising due to future rate hike expectations as nominal GDP would be boosted by full employment and increased inflation. But that’s not what’s happening at all.

Instead, the US 10-year bond is pretty close to 2.5% and the yield curve is heading into inversion.

Since inversions are symptomatic of weaker economic growth, such would predict future rate hikes by the Fed will be limited. Not surprisingly, that is exactly what is happening now as shown by yesterday’s rapid decline in the Fed’s outlook.

Why?

Let’s go back to that 2017 article:

“However, the issue of rising borrowing costs spreads through the entire financial ecosystem like a virus. The rise and fall of stock prices have very little to do with the average American and their participation in the domestic economy. Interest rates are an entirely different matter.

Since interest rates affect ‘payments,’ increases in rates quickly have negative impacts on consumption, housing, and investment which ultimately deters economic growth.”

All it took was for interest rates to crest 3% and home, auto, and retail sales all hit the skids. Given the current demographic, debt, pension, and valuation headwinds, the future rates of growth are going to be low over the next couple of decades – approaching ZERO.

While there is little left for interest rates to fall in the current environment, there is also not a tremendous amount of room for increases. Therefore, bond investors are going to have to adopt a “trading” strategy in portfolios as rates start to go flat-line over the next decade.

Whether, or not, you agree there is a high degree of complacency in the financial markets is largely irrelevant. The realization of “risk,” when it occurs, will lead to a rapid unwinding of the markets pushing volatility higher and bond yields lower. This is why I continue to acquire bonds on rallies in the markets, which suppresses bond prices, to increase portfolio income and hedge against a future market dislocation.

In other words, I get paid to hedge risk, lower portfolio volatility and protect capital.

Bonds aren’t dead, in fact, they are likely going to be your best investment in the not too distant future.

“I don’t know what the seven wonders of the world are, but the eighth is compound interest.” – Baron Rothschild 


Stock Buybacks Aren’t Bad, Just Misused & Abused

There has been a lot of commentary as of late regarding the issue of corporate share repurchases. Even Washington D.C. has chimed into the rhetoric as of late discussing potential bills to limit or eliminate these repurchases. It is an interesting discussion because most people don’t remember that share repurchases were banned for decades prior to President Reagan in 1982. 

Even after the ban was lifted, share repurchases were few and far between as during the “roaring bull market of the 90’s” it was more about increasing outstanding shares through stock splits. Investors went crazy over stock splits as they got more shares of the company they loved at half the price. Most didn’t realize, or understand the effective dilution; but for them it was more of a Yogi Berra analogy:

“Can you cut my pizza into four pieces because I can’t eat eight.” 

However, following the financial crisis stock splits disappeared and a new trend emerged – share repurchases. Like stock splits, share repurchases in and of themselves are not necessarily a bad thing, it is just the least best use of cash. Instead of using cash to expand production, increase sales, acquire competitors, or buy into new products or services, the cash is used to reduce the outstanding share count and artificially inflate earnings per share. Here is a simple example:

  • Company A earns $1 / share and there are 10 / shares outstanding. 
  • Earnings Per Share (EPS) = $0.10/share.
  • Company A uses all of its cash to buy back 5 shares of stock.
  • Next year, Company A earns $0.20/share ($1 / 5 shares)
  • Stock price rises because EPS jumped by 100%.
  • However, since the company used all of its cash to buy back the shares, they had nothing left to grow their business.
  • The next year Company A still earns $1/share and EPS remains at $0.20/share.
  • Stock price falls because of 0% growth over the year. 

This is a bit of an extreme example but shows the point that share repurchases have a limited, one-time effect, on the company. This is why once a company engages in share repurchases they are inevitably trapped into continuing to repurchase shares to keep asset prices elevated. This diverts ever-increasing amounts of cash from productive investments and takes away from longer term profit and growth.

As shown in the chart below, the share count of public corporations has dropped sharply over the last decade as companies scramble to shore up bottom line earnings to beat Wall Street estimates against a backdrop of a slowly growing economy and sales.

(The chart below shows the differential added per share via stock backs. It also shows the cumulative growth in EPS and Revenue/Share since 2011)

The Abuse & Misuse 

As I stated, share repurchases aren’t necessarily a bad thing. It is just the misuse and abuse of them which becomes problematic. It’s not just share repurchases though. In “4-Tools To Beat The Wall Street Estimate Game” we discussed how companies not only use stock repurchases, but a variety of other accounting gimmicks to “meet their numbers.” 

“The tricks are well-known: A difficult quarter can be made easier by releasing reserves set aside for a rainy day or recognizing revenues before sales are made, while a good quarter is often the time to hide a big ‘restructuring charge’ that would otherwise stand out like a sore thumb.

What is more surprising though is CFOs’ belief that these practices leave a significant mark on companies’ reported profits and losses. When asked about the magnitude of the earnings misrepresentation, the study’s respondents said it was around 10% of earnings per share.

cooking-the-books-2

The reason that companies do this is simple: stock-based compensation. Today, more than ever, many corporate executives have a large percentage of their compensation tied to company stock performance. A “miss” of Wall Street expectations can lead to a large penalty in the companies stock price.

As shown in the table above, it is not surprising to see that 93% of the respondents pointed to “influence on stock price” and “outside pressure” as the reason for manipulating earnings figures.

The use of stock buybacks has continued to rise in recent years and went off the charts following the passage of tax cuts in 2017. As I wrote in early 2018. while it was widely believed that tax cuts would lead to rising capital investment, higher wages, and economic growth, it went exactly where we expected it would. To wit:

“Not surprisingly, our guess that corporations would utilize the benefits of “tax cuts” to boost bottom line earnings rather than increase wages has turned out to be true. As noted by Axios, in just the first two months of this year companies have already announced over $173 BILLION in stock buybacks.  This is ‘financial engineering gone mad'” 

Share buybacks are expected to hit a new record by the end of 2019.

“Share repurchases aren’t bad. It is simply the company returning money to shareholders.”

There is a problem with that statement.

Share buybacks only return money to those individuals who sell their stock. This is an open market transaction so if Apple (AAPL) buys back some of their outstanding stock, the only people who receive any capital are those who sold their shares.

So, who are the ones mostly selling their shares?

As noted above, it’s the insiders, of course, as changes in compensation structures since the turn of the century has become heavily dependent on stock based compensation. Insiders regularly liquidate shares which were “given” to them as part of their overall compensation structure to convert them into actual wealth. As the Financial Times recently penned:

Corporate executives give several reasons for stock buybacks but none of them has close to the explanatory power of this simple truth: Stock-based instruments make up the majority of their pay and in the short-term buybacks drive up stock prices.

A recent report on a study by the Securities & Exchange Commission found the same:

  • SEC research found that many corporate executives sell significant amounts of their own shares after their companies announce stock buybacks, Yahoo Finance reports.

What is clear, is that the misuse and abuse of share buybacks to manipulate earnings and reward insiders has become problematic. As John Authers recently pointed out:

“For much of the last decade, companies buying their own shares have accounted for all net purchases. The total amount of stock bought back by companies since the 2008 crisis even exceeds the Federal Reserve’s spending on buying bonds over the same period as part of quantitative easing. Both pushed up asset prices.”

In other words, between the Federal Reserve injecting a massive amount of liquidity into the financial markets, and corporations buying back their own shares, there have been effectively no other real buyers in the market. 

As Jesse Felder wrote:

“Without that $4 trillion in stock buybacks and in a market where trading volume has been falling for decades they never would have been able to soar as high as they have. The chart below plots ‘The Buffett Yardstick’ (total equity market capitalization relative to gross national product) against total net equity issuance (inverted). Since the late-1990’s both valuations and buybacks have been near record highs. Is this just a coincidence? I think it’s safe to say it’s not.”

The other problem with the share repurchases is that is has increasingly been done with the use of leverage. The ongoing suppression of interest rates by the Federal Reserve led to an explosion of debt issued by corporations. Much of the debt was not used for mergers, acquisitions or capital expenditures but for the funding of share repurchases and dividend issuance. 

The explosion of corporate debt in recent years will become problematic if rates rise markedly, further deterioration in credit quality locks companies out of refinancing, or if there is a recessionary drag which forces liquidation of debt. This is something Dallas Fed President Robert Kaplan warned about:

U.S. nonfinancial corporate debt consists mostly of bonds and loans. This category of debt, as a percentage of gross domestic product, is now higher than in the prior peak reached at the end of 2008.

A number of studies have concluded this level of credit could ‘potentially amplify the severity of a recession,’

The lowest level of investment-grade debt, BBB bonds, has grown from $800 million to $2.7 trillion by year-end 2018. High-yield debt has grown from $700 million to $1.1 trillion over the same period. This trend has been accompanied by more relaxed bond and loan covenants, he added.

This was recently noted by the Bank of International Settlements. 

“If, on the heels of economic weakness, enough issuers were abruptly downgraded from BBB to junk status, mutual funds and, more broadly, other market participants with investment grade mandates could be forced to offload large amounts of bonds quickly. While attractive to investors that seek a targeted risk exposure, rating-based investment mandates can lead to fire sales.”

Summary

While share repurchases by themselves may indeed be somewhat harmless, it is when they are coupled with accounting gimmicks and massive levels of debt to fund them in which they become problematic. 

The biggest issue was noted by Michael Lebowitz:

“While the financial media cheers buybacks and the SEC, the enabler of such abuse idly watches, we continue to harp on the topic. It is vital, not only for investors but the public-at-large, to understand the tremendous harm already caused by buybacks and the potential for further harm down the road.”

Money that could have been spent spurring future growth for the benefit of investors was instead wasted only benefiting senior executives paid on the basis of fallacious earnings-per-share.

As stock prices fall, companies that performed un-economic buybacks are now finding themselves with financial losses on their hands, more debt on their balance sheets, and fewer opportunities to grow in the future. Equally disturbing, the many CEO’s who sanctioned buybacks, are much wealthier and unaccountable for their actions.

This article may be best summed up with just one word:

Fraud – frôd/ noun:

Wrongful or criminal deception intended to result in financial or personal gain.


United Technologies (UTX) Faces Reality- Will Other Companies Follow Suit Before It’s Too Late.

On November 27, 2018, the CFO from United Technologies (UTX) stated that his company will focus on deleveraging and not stock buybacks. This announcement comes as General Electric (GE) is struggling mightily to retain investment grade status and its stock is nearing levels last seen during the depths of the financial crisis. While there is much to attribute to GE’s decline, massive stock buybacks in 2016 and 2017 are largely to blame.

To wit: “The root problem at GE — and why the stock is where it is — is poor capital allocation,” said RBC Capital Markets analyst Deane Dray.

Corporate debt now stands at record levels versus GDP as shown below. While the debt has been used to fund expansion and R&D it has also been used to fund record numbers of share buybacks. The pitfalls of such a strategy are now encroaching upon GE’s ability to survive. We suspect that UTX is the first of many companies to acknowledge this realization.

In February of 2016 we wrote an article on Conoco Phillips (COP). The missive, which is one of six articles we have written criticizing stock buybacks, describes how COP was forced to cut a reliable dividend and capital expenditures as they were strapped for cash. The price of oil at the time was hurting cash-flows. Unfortunately COP, like GE, had previously bought back a significant number of shares which greatly reduced their liquidity status when it was needed most.

While the article is nearly three years old we think it is every bit as important today as it was then. It exemplifies how precarious a company’s ability to survive financial weakness and/or an economic downturn is when capital is squandered in efforts to temporarily boost share prices. This story is likely to become a common theme for the next few years especially if, as we suspect, economic growth declines and stocks prices fall.


As the Tide Goes Out, Effects of Buybacks are Exposed  :  The ConocoPhillips Poster Child

 “The words of men may temporarily suspend but they do not alter the laws of financial dynamics. The fundamentals always take precedence eventually”- 720 Global 11/30/2015

The quote above was from an article we wrote that scrutinized stock buybacks and the unforeseen impacts they may have. In that piece as well as an earlier missive, “Corporate Buybacks; Connecting Dots to the F-word”, we rebuked the short-termism stock buyback fad. Both articles made the case that corporate executives, through buybacks, promote higher short-term stock prices that serve largely only to benefit their own compensation. The costs of these actions are felt later as the future growth for the respective companies, employees and entire economy are robbed.

This case study details how the “the laws of financial dynamics” have caught up with ConocoPhillips (COP) and demonstrates how shareholders are suffering while executives prosper.

COP

On February 4th, 2016 COP, in reaction to their fourth quarter earnings release, slashed its quarterly dividend from $0.74 to $0.25 per share, a level not seen since March 2005. COP also lowered its current year capital expenditure (capex) budget by $1.31 billion, marking the second reduction in as many months. The actions are a direct response to the plummeting price of oil and the damage it is having on COP’s bottom line. The company’s net loss for the fourth quarter 2015 was $3.50 billion or $0.90 per share.

While the losses and expense cuts are not shocking given the severe decline in oil prices, the dividend cut was a jolt to many investors. COP has consistently paid a dividend, as shown below, since 1990. During that 25 year period the dividend was increased 19 times but COP had never decreased it, until now. Even during the financial crisis of 2008/09, COP raised its dividend despite the price of crude oil dropping $100 per barrel.

Maybe the biggest cause for the shock is not the steadfastness of their prior dividend policy, but official corporate presentations.  On the first page of their 2016 Operating Plan (Analyst & Investor Update – December 10, 2015) they make the following statements: “Dividend is highest priority use of cash” and “DIVIDEND Remains Top Priority”. The statements are repeated in the summary on the final page. The cover of their most recent annual report has a word cloud diagram with “dividend” shown among other key corporate values.

What Could Have Been

The dividend and capex reductions are prudent measures undertaken by management to help manage corporate assets and bolster their financial conditions during an historic swoon in revenue. This article does not question those actions, it instead asks if such drastic measures would be necessary had management not spent enormous sums of capital on stock buybacks in the preceding years.

Since 2011, COP repurchased 251.316 million shares representing roughly 20% of their shares outstanding, at an approximate cost of $14.168 billion. The majority of these purchases occurred between 2011 and 2012 when the stock traded between $48 and $58 per share.  Today the stock trades at $32 per share, matching prices last seen 12 years ago.  The graph below charts the share price of COP with an overlay of the share repurchases by quarter.

Now let us contemplate what COP’s current financial situation might look like had management and the board of directors not engaged in repurchases. First of all, COP would still have the $14.168 billion spent on buybacks since 2011, which could be used to support the $0.74 per share dividend for almost 5 years.   More importantly, the company could be in the envious position of employing the capital to buy assets that are being liquidated by other companies at cents on the dollar.  Shareholders are suffering in many ways from the abuses of management in years past and will continue to do so for years to come.

The Rich Get Richer…

Fortunately for James Mulva, COP’s CEO during the 2011/2012 stock buyback era, his overly generous compensation is beyond COP’s ability to reclaim. Mr. Mulva retired in June of 2012 after repurchasing approximately 20% of the company’s outstanding shares. Upon retirement he received a $260 million golden parachute from the company. That was on top of $141 million in total compensation he received in 2011.

The board of directors and shareholders must have been enamored with Mulva’s performance despite poor earnings trends in his final 2 years.  From 2011 to 2012 the company earnings per share fell 25% from $8.97/share to $6.72/share. Had the board factored in the effect of buybacks on earnings per share when determining Mr. Mulva’s compensation, they would have realized that earnings per share were actually 40% lower at $5.37 per share.

We provide the following snippets on James Mulva to better gauge the potential motivations behind the tremendous buyback program.

Summary

While the financial media cheers buybacks and the SEC, the enabler of such abuse idly watches, we continue to harp on the topic. It is vital, not only for investors but the public at-large, to understand the tremendous harm already caused by buybacks and the potential for further harm down the road. Unfortunately, COP is not an isolated case. Hess Oil, for instance, just sold 25 million shares at $39 per share to improve their capital position. Sadly for Hess shareholders, many of whom likely supported buybacks, this shareholder dilution was unnecessary had Hess not bought nearly 63 million shares at a price of nearly $60 per share in the 3 years prior. Money that could have been spent spurring future growth for the benefit of investors was instead wasted only benefitting senior executives paid on the basis of fallacious earnings-per-share.  

As stock prices fall, companies that performed un-economic buybacks are now finding themselves with financial losses on their hands, more debt on their balance sheets, and fewer opportunities to grow in the future. Equally disturbing, many CEO’s like James Mulva, who sanctioned buybacks, are much wealthier and unaccountable for their actions.

This article may be best summed up with the closing to our first article on buybacks.

Fraud – frôd/ noun:

wrongful or criminal deception intended to result in financial or personal gain.

How The Bubbles In Stocks And Corporate Bonds Will Burst

As someone who has been warning heavily about dangerous bubbles in U.S. corporate bonds and stocks, people often ask me how and when I foresee these bubbles bursting. Here’s what I wrote a few months ago:

To put it simply, the U.S. corporate debt bubble will likely burst due to tightening monetary conditions, including rising interest rates. Loose monetary conditions are what created the corporate debt bubble in the first place, so the ending of those conditions will end the corporate debt bubble. Falling corporate bond prices and higher corporate bond yields will cause stock buybacks to come to a screeching halt, which will also pop the stock market bubble, creating a downward spiral. There are extreme consequences from central bank market-meddling and we are about to learn this lesson once again.

Interestingly, Zero Hedge tweeted a chart today of the LQD iShares Investment Grade Corporate Bond ETF saying that it was “about to break 7 year support: below it, the buybacks end.” That chart resonated with me, because it echos my warnings from a few months ago. I decided to recreate this chart with my own commentary on it. The 110 to 115 support zone is the key line in the sand to watch. If LQD closes below this zone in a convincing manner, it would likely foreshadow an even more powerful bond and stock market bust ahead.

Corporate Grade Bonds - LQD

Thanks to ultra-low corporate bond yields, U.S. corporations have engaged in a borrowing binge since the Global Financial Crisis. Total outstanding non-financial U.S. corporate debt is up by an incredible $2.5 trillion or 40 percent since its 2008 peakwhich was already a precariously high level to begin with.

Corporate Debt

U.S. corporate debt is now at an all-time high of over 45% of GDP, which is even worse than the levels reached during the dot-com bubble and U.S. housing and credit bubble:

Corporate Debt vs. GDP

Please watch my presentations about the U.S. corporate debt bubble and stock market bubble to learn more:

Billionaire fund manager Jeff Gundlach shares similar concerns as me, saying “The corporate bond market is going to get much worse when the next recession comes. It’s not worth trying to wait for that last ounce of return, or extra yield from the corporate bond market.” Another billionaire investor, Paul Tudor Jones, put out a warning this week, saying “it is in the corporate bond market where the first signs of trouble will emerge.” GE’s terrifying recent credit meltdown may be the initial pinprick for the corporate debt bubble, but make no mistake – it is not an isolated incident. GE may be the equivalent to Bear Stearns in 2007 and 2008 – just one of the first of many casualties. Anyone who thinks that the Fed can distort the credit markets for so long without terrible consequences is extremely naive and will be taught a lesson in the days to come.

Please follow me on LinkedIn and Twitter to keep up with my updates.

If you have any questions about anything I wrote in this piece or would like to learn how Clarity Financial can help you preserve and grow your wealth in the dangerous financial environment ahead, please contact me here.

Yes, We Are In Another Tech Bubble

Technology has touched our lives in so many ways, and especially so for investors. Not only has technology provided ever-better tools by which to research and monitor investments, but tech stocks have also provided outsized opportunities to grow portfolios. It’s no wonder that so many investors develop a strong affinity for tech.

Just as glorious as tech can be on the way up, however, it can be absolutely crushing on the way down. Now that tech stocks have become such large positions in major US stock indexes as well as in many individual portfolios, it is especially important to consider what lies ahead. Does tech still have room to run or has it turned down? What should you do with tech?

For starters, recent earnings reports indicate that something has changed that deserves attention. Bellwethers such as Amazon, Alphabet and Apple all beat earnings estimates by a wide margin. All reported strong revenue growth. And yet all three stocks fell in the high single digits after they reported. At minimum, it has become clear that technology stocks no longer provide an uninterrupted ride up.

These are the kinds of earnings reports that can leave investors befuddled as to what is driving the stocks. Michael MacKenzie gave his take in the Financial Times late in October [here]:

“The latest fright came from US technology giants Amazon and Alphabet after their revenue misses last week. Both are highly successful companies but the immediate market reaction to their results suggested how wary investors are of any sign that their growth trajectories might be flattening.”

Flattening growth trajectories may not seem like such a big deal, but they do provide a peak into the often-tenuous association between perception and reality for technology. Indeed, this relationship has puzzled economists as much as investors. A famous example arose out of the environment of slowing productivity growth in the 1970s and 1980s [here] which happened despite the rapid development of information technology at the time. The seeming paradox prompted economist Robert Solow to quip [here],

You can see the computer age everywhere but in the productivity statistics.”

The computer age eventually did show up in the productivity statistics, but it took a protracted and circuitous route there. The technologist and futurist, Roy Amara, captured the essence of that route with a fairly simple statement [here]:

“We tend to overestimate the effect of a technology in the short run and underestimate the effect in the long run.” Although that assertion seems innocuous enough, it has powerful implications. Science writer Matt Ridley [here] went so far as to call it the “only one really clever thing” that stands out among “a great many foolish things that have been said about the future.”

Gartner elaborated on the concept by describing what they called “the hype cycle” (shown below).

The cycle is “characterized by the ‘peak of inflated expectations’ followed by the ‘trough of disillusionment’.” It shows how the effects of technology get overestimated in the short run because of inflated expectations and underestimated in the long run because of disillusionment.

Amara’s law/ the hype cycle

Source: Wikipedia [here]

Ridley provides a useful depiction of the cycle:

“Along comes an invention or a discovery and soon we are wildly excited about the imminent possibilities that it opens up for flying to the stars or tuning our children’s piano-playing genes. Then, about ten years go by and nothing much seems to happen. Soon the “whatever happened to …” cynics are starting to say the whole thing was hype and we’ve been duped. Which turns out to be just the inflexion point when the technology turns ubiquitous and disruptive.”

Amara’s law describes the dotcom boom and bust of the late 1990s and early 2000s to a tee. It all started with user-friendly web browsers and growing internet access that showed great promise. That promise lent itself to progressively greater expectations which led to progressively greater speculation. When things turned down in early 2000, however, it was a long way down with many companies such as the e-tailer Pets.com and the communications company Worldcom actually going under. When it was all said and done, the internet did prove to be a massively disruptive force, but not without a lot of busted stocks along the way.

How do expectations routinely become so inflated? Part of the answer is that we have a natural tendency to adhere to simple stories rather than do the hard work of analyzing situations. Time constraints often exacerbate this tendency. But part of the answer is also that many management teams are essentially tasked with the effort of inflating expectations. A recent Harvard Business Review article [here] (h/t Grants Interest Rate Observer, November 2, 2018) provides revealing insights from interviews with CFOs and senior investment banking analysts of leading technology companies.

For example, one of the key insights is that “Financial capital is assumed to be virtually unlimited.” While this defies finance and economics theory and probably sounds ludicrous to most any industrial company executive, it passes as conventional wisdom for tech companies. For the last several years anyway, it has also largely proven to be true for both public tech-oriented companies like Netflix and Tesla as well as private companies like Uber and WeWork.

According to the findings, tech executives,

“…believe that they can always raise financial capital to meet their funding shortfall or use company stock or options to pay for acquisitions and employee wages.”

An important implication of this capital availability is,

“The CEO’s principal aim therefore is not necessarily to judiciously allocate financial capital but to allocate precious scientific and human resources to the most promising projects …”

Another key insight is, “Risk is now considered a feature, not a bug.” Again, this defies academic theory and empirical evidence for most industrial company managers. Tech executives, however, prefer to, “chase risky projects that have lottery-like payoffs. An idea with uncertain prospects but with at least some conceivable chance of reaching a billion dollars in revenue is considered far more valuable than a project with net present value of few hundred million dollars but no chance of massive upside.”

Finally, because technology stocks provide a significant valuation challenge, many tech CFOs view it as an excuse to abdicate responsibility for providing useful financial information. “[C]ompanies see little value in disclosing the details of their current and planned projects in their financial disclosures.” Worse, “accounting is no longer considered a value-added function.” One CFO went so far as to note “that the CPA certification is considered a disqualification for a top finance position [in their company].”

While some of this way of thinking seems to be endemic to the tech industry, there is also evidence that an environment of persistently low rates is a contributing factor. As the FT mentions [here], “When money is constantly cheap and available everything seems straightforward. Markets go up whatever happens, leaving investors free to tell any story they like about why. It is easy to believe that tech companies with profits in the low millions are worth many billions.”

John Hussman also describes the impact of low rates [here]:

“The heart of the matter, and the key to navigating this brave new world of extraordinary monetary and fiscal interventions, is to recognize that while 1) valuations still inform us about long-term and full-cycle market prospects, and; 2) market internals still inform us about the inclination of investors toward speculation or risk-aversion, the fact is that; 3) we can no longer rely on well-defined limits to speculation, as we could in previous market cycles across history.”

In other words, low rates unleash natural limits to speculation and pave the way for inflated expectations to become even more so. This means that the hype cycle gets amplified, but it also means that the cycle gets extended. After all, for as long as executives do not care about “judiciously allocating capital”, it takes longer for technology to sustainably find its place in the real economy. This may help explain why the profusion of technology the last several years has also coincided with declining productivity growth.

One important implication of Amara’s law is that there are two distinctly different ways to make money in tech stocks. One is to identify promising technology ideas or stocks or platforms relatively early on and to ride the wave of ever-inflating expectations. This is a high risk but high reward proposition.

Another way is to apply a traditional value approach that seeks to buy securities at a low enough price relative to intrinsic value to ensure a margin of safety. This can be done when disillusionment with the technology or the stock is so great as to overshoot realistic expectations on the downside.

Applying value investing to tech stocks comes with its own hazards, however. For one, several factors can obscure sustainable levels of demand for new technologies. Most technologies are ultimately also affected by cyclical forces, incentives to inflate expectations can promote unsustainable activity such as vendor financing, and debt can be used to boost revenue growth through acquisitions.

Further, once a tech stock turns decidedly down, the corporate culture can change substantially. The company can lose its cachet with its most valuable resource — its employees. Some may become disillusioned and even embarrassed to be associated with the company. When the stock stops going up, the wealth creation machine of employee stock options also turns off. Those who have already made their fortunes no longer have a good reason to hang around and often set off on their own. It can be a long way down to the bottom.

As a result, many investors opt for riding the wave of ever-inflating expectations. The key to succeeding with this approach is to identify, at least approximately, the inflection point between peak inflated expectations and the transition to disillusionment.

Rusty Guinn from Second Foundation Partners provides an excellent case study of this process with the example of Tesla Motors [here]. From late 2016 through May 2017 the narrative surrounding Tesla was all about growth and other issues were perceived as being in service to that goal. Guinn captures the essence of the narrative:

“We need capital, but we need it to launch our exciting new product, to grow our factory production, to expand into exciting Semi and Solar brands.” In this narrative, “there were threats, but always on the periphery.”

Guinn also shows how the narrative evolved, however, by describing a phase that he calls “Transitioning Tesla”. Guinn notes how the stories about Tesla started changing in the summer of 2017:

“But gone was the center of gravity around management guidance and growth capital. In its place, the cluster of topics permeating most stories about Tesla was now about vehicle deliveries.”

This meant the narrative shifted to something like, “The Model 3 launch is exciting AND the performance of these cars is amazing, BUT Tesla is having delivery problems AND can they actually make them AND what does Wall Street think about all this?” As Guinn describes, “The narrative was still positive, but it was no longer stable.” More importantly, he warns, “This is what it looks like when the narrative breaks.”

The third phase of Tesla’s narrative, “Broken Tesla”, started around August 2017 and has continued through to the present. Guinn describes,

“The growing concern about production and vehicle deliveries entered the nucleus of the narrative about Tesla Motors in late summer 2017 and propagated. The stories about production shortfalls now began to mention canceled reservations. The efforts to increase production also resulted in some quality control issues and employee complaints, all of which started to make their way into those same articles.”

Finally, Guinn concludes, “Once that happened, a new narrative formed: Tesla is a visionary company, sure, but one that doesn’t seem to have any idea how to (1) make cars, (2) sell cars or (3) run a real company that can make money doing either.” Once this happens, there is very little to inhibit the downward path of disillusionment.

Taken together, these analyses can be used by investors and advisors alike to help make difficult decisions about tech positions. Several parts of the market depend on the fragile foundations of growth narratives including many of the largest tech companies, over one-third of Russell 2000 index constituents that don’t make money, and some of the most over-hyped technologies such as artificial intelligence and cryptocurrencies.

One common mistake that should be avoided is to react to changing conditions by modifying the investment thesis. For example, a stock that has been owned for its growth potential starts slowing down. Rather than recognizing the evidence as potentially indicative of a critical inflection point, investors often react by rationalizing in order to avoid selling. Growth is still good. The technology is disruptive. It’s a great company. All these things may be true, but it won’t matter. Growth is about narrative and not numbers. If the narrative is broken and you don’t sell, you can lose a lot of money. Don’t get distracted.

In addition, it is important to recognize that any company-specific considerations will also be exacerbated by an elemental change in the overall investment landscape. As the FT also noted, “But this month [October] can be recognised as the point at which the market shifts from being driven by liquidity to being driven by fundamentals.” This turning point has significant implications for the hype cycle: “Turn off the liquidity taps at the world’s central banks and so does the ability of the market to believe seven impossible things before breakfast.”

Yet another important challenge in dealing with tech stocks that have appreciated substantially is dealing with the tax consequences. Huge gains can mean huge tax bills. In the effort to avoid a potentially complicated and painful tax situation, it is all-too-easy to forego the sale of stocks that have run the course of inflated expectations.

As Eric Cinnamond highlights [here], this is just as big of a problem for fiduciaries as for individuals:

“The recent market decline is putting a growing number of portfolio managers in a difficult situation. The further the market falls, the greater the pressure on managers to avoid sending clients a tax bill.”

Don’t let tax considerations supersede investment decisions.

So how do the original examples of Amazon, Alphabet and Apple fit into this? What, if anything, should investors infer from their quarterly earnings and the subsequent market reactions?

There are good reasons to be cautious. For one, all the above considerations apply. Further, growth has been an important part of the narrative of each of these companies and any transition to lower growth does fundamentally affect the investment thesis. In addition, successful companies bear the burden of ever-increasing hurdles to growth as John Hussman describes [here]:

“But as companies become dominant players in mature sectors, their growth slows enormously.”

“Specifically,” he elaborates, “growth rates are always a declining function of market penetration.” Finally, he warns,

“Investors should, but rarely do, anticipate the enormous growth deceleration that occurs once tiny companies in emerging industries become behemoths in mature industries.”

For the big tech stocks, wobbles from the earnings reports look like important warning signs.

In sum, tech stocks create unique opportunities and risks for investors. Due to the prominent role of inflated expectations in so many technology investments, however, tech also poses special challenges for long term investors. Whether exposure exists in the form of individual stocks or by way of major indexes, it is important to know that many technology stocks are run more like lottery tickets than as a sustainable streams of cash flows. Risk may be perceived as a feature by some tech CFOs, but it is a bug for long term investment portfolios.

Finally, tech presents such an interesting analytical challenge because the hype cycle can cause perceptions to deviate substantially from the reality of development, adoption and diffusion. Ridley describes a useful general approach: “The only sensible course is to be wary of the initial hype but wary too of the later scepticism.” Long term investors won’t mind a winding road but they need to make sure it can get them to where they are going.

Give Me An “L” For Liquidity

After a rocky first quarter markets posted a solid second quarter and improved steadily through the third quarter. The US economy is currently rolling along at a pretty healthy pace as GDP grew at 4.2% in the second quarter and earnings have been strong. Unemployment clocked in at 3.7% for September which is incredibly low by historical standards. Indications of inflation are starting to creep into wages, materials, and transportation and many manufacturers have been able to offset them by raising prices. Through the lens of economics, investors are in good shape.

It wasn’t that long ago, however, that investors looked past a feeble economic recovery and took cheer in the large volumes of liquidity major central banks around the world infused to support financial assets. Now the time has come to reverse course. As the Economist states [here] in no uncertain terms,

“Central banks are pitiless executioners of long-lived booms and monetary policy has shifted.”

Investors who view these conditions exclusively through the lens of economics risk misreading this pivotal event: global liquidity is falling and will bring asset prices down with it.

Liquidity is one of those finance topics that often gets bandied about but it is often not well understood. It seems innocuous enough but it is critical to a functioning economy. In short, it basically boils down to cash. When there is more cash floating around in an economic system, it is easier to buy things. Conversely, when there is less, it is harder to buy things.

Chris Cole from Artemis Capital Management has his own views as to why investors often overlook liquidity [here]. He draws an analogy between fish and investors. Because fish live in water, they don’t even notice it. Because investors have been living in a sea of liquidity, they don’t even notice it. As he notes,

“The last decade we’ve seen central banks supply liquidity, providing an artificial bid underneath markets.”

Another aspect of liquidity that can cause it to be under appreciated is that it is qualitatively different at scale. A drop of water may be annoying, but it rarely causes harm. A tsunami is life-threatening. Conversely, a brief delay in getting a drink of water may leave one slightly parched, but an extended stay in the desert can also be life-threatening. We have a tendency to take water (and liquidity) for granted until confronted with extreme conditions.

One person who does not take liquidity for granted is Stanley Druckenmiller. In an overview of his uniquely successful approach to investing on Realvision [here], he describes,

“But everything for me has never been about earnings. It’s never been about politics. It’s always about liquidity.”

Not earnings or politics, but liquidity. 

While not yet extreme, the liquidity environment is changing noticeably. Druckenmiller notes,

“we’ll [the Fed will] be shrinking our balance sheet $50 billion a month,” and, “at the same time, the ECB will stop buying bonds.”

Cole describes the same phenomenon in his terms,

“Now water is being drained from the pond as the Fed, ECB, and Bank of Japan shrink their balance sheets and raise interest rates.” 

Michael Howell of CrossBorder Capital, a research firm focusing on global money flows, summarizes the situation in a Realvision interview [here]:

“In terms of global liquidity, it’s currently falling at the fastest rate that we’ve seen since 2008 …”

For some investors, the decrease in liquidity is setting off alarms. Druckenmiller points out,

“It’s going to be the shrinkage of liquidity that triggers this thing.” He goes on, “And my assumption is one of these hikes- I don’t know which one- is going to trigger this thing. And I am on triple red alert because we’re not only in the time frame, we’re in the part …” He continues, “There’s no more euro ECB money spilling over into the US equity market at the end of the year …”

Or, as Zerohedge reported [here],

“We have previously discussed the market’s mounting technical and structural problems – we believe these are a direct result of the increasingly hostile monetary backdrop (i.e., there is no longer enough excess liquidity to keep all the plates in the air).”

As the Economist notes,

“Shifts in America’s monetary stance echo around global markets,” and there is certainly evidence this is happening. Cole notes, “The first signs of stress from quantitative tightening are now emerging in credit, international equity, and currency markets. Financial and sovereign credits are weakening and global cross asset correlations are increasing.” 

Howell also chimes in, 

“You’re also seeing emerging markets central banks being forced to tighten because of the upward shock to the US  dollar.” He concludes, “Emerging market currencies are very fragile. And emerging markets stock markets are falling out of bed. These are all classic symptoms of a tightening liquidity environment.”

The governor of the Reserve Bank of India, Urjit Patel, highlighted these issues when he wrote that “Emerging markets face a dollar double whammy” in the Financial Times [here]. He describes, “The upheaval stems from the coincidence of two significant events: the Fed’s long-awaited moves to trim its balance sheet and a substantial increase in issuing US Treasuries to pay for tax cuts.” He claims that if the Fed does not recalibrate the shrinkage of its balance sheet, “Treasuries will absorb such a large share of dollar liquidity that a crisis in the rest of the dollar bond markets is inevitable.”

Although there is evidence that liquidity is tightening, it has not done so uniformly yet. The Economist describes,

“The integration of the global financial system has turned national financial systems into a vast single sea of money that rises and falls with changes in saving and investment around the world.”

As a result, there are a lot of crosscurrents that confound simple analysis.

For example, Zerohedge reports [here],

“When ‘QT’ [quantitative tightening] started in September of 2017, outstanding Fed credit initially kept growing well into 2018, largely because reverse repos with US banks ran off faster than securities held by the Fed decreased …” The story continues, “The markets evidently never ‘missed’ the liquidity tied up in these reverse repos, not least because high quality treasury collateral serves as a kind of secondary medium of exchange in repo markets, where it supports all kinds of other transactions.” 

Flows of capital into US markets have also temporarily concealed tighter conditions. Howell highlights “the huge amounts of money of flight capital that have come into the US over the last four years” and quantifies it as “something like $4 trillion.”

But the turning tides of liquidity that have been so noticeable abroad are now also starting to wash up on US shores, as John Dizard demonstrates in the FT [here]. When rates are higher in the US, foreign investors can buy US Treasuries and hedge out the currency risk. He notes, “This made it possible for non-US institutions to hold large bond positions that paid a positive rate of interest without incurring foreign exchange risk.” However, by the end of September, “the interbank market’s cross-currency ‘basis swap’ for euros to US dollars rose by 30 basis points and the cost of yen-dollar basis swaps went up by 46 bp.” Dizard summarizes the likely consequences:

“That was the end of foreigners paying for the US economic expansion. It also probably marked the end of the housing recovery.”

Additional factors further muddy the mix. Repatriation flows have disguised the decline in liquidity but will only do so temporarily. Further, China has historically been a large buyer of US assets., but that is changing too. As Howell notes, “China has shown no appetite for buying further US dollar assets over the last 18 months.” He concludes,

“We think they’ve now stopped. And they’re redeploying their foreign exchange reserves into Central Asia in terms of real infrastructure spending.”

Bill Blain points to yet another factor in his analysis of liquidity in Zerohedge [here]. He notes,

“What’s happened since Lehman’s demise has been a massive transfer of risk from the banking sector – which means, so the regulators tell us, that banks are now safer. Marvellous [sic]. Where did that risk go? Into the non-bank financial sector.”

Almost as if on cue, the FT reported on liquidity issues at a shadow bank in India [here]: “The banks’ woes have meant India has come to rely for credit growth increasingly on its shadow banking sector. Non-bank lenders accounted for 40 per cent of loan growth in the past year, according to Nomura, funding their expansion by relying heavily on the short-term debt market.”

This case serves as a useful warning signal for investors because it is reflective of the global expansion of shadow banking and because it demonstrates the kind of pro-cyclical and mismatched funding that caused so many problems during the financial crisis.

In sum, although various transient factors have created some noise, the overall signal is fairly clear. Zerohedge reports [here],

“With net Fed credit actually decreasing, an important threshold has been crossed. The effect on excess liquidity is more pronounced, which definitely poses a big risk for overextended financial markets.”

Whether or not the big risk is immediate or not is open for some interpretation. As Druckenmiller puts it, “we’re kind of at that stage of the cycle where bombs are going off,” which suggests the time is now. However, he implicitly suggests developed market investors still have some time when he says,

“And until the bombs go off in the developed markets, you would think the tightening will continue.”

Problems for developed markets are on the way though, as liquidity is likely to get a lot worse. Cole says,

“Expect a crisis to occur between 2019 and 2021 when a drought caused by dust storms of debt refinancing, quantitative tightening, and poor demographics causes liquidity to evaporate.” He also warns, “[Y]ou should be VERY worried about how the bigger implicit short volatility trade affects liquidity in the overall market… THAT is the systemic risk.”

If it is still hard to imagine how a subtle and abstract thing like liquidity could overwhelm demonstrably strong economic results, perhaps a lesson from history can provide a useful illustration.

In Ken Burns’ Vietnam War documentary, Donald Gregg from the CIA captures the strategic perspective of the war:

“We should have seen it as the end of the colonial era in southeast Asia, which it really was. But instead we saw it in Cold War terms and we saw it as a — a defeat for the free world — that was related to the rise of China — and it was a total misreading of a pivotal event — which cost us very dearly.” 

In other words, the subtle and abstract force of independence from colonial rule ultimately proved to be an incredibly powerful one in Vietnam. Many people wanted to believe something else and that led to very costly decisions.

Liquidity is playing the same role for investors today and investors who believe otherwise are also likely to suffer. The important lesson is that long-term investors don’t need to worry about getting all the day-to-day cross-currents just right. But they do need to appreciate the gravity of declining liquidity.

A recent story in P&I [here] articulated the challenge well: 

“Investors also must be more aware. Few recognize when conditions that could lead to a crisis are brewing, and those who do often misjudge the timing and fail to act to protect themselves and their clients from the full impact of the storm.” More specifically, “The best laid plans for protecting investment gains, and even the corpus of a portfolio, could fail if attention is not paid to the likely shortage of liquidity” 

This isn’t to say it will be easy to do or that the message will be uniformly broadcast. For example, after the significant market losses in the second week of October, the FT reports [here] that Vanguard notified clients via a tweet:

“You know the drill. In face of market volatility, keep calm and stay the course.”

“Keeping calm” is certainly good advice; it is even harder to make good decisions when one is wildly emotional and/or impulsive. However, “staying the course” makes some dubious assumptions. 

If a market decline is just a random bout of volatility then it doesn’t make sense to change course. But when liquidity is declining and Druckenmiller sees “bombs going off” and Cole expects “a crisis to occur between 2019 and 2021,” a market decline has very different information content.  

Staying the course would also make sense if your exposure to stocks is low and your investment horizon is very long, but the numbers say just the opposite. As Zerohedge reports [here],

“Outside of the 2000 dotcom bubble, U.S. households have never had more of their assets invested in the stock market.”

Further, as Gallup documents [here], the 65 and older demographic, the one presumably with the shortest investment horizon, has actually slightly increased their stock holdings. As Bill Blain comments,

“You’ve got a whole market of buy-side investors who think liquidity and government largesse is unlimited.” 

Investors reluctant to heed the warnings on liquidity can consider one more argument — which comes from Druckenmiller’s own actions. As he puts it,

“I also have bear-itis, because I made– my highest absolute returns were all in bear markets. I think my average return in bear markets was well over 50%.”

Based on what he is seeing now, he is ready to pounce:

“I … kind of had this scenario that the first half would be fine, but then by July, August, you’d start to discount the shrinking of the balance sheet. I just didn’t see how that rate of change would not be a challenge for equities … and that’s because margins are at an all time record. We’re at the top of the valuation on any measures you look, except against interest rates …”

So, investors inclined to dismiss concerns about liquidity and who would be hurt if stocks should go down a lot, should know that on the other side is Stanley Druckenmiller, with an itchy trigger finger, ready to put his money where his mouth is.

Wrapping up, it is difficult to capture just how fundamentally important liquidity is to investing, but Chris Cole probably does it as well as anyone: 

“When you are a fish swimming in a pond with less and less water, you had best pay attention to the currents.”

So let’s hear it for liquidity: It is a powerful force that can boost portfolios and one that can diminish them just as easily. 

Do You Believe In Magic

Like so many things, magic can have different meanings. Many times, it is regarded as something special that defies easy explanation. Sometimes it also includes elements of nostalgia as in the Lovin’ Spoonful’s “It makes you feel happy like an old-time movie.” Positive, serendipitous experiences are often described as mystical, remarkable, or “magical”.

But magic can also have negative connotations. Common phrases such as “sleight of hand” and “smoke and mirrors” emphasize the misdirection of our attention, often for the purpose of gaining advantage. Increasingly, these types of “magic” infest investment analyses and financial statements and in doing so, belie underlying fundamentals. Just as hope is not a strategy, belief is not an investment plan.

One of the great lessons of history is that it is not so much periodic downturns that can cause problems for long term investment plans so much as it is specious beliefs about supporting fundamentals that can really wreak havoc. Often, we have decent information in front of us but we get distracted and focus on, and believe, something else.

In the tech bust of 2000, for example, investors learned that some companies inflated revenues through vendor financing. Some backdated options to retain high levels of compensation for key staff. Many used alternative metrics such as growth in “eyeballs” to embellish visions of growth while de-emphasizing real progress and costs.

Similar phenomena existed in the financial crisis of 2008. Exceptionally low interest rates boosted mortgage originations above sustainable levels. “No income, no assets” (NINA) mortgages allowed a large number of people to take out mortgages who were wholly unqualified to do so. Structured credit products boosted growth by creating a perception of manageable risk.

In both cases, there was a period of time during which people thought they were wealthier than they actually were, because they had not yet learned of the deceptions. Renown economist John Kenneth Galbraith thought enough of this phenomenon to develop a theory about it. John Kay describes it [here]: “Embezzlement, Galbraith observed, has the property that ‘weeks, months, or years elapse between the commission of the crime and its discovery. This is the period, incidentally, when the embezzler has his gain and the man who has been embezzled feels no loss. There is a net increase in psychic wealth.’ Galbraith described that increase in wealth as ‘the bezzle’.”

Charlie Munger went on to expand and generalize the theory: “This psychic wealth can be created without illegality: mistake or self-delusion is enough.” Kay notes that “Munger coined the term ‘febezzle,’ or ‘functionally equivalent bezzle,’ to describe the wealth that exists in the interval between the creation and the destruction of the illusion.”

As any magician knows, there are lots of ways to create illusions. For better and worse, the current investment landscape is riddled with them. One of the most common is to create a story about a stock or an industry. Investment “stories” are nothing new. In the late 1990s and early 2000s the story was that the internet was going to transform our lives and create enormous growth. In the financial crisis of 2008 the story was that low rates and low inflation created a “goldilocks” environment for global growth. Both stories, shall we say, overlooked some relevant factors.

New stories are popping up almost as reliably as weeds after summer rains. Zerohedge highlighted [here], “Back in December 2017 it was ‘blockchain.’ Now, the shortcut to market cap riches, and a flurry of speculative buying, is simply mentioning one word: ‘cannabis’.” If you are curious what a story stock looks like, take a look at the price action of cannabis company TLRY over the last month. After you do, try formulating an argument that the market prices reflect only fundamental information and no illusion.

Daniel Davies, author of Lying for Money, points out one overlooked, but highly relevant aspect of the cannabis story [here]: “Despite the “bright future of legalized pot”, he says, “The US Securities and Exchange Commission has already prosecuted several companies which appeared to be less interested in selling weed to the public and more interested in selling stock owned by the founders for cash.” As is often the case, the whole story is often more complicated and less alluring.

Stories are conjured about more than just exciting new stocks and industries, however. Sometimes they define a narrative about the economy or the market as a whole. One such story describes the economy as finally getting back on track and resuming its historical growth trajectory of 3 – 4%. It’s a nice, appealing story with significant tones of nostalgia.

It is also a story that is less than entirely realistic, however. The FT cites JPMorgan analysis [here]: “Jacked up on tax cuts, a $1.3tn spending bill, easy monetary policy and a weakening dollar, Wall Street and the US economy have enjoyed their own version of a ‘sugar high’.”

John Hussman describes how the discrepancy between real growth and perceived growth arises [here]: “The reason investors imagine that growth is running so much higher than 2-3% annually is that Wall Street and financial news gurgles about quarterly figures and year-over-year comparisons without placing them into a longer-term perspective.” He explains, “The way to ‘reconcile’ the likely 1.4% structural growth rate of GDP with the 4% second quarter growth rate of real GDP is to observe that one is an expected multi-year average and the other is the annualized figure for a single quarter, where a good portion of that figure was driven by soybean exports in anticipation of tariffs.”

Further, he reveals that fundamental drivers have actually languished during the huge run-up in the market: “[W]hen we measure peak-to-peak across economic cycles, annual S&P 500 earnings growth has averaged less than 3% annually since 2007, while S&P 500 revenue growth has averaged less than 2% annually.”

Tax cuts provide an especially interesting component of the investment landscape. Not only did the cuts in corporate tax rates quickly and substantially increase earnings estimates in financial models, they also provided a powerful signal to many investors that finally there is a business-friendly administration in the White House.

The reality, again, is more complicated and less sanguine, however. For one, the tax cuts came along with higher fiscal deficits, the cost of which will be borne in the future. Secondly, and importantly, the tax cuts did not come as a singular benefit but rather as part of a “package” of public policy.

The FT reported [here]: “At a meeting in Beijing late last year, US business executives tried to explain their concerns about imposing tariffs on Chinese exports to a group of visiting Trump administration officials.” It continued, “The meeting was held after President Donald Trump’s state visit to Beijing and the congressional passage of a large tax cut for corporate America. The executives, who had expected a polite exchange of views, were shocked by the officials’ robust response. One of the attendees reported that they were told, “your companies just got a big tax cut and things are going to get a lot tougher with China — fall in line”.

The attendee summarized, “The message we are getting from DC is ‘you’re just going to have to buck up and deal with it’.” Lest this be perceived as a one-off misunderstanding, it is completely consistent with Steve Bannon’s analysis of the situation reported [here], “Donald Trump may be flexible on so much stuff, but the hill he’s willing to die on is China.”

While “story stocks” and “tax cuts” and record growth” tend to steal headlines, they aren’t the only things that can engender perceptions that differ from reality. Sometimes the most powerful sources of misunderstanding are also the most mundane — because they garner so little attention.

While accounting in general is often overlooked because the subject is dry and technical, it also provides the measures and rules of the game by which financial endeavors are evaluated. But those rules, their enforcement, and the economic landscape have changed considerably over the years.

One big issue is the increasing use of non-GAAP metrics in earnings presentations. As I discussed in a blog post [here], the vast majority of S&P 500 firms present non-GAAP metrics in their earnings releases. Further, as the FT reported, “Most of those non-GAAP numbers make the company look better. Last year a FactSet study found that the average difference between non-GAAP and GAAP profits reported by companies in the Dow Jones Industrial Average was 31 per cent, up from 12 per cent in 2014.” A key takeaway, I noted, is that “non-GAAP financial presentations can play a significant role in cleaving perception from underlying investment reality.”

Another issue is that intellectual capital presents special accounting challenges and is far more important to the economy today than it used to be. The Economist reports [here]: “Total goodwill for all listed firms world-wide is $8tn, according to Bloomberg. That compares to $14tn of physical assets. Dry? Yes. Irrelevant? Far from it.” Further, one-half of the top 500 European and top 500 American firms by market value “have a third or more of their book equity tied up in goodwill.”

The Economist also reports, “Just as the stock of goodwill sitting on balance-sheets has become vast, so have the write-downs. For the top 500 European and top 500 American firms by market value, cumulative goodwill write-offs over the past ten years amount to $690bn. There is a clear pattern of bosses blowing the bank at the top of the business cycle and then admitting their sins later.” Because “the process of impairment is horrendously subjective,” the numbers for reported assets have become less defensible.

In addition, investors need to be on the watch for even more than clever numbers games and accounting obfuscation. The reliability of corporate audits has also been declining for a variety of reasons — which should reduce investors’ confidence in them.

As the FT reports [here], the original purpose of audited numbers was “to assure investors that companies’ capital was not being abused by overoptimistic or fraudulent managers.” However, Sharon Bowles, former chair of the European Parliament’s economic and monetary affairs committee, assesses, “But the un-anchoring of auditing from verifiable fact has become endemic.”

An important part of the “un-anchoring” process involves the increasing acceptance of fair value accounting, which was implemented (ostensibly) to provide more useful information to investors: “From the 1990s, fair values started to supplant historical cost numbers in the balance sheet, first in the US and then, with the advent of IFRS accounting standards in 2005, across the EU. Banking assets held for trading started to be reassessed regularly at market valuations. Contracts were increasingly valued as discounted streams of income, stretching seamlessly into the future.” “The problem with fair value accounting,” according to one audit professional, “is that it’s very hard to differentiate between mark-to-market, mark-to-model and mark-to-myth.” Yet another case of diminished verifiability.

At the same time as the reliability of audited numbers was decreasing, so too was the accountability for the audits. “[A]uditing firms have used their lobbying power to erase ever more of the discretion and judgment involved in what they do. Hence the explosion of ‘tick box’ rules designed to achieve mechanistic ‘neutral’ outcomes.” Professor Karthik Ramanna calls it a process “that is tantamount to a stealthy ‘socialisation or collectivisation of the risks of audit’.” In other words, don’t expect auditing firms to pay when their work fails, expect investors to pay.

To make matters worse, “There is also the perception that the dominant Big Four, which are now profit-hungry professional services conglomerates, are not that worried about audit quality anyway.” Erik Gordon, a professor at the University of Michigan Ross School of Business, highlights, “They have been able to do better with low quality than with high quality work.”

Jean-Marie Eveillaird, who accumulated an impressive record as an investment professional, summarized the effects of accounting changes in a RealVisionTV interview [here]: “[M]ost accounting numbers are estimates. And indeed, what happened in the ’90s, where there are a number … of chief financial officers decided that- with the help of some shop lawyers- decided that you could observe the letter of the regulations, and at the same time betray the spirit of the regulations, and you wouldn’t go to jail for that.”

In sum, there are a lot of different ways in which illusions about financial performance can be created and many have been getting progressively worse. Notably, they don’t even include the examples of intentional wrongdoing such as the Enron or Madoff frauds. Munger is right, “psychic wealth can be created without illegality: mistake or self-delusion is enough.”

The one thing all these examples have in common is that they are all essentially category errors. As Ben Hunt tells us [here]: “What’s a category error? It’s calling something by the wrong name.” In particular, a Type 1 category error is also called a false positive.

One opportunity for investors is pretty straightforward: Just don’t carelessly and uncritically accept a story as real fundamental information. Don’t call a narrative a fact. Don’t assign 100% value to numbers enshrouded with uncertainty. As Davies highlighted in regard to cannabis investors, “What they are not doing is asking the basic questions of securities analysts.” So ask the basic questions.

Davies also provides some useful clues as to when investors should be on special alert: “The way to identify a story-stock craze — overblown enthusiasm for a sector where there is a good tale to tell about its future — is if the justification for buying into the new hot venture is big on vision and short on detail.” For example, is the earnings presentation dominated by bullet points describing qualitative achievements or by revenue and earnings numbers accompanied by substantive explanations? If you are going to get involved with a story, a useful rule of thumb is: “the time to buy is either when very few people have heard the story, or when everyone has heard it and everyone hates it.”

In addition, the concept of the febezzle presents a fairly useful model for thinking about investment risk. Asset valuations can be thought of as being comprised of two separate components: One is based on fundamentals and reflects intrinsic value while the other is based on the febezzle and reflects illusory, or psychic, wealth. An important consequence of this is that when the illusion is shattered, the febezzle element vanishes and there is virtually nothing to prevent a quick adjustment to intrinsic value. In other words, the febezzle is much more of a binary (either/or) function than a linear one.

This matters for long term investors who are most concerned about creating a very high probability of achieving their long-term investment goals. Not only does the febezzle component subject their portfolios to sudden, substantial, and effectively permanent drawdowns, but it also defies conventional investment analysis. It is exceptionally hard to confirm that a popular illusion is being shattered, especially before everyone else does.

One signal of change, however, is volatility. Using language that closely parallels “destruction of the illusion,” Chris Cole, from Artemis Capital Management, explains [here], “Volatility is always the failure of medium… the crumpling of a reality we thought we knew to a new truth.” In this context, the absurdly low volatility of 2017 was ripe breeding ground for illusions. Investors believed. Higher volatility in 2018, however, suggests that some of those beliefs are becoming increasingly fragile.

Perhaps the greatest illusion of all is the belief that continued market strength confirms strongly improving fundamentals. While recent economic performance has been good, Cole rejects this view and offers an alternative explanation: “When the market is dominated by passive players prices are driven by flows rather than fundamentals.” In other words, strong market performance mainly means that more people are piling into passive funds. By doing so, they have the dangerously intoxicating effect of propagating the illusion of commensurate fundamental strength.

None of this is to suggest that stock fundamentals are strong or weak, per se. Rather, it is to suggest that, for several reasons, stock prices do not comport well with the reality of underlying fundamentals; there is less than meets the eye. As Ben Hunt warns, “It’s the Type 1 [false positive] errors that are most likely to kill you. Both in life and in investing.” If calling something real when it is not can kill you, it is hard to understand why so many people are so tolerant of mistakes and self-delusion when it comes to their investments. The question is simple: Can you handle the truth, or do you believe in magic?

15 Bullish Assumptions

If all goes well for nine more months, the post-financial crisis economic expansion will become the longest economic expansion in recent U.S. history. The U.S. stock markets are also on a tear, having just become the longest bull market since World War II. Regardless of your views about these trends continuing, the fact of the matter is that they are both much closer to ending than a beginning. Ray Dalio recently quantified this continuum, declaring that the economy is in the 7th inning, implying another one to three years of continuation.

While the markets can certainly keep motoring ahead, as Dalio and many others expect, there are some factors supporting the bullish case that investors should contemplate.

While this list is not by any means exhaustive, it does offer many of the most important assumptions supporting the market and some details to provide context and clarity.

1. Corporate managers have become so adept at their jobs that profit margins and equity valuations will remain at, or rise from current nearly unprecedented levels.

  • Market Cap : GDP – 99% historical percentile according to Goldman Sachs Investment Research (GS)
  • Enterprise Value-to-Sales – 97% historical percentile (GS)
  • Shiller’s CAPE 10 – 90% historical percentile (GS)
  • Price-to-Book Value – 89% historical percentile (GS)
  • John Hussman’s margin-adjusted CAPE – Record high including 1929 and 1999.
  • Expected 10 year S&P 500 return as depicted in our article Allocating on Blind Faith is negative
  • GMO 7-Year real return forecast -4.90% for U.S. large cap, -2.30% for U.S. small cap and -3.80% for U.S. high quality
  • Doug Short’s (Advisor Perspectives) Average of the Four Valuation Indicators is 117% overvalued as shown below and nearly 3 standard deviations from the mean

2. Bond yields will remain historically low and the 30-year downward trend will not reverse

  • The 10-year U.S Treasury yield is slightly above a key 30-year resistance line at 3.11%
  • The 30- and 10-year U.S. Treasury yields are testing multi-year highs of 3.23% and 3.12% respectively
  • Since the lows of 0.70% in November 2016, the 2-year U.S. Treasury yield has risen 300% to 2.80%
  • 3-month LIBOR, a key global interest rate for floating rate financing, has risen 282% from 0.62% in June 2016 to the current level of 2.37%
  • Implied volatility on Treasury note futures is at historically low levels indicating extreme complacency
  • GMO’s 7-Year real return forecast is -0.20% for US bonds

3. Future Fed rate hikes and possible yield curve inversion will not cause economic contraction

  • The Federal Reserve (Fed) currently expects to hike rates an additional 1.50% bringing the Fed Funds rate to 3.50%, by the end of 2019
  • The 2s/10s U.S. Treasury yield curve stands at 26 basis points and has flattened 110 bps since December 2016
  • The Fed appears increasingly comfortable with inverting the yield curve “Over the next year or two, barring unexpected developments, continued gradual increases in the federal funds rate are likely to be appropriate to sustain full employment and inflation near its objective.” – Lael Brainard – Fed Governor
  • The last five recessions going back to 1976 were all preceded by a 2s/10s yield curve inversion
  • All six recessions going back to 1971 were preceded by Fed interest rate hikes. Two exceptions where rates hike did not lead to recession were in 1983-84 and 1994-95

4. Weakness in interest rate sensitive sectors will not have a dampening effect on the economy or markets

  • Total automotive vehicle sales have declined 7.8% since the Fed started raising rates
  • New and existing home sale have steadily declined since November 2017 as mortgage rates risen by over 0.50% over the this period

5. Wage growth will not accelerate further thus stoking inflationary pressures

  • Employees gaining leverage over employers as jobless claims and the unemployment rate both stand near 50-year lows
  • Wage growth is at a 9-year high
  • Spike in the “quit rate” to 18-year high suggests more wage growth pressure coming

6. Annual fiscal deficits over $1 trillion will power economic growth with no consequences

  • Current deficit equals 4.4% of GDP and is projected to rise to 5.5% in 2019 ($1.2T)
  • Recent projections of budget deficits have been revised aggressively higher
  • Interest expense rose 10% this past fiscal year and now accounts for $500 billion spending. To put that in context, the defense budget for 2019 is $717 billion.

7. Domestic political turmoil will not roil markets or inhibit consumer and corporate spending habits

  • Mueller’s findings
  • Mid-term elections
  • The potential for the Democrats to take a majority in the House and/or Senate and advance calls for Trump impeachment as well as impede further tax reform and possibly other corporate-friendly legislation

8. Possible additional U.S. dollar appreciation and the resulting financial crises engulfing many emerging markets will not cause financial contagion or economic slowdown to spread to developed nations or to the world’s largest banks 

9. Geopolitical turmoil will not roil markets or stunt global growth and trade

  • Brexit
  • Italy
  • Iran
  • Russia
  • Syria
  • Turkey
  • Brazil
  • Argentina
  • Venezuela
  • South Africa

10. The performance of U.S. stocks can diverge from the rest of the world

  • The following developed markets are all negative year to date and have a 50-day moving average below its 200-day moving average
    • United Kingdom -5%
    • Japan -3%
    • Hong Kong -9%
    • South Korea -6%
    • Germany -6%
  • World Index EFA (blue) vs. S&P 500 (orange) (Graph below courtesy Stockcharts.com)

11. Trade wars and increasing tariffs benefit the economy and global markets

  • China
  • Canada
  • Mexico
  • Europe
  • Japan

12. Corporations, via stock buybacks, will continue to be the predominant purchaser of U.S. stocks

  • Buybacks will reach a record high in 2018 (Graph below courtesy Trim Tabs)
  • Corporate debt can continue to rise to fund buybacks despite rising interest rates and risk of credit downgrades
  • Corporate debt as a percentage of GDP is now the highest on record 

13. Liquidity in the markets will remain plentiful

14. Central Banks can permanently prop up asset prices if they are to fall

 And…The most important factor long-term bulls must assume to be true:

15. This time is different

A Walking Contradiction – Warren Buffett

I have ways of making money you know nothing about.” – John D. Rockefeller

Contradiction- A situation in which inherent factors, actions, or propositions are inconsistent or contrary to one another- Merriam-Webster’s Dictionary

Investors and the media can’t seem to get enough of Warren Buffett. They hang on his every word as if he was sent from the heavens offering divine words of wisdom. Unfortunately, Buffett is a mere mortal, and like the rest of us, he tends to promote ideals that benefit his self-interests over yours.

The purpose of this article is not to degrade Buffett, as we have a tremendous amount of respect for his success and knowledge. In this article we look at a few recent statements and actions of Buffett’s to highlight some contradictions that lie in their wake. Our conclusion is that it is far better for investors to watch what “The Oracle” does as an investor rather than hang on his words.

This article also serves as a reminder that the most successful investors think and act for themselves. These investors are not easily persuaded to take action from others, even from the best of the best.

Buffett on Stock Buybacks

Warren Buffett has, for a long time stated that corporate stock buybacks should only occur when the following two conditions are met:

“First, the company has available funds — cash plus sensible borrowing capacity — beyond the near-term needs of the business and, second, finds its stock selling in the market below its intrinsic value, conservatively calculated.”

The quote above was from nearly 20 years ago, however based on more recent quotes his thoughts about buybacks remain the same. The following comes from a recent CNBC article:

At the 2016 meeting, Buffett said that buyback plans were getting “a life of their own, and it’s gotten quite common to buy back stock at very high prices that really don’t do the shareholders any good at all.”

“Can you imagine somebody going out and saying, we’re going to buy a business and we don’t care what the price is? You know, we’re going to spend $5 billion this year buying a business, we don’t care what the price is. But that’s what companies do when they don’t attach some kind of a metric to what they’re doing on their buybacks.”

Buffett added: “You will not find a lot of press releases about buybacks that say a word about valuation,” but he clearly believes they should.

Knowing his opinion of buybacks, let’s explore his own firm, Berkshire Hathaway (BRK/A). It turns out BRK/A is now “seriously considering” buying back their own stock. Given their cash and cash equivalent hoard of over $320 billion, such an action would seem to fit right in line with Buffett’s first qualification noted above. Unfortunately, the stock is far from cheap and fails his second test. Currently BRK/A trades at a price to book value of 145% and at a price to earnings of 28 (28 is considered a very high multiple for a company that has consistently grown earnings at a 4% clip over the last 8 years). Altering the firm’s buyback policy would require relaxing or eliminating Buffet’s price-to-book value requirement of “below 120%”.

When stock can be bought below a business’s value, it is probably the best use of cash.”

The bottom line: Buying back BRK/A at a price to book value of 145% and P/E of 28 is clearly not the “best use of cash”, and the market certainly is not valuing BRK/A at “below intrinsic value.” To counter his contradiction, it would be nice if he either came out and said he has changed his opinion about the optimal factors promoting buybacks, or stated that BRK/A does not have reasonable opportunities to grow earnings and returning cash to shareholders is the best option.

In the end, Buffett is unreliable on this topic, and BRK/A does not make a habit of returning cash to shareholders. In the long history of the firm, they have only conducted a few very small share buybacks and only once issued a dividend of $0.10 in 1967. It seems to us he is feeding the buyback frenzy occurring in the market today and will likely avoid meaningful buybacks in BRK/A.

Buffett on Valuations : Market Cap to GDP

One of the most widely followed equity valuation gauges is what is commonly referred to as the Buffett Indicator. The indicator, Buffett’s self-professed favorite, is the ratio of the total market capitalization to GDP. Currently, as shown below, the indicator stands at 132% and dwarfs all prior experiences except the final throes of the Tech boom in the late 1990’s.

The following section highlighted in orange is from a recent article entitled Would You Rather with Warren Buffett by Eric Cinnamond:

Question to Warren Buffett: “One of the things you look at is the total value of the stock market compared to GDP. If you look at that graph it’s at a high point, the highest it’s been since the tech crash back in the late 90’s. Does that mean we’re overextended? Is it a better time to be fearful rather than greedy?”

Eric Cinnamond (EC): What a great question, I thought. I couldn’t wait for his answer. Let him have it Warren! It’s your favorite valuation metric flashing red – tell everyone how expensive stocks have become! I was very excited to hear his response.  Buffett replied,

Warren Buffett (WB): “I’m buying stocks.”

EC: But in 1999 when this valuation was actually less than today he said this…

WB: “Let me summarize what I’ve been saying about the stock market: I think it’s very hard to come up with a persuasive case that equities will over the next 17 years perform anything like–anything like–they’ve performed in the past 17. If I had to pick the most probable return, from appreciation and dividends combined, that investors in aggregate–repeat, aggregate–would earn in a world of constant interest rates, 2% inflation, and those ever hurtful frictional costs, it would be 6%. If you strip out the inflation component from this nominal return (which you would need to do however inflation fluctuates), that’s 4% in real terms. And if 4% is wrong, I believe that the percentage is just as likely to be less as more.”

Our take: Stocks are far from cheap. Based on Buffett’s preferred valuation model and historical data, as depicted in the scatter graph below, return expectations for the next ten years are as likely to be negative as they were for the ten-year period following the late ‘90’s. To read more about this graph click on the following link –Allocating on Blind Faith.

The article provides a glimpse of the value added in our new service RIA Pro.

The more compelling question for Mr. Buffett is not whether or not he generally likes stocks but which stocks he likes. As a value investor, he ardently discriminates on price within the context of which companies operate with unique pricing power. This characteristic, more than any other, best defines Buffett’s investment preferences. He routinely speaks about the competitive “moat” that he likes for his companies to have. Understanding what he means by that is important. The following quote captures the essence:

“If you’ve got a good enough business, if you have a monopoly newspaper or if you have a network television station, your idiot nephew could run it.”

Keyword: Monopoly. That is how a company retains pricing power. The empire of the perceived champion of American capitalism and free markets is built on monopolistic companies. Yes, I think we can add that to the list of contradictions.

Buffett on Bullish Market Prospects

The following recent quotes are from a CNBC interview of Mr. Buffett on June 7, 2018 about bullish market prospects:

  • “The decision on the stock market should be made independent of the current business outlook. When you should buy stocks is when you think you’re getting a lot for your money not necessarily when you think business is going to be good next year. The time to buy stocks in America generally has been always with a few exceptions because the long-term outlook is exceptionally good and I don’t think you should buy stocks based on what you think the next 6 months or year is going to bring.”
  • “I like buying stocks. I’m a net buyer.”
  • “I’m no good at predicting out 2 or 3 or 5-years from now although I will say this, there’s no question in my mind that America’s going to be far ahead of where we are now, 10, 20 and 30-years from now.”

If the economic outlook is so constructive, and you can afford and are willing to hold investments for long periods, why does BRK/A hold so much dry powder as shown below?

A growing war chest of over $300 billion in cash certainly appears to be inconsistent with his stated outlook.

Buffett’s True Concerns

The general platitudes of market and economic optimism Buffett shares in his CNBC interviews, letters to investors and shareholder meetings often run counter to the actions he has taken in his investment approach. Not only does he seek out companies with monopolistic characteristics and pricing advantages, he seems to be increasingly positioning to protect against imprudent central bank policies that have fueled this bull market.

His purchase of Burlington Northern Santa Fe (BNSF) railroad is an acquisition of hard assets. Control of BNSF affords a multitude of other benefits in the form of rights of way and adjacent mining rights, and it allows him to move other energy resources he has been steadily accumulating as well.

Four of his top ten holdings are financial services companies such as Wells Fargo (WFC), Bank of America (BAC), and American Express (AXP). Additionally, he is also known to hold large offshore assets in Asia and elsewhere which generate non-dollar profits that can be held tax-free.

The common theme behind these holdings, besides the fact that they each have their monopolistic “moat”, is that they serve as a firebreak against an uncontrolled outbreak of inflation. If monetary policy sparked serious inflation, the hard assets he owns would skyrocket in value, and the off-shore holdings in foreign currencies would be well protected. As for the financial institutions, inflation would effectively minimize the costs of their outstanding debt, while their assets rise in value. Further, their net interest margin on new business would likely increase significantly. All of that would leave BRK/A and Buffett in a position of strength, allowing them to easily buy out bankrupt competitors from investors at pennies on the dollar.

Summary

Warren Buffett is without question the modern day icon of American investors. He has become a living legend, and the respect he receives is warranted. He has certainly been a remarkable steward of wealth for himself and his clients. Where we are challenged with regard to his approach, is the way in which he shirks his responsibilities as a leader. To our knowledge, he is not being overtly dishonest but he certainly has a way of rationalizing what appears to be obvious contradictions. Because of his global following and the weight given to each word he utters, the fact that his actions often do not match the spirit of his words is troubling.

Reflecting back on the opening quote from John D. Rockefeller, Buffett has ways of making money that we know nothing about, and he seems intent on obscuring his words to make sure we don’t figure it out. Putting that aside, Warren Buffett did not amass his fortune by following the herd but by leading it.

The Most Important Asset Class In The World

Here we are, ten years after the bankruptcy of Lehman Brothers, and one would be hard pressed to find evidence of meaningful lessons learned.

“As long as the music is playing, you’ve got to get up and dance,” – Chuck Prince, Citigroup

Chuck’s utterance now sounds more like a quaint remembrance than a stark reminder. Ben Bernanke’s proclamation also sounds more like an “oopsie” than a dangerous misjudgment by a top official.

“We believe the effect of the troubles in the subprime sector on the broader housing market will be limited and we do not expect significant spillovers …” 

One of the most pernicious aspects of the financial crisis for many investors was that it seemed to come out of nowhere. US housing prices had never declined in a big way and subprime was too small to show up on the radar. Nonetheless, the stage was set by rapid growth in credit and high levels of debt. Today, eerily similar underlying conditions exist in the Chinese residential real estate market. Indeed, a lot of investors might be surprised to hear it called the most important asset class in the world.

China certainly qualifies as important based on rapid credit growth and high levels of debt. The IMF’s Sally Chen and Joong Shik Kang concluded [here],

“China’s credit boom is one of the largest and longest in history. Historical precedents of ‘safe’ credit booms of such magnitude and speed are few and far from comforting.”

The July 27, 2018 edition of Grants Interest Rate Observer assesses,

“Following a decade of credit-fueled stimulus, China’s banking system is the most bloated in the world.”

Jim Chanos, the well-known short seller, adds his own take on RealvisionTV [here], “So comparing Japan [in the late 1980s] to China, I would say Japan was a piker compared to where China is today. China has taken that model and put it on steroids.”

One of the lessons that was laid bare from the financial crisis of 2008 (and from Japan in the 1980s) was the degree to which easily available credit can inflate asset prices. This is especially true of real estate since it is so often financed (at least partially) with debt. The cheaper and easier credit is to attain, the easier it is to buy homes (or any real estate), and the higher prices go.

These excesses provide the foundation for one of the bigger (short) positions of Jim Chanos. He describes:

“China is building 20 million apartment flats a year. It needs about 6 to 8 to cover both urban migration and depreciation of existing stock. So 60% of that 25% is simply being built for speculative purposes, for investment purposes. And that’s 15% of China’s GDP of $12 trillion. Put another way, it’s about $2 trillion. That $2 trillion is 3% of global GDP.”

And so I can’t stress enough of just how important that number is and that activity is to global growth, to commodity demand, and a variety of different things. It [Chinese residential real estate] is the single most important asset class in the world.”

Chanos is not the only one who sees building for “speculative purposes” as an impending problem. Leland Miller, CEO of China Beige Book, describes in another RealvisionTV interview [here],

“The heart of the Chinese model is malinvestment. It’s about building up non-performing loans and figuring out what to do with them.”

The WSJ’s Walter Russell Mead captured the same phenomenon [here],

“Chinese leaders know that their country suffers from massive over-investment in construction and manufacturing, [and] that its real-estate market is a bubble that makes the Dutch tulip frenzy look restrained. Chinese debt is the foundation of the system.”

Increasingly too, household debt is becoming a problem. As the Financial Times reports [here], apparently China’s young consumers have:

“…rejected the thrifty habits of their elders and become used to spending with borrowed money. Outstanding consumer loans — used to buy cars, holidays, household renovations and other household goods — grew nearly 40 per cent last year to Rmb6.8tn, according to the Chinese investment bank CICC. Consumer loans pushed household borrowing to Rmb33tn by the end of 2017, equivalent of 40 per cent of gross domestic product. The ratio has more than doubled since 2011.”

Again, there are striking parallels to the financial crisis in the US. As Atif Mian and Amir Sufi report in their book, House of Debt, “When it comes to the Great Recession, one important fact jumps out: The United States witnessed a dramatic rise in household debt between 2000 and 2007—the total amount doubled in these seven years to $14 trillion, and the household debt-to-income ratio skyrocketed from 1.4 to 2.1.”

The inevitable consequence of unsustainable increases in household debt is that eventually those households will have to cut spending. When they do, “the bottom line is that very serious adjustments in the economy are required … Wages need to fall, and workers need to switch into new industries. Frictions in this reallocation process translate the spending decline into large job losses.”

In addition, just as the composition of consumers of debt affects the ultimate adjustment process, so too does the composition of its providers. For example, debt provided outside of the conventional banking system, such as from shadow banks, is not subject to the same reporting or reserve requirements.

Once again, the landscape of Chinese debt is problematic. Russell Napier states,

“The surge in non-bank lending in China has clearly played a key role in the rise of the country’s debt to GDP ratio and also its asset prices.”

Zerohedge adds [here] that the Chinese central government has become “alarmed at its [shadow banking’s] vast scale, and potential for corruption.”

Further, nebulous practices are not confined to the “shadows” in China. The FT reports [here],

“These [small] banks are quite vague and blurry when it comes to investment receivables … There’s so much massaging of the balance sheet, and they won’t tell you about their internal manoeuvrings.”

As it happens, “Problems at small banks matter because their role in China’s financial system is growing.” While China surpassed the eurozone last year to become the world’s largest banking system, “small and mid-sized banks have more than doubled their share of total Chinese banking assets to 43 per cent in the past decade.”

Nor is the lack of transparency confined to the financial system; it also extends to the entire economy. Miller describes,

“We’re constantly asked about how good Chinese data are. Is it all bad? It’s all bad, but it’s bad and different variations.” 

Chanos shared his opinion as well:

“As much as the macro stuff has intrigued me … what’s so interesting about China is the lower down you get, the more micro you get, the worse it looks, in that the companies don’t seem to be profitable, the accounting is a joke.”

Miller makes clear what the challenge is:

“[China] is the second largest economy in the world. This is probably the most mysterious big economy in the world. And people have been so willing to work on it based on guestimates.”

Normally, investors prefer certainty and discount uncertainty. The pervasive lack of discipline and due diligence echoes that of the structured debt products of the financial crisis.

Just as in the financial crisis, all of these excesses and shortcomings are likely to have consequences. Many of them will sound familiar [here]:

“[A] crisis of some kind is likely. The salient characteristics of a system liable to a crisis are high leverage, maturity mismatches, credit risk and opacity. China’s financial system has all these features.”

That said, the “flavor” of China’s crisis will depend on uniquely Chinese characteristics. Miller identifies an important one:

“I think the problem is that people didn’t understand that this is not a commercial financial system. That’s one of the major takeaways we stress all the time. This [China’s] is not a commercial financial system. What that means is when the Chinese are threatened, they can squash capital from one side of the economy to the other.”

In other words, China has substantial capability to manage liquidity and contagion risks.

As a result, according to Miller,

“We don’t spend a lot of time worrying about an acute crisis. If China falls and China does have the hard landing that a lot of people predicted, it’s not going to look like it did in the United States or in Europe. You have a state system, a state-led system in which almost all the counter-parties are either state banks or state companies. They’re not going to have the same freeze-up of credit that you did in some of these other Western economies.”

That said, there are still likely to be severe consequences. Miller reports,

“China has gotten themselves into a real difficult situation, because you have an enormous economy awash in credit that is leading to lesser and less productivity based on that capital. And that is why, rather than some sort of implosion, which could happen, or any type of miraculous continued prosperity indefinitely — we think that China’s economy is, for the most part, headed towards stasis.” More specifically he says, “So I think that we’re heading towards a Chinese economy which is going to slow down quite dramatically when we’re talking about 10, 15 years time.”

Indeed, it appears that process has started. As noted [here],

“Housing sales in China will peak this year and then begin a long-term decline, an inflection point that will drag on growth in the construction-heavy economy and hit global commodity demand, say economists.”

Throughout the process, Miller expects China to pursue a policy agenda designed to get the country “on a more sustainable track.” In particular, “that means cracking down on some of these bad debt problems, cracking down on shadow lending, becoming more transparent, injecting risk and failure into the system, and trying to build a stronger economy from that.” He is careful to note, however, “But it’s not easy.”

Neither will it be easy for investors to judge the puts and takes of various policy measures in a dynamic and opaque system. Henny Sender at the FT warns international investors [here]

“To take heed as Beijing continues a war against non-bank lenders and fintech companies that is tightening liquidity and spooking investors in mainland China.”

The FT also notes [here],

“New rules for recognising bad loans in China are set to obliterate regulatory capital at several banks” which will disproportionately affect small and mid-sized banks. Further, as reported [here], “the paring back of a state subsidy programme that provided Rmb2tn ($300bn) in cash support to homebuyers since 2014 is adding to structural factors weighing on the market.”

The good news is that investors can take several lessons from China and its residential real estate market. The first is that, like the US subprime market was, the Chinese real estate market is understated and under-appreciated. Perhaps it is because the numbers don’t seem that big. Perhaps it is because so few people have much clarity at all on what the numbers really are. Or perhaps it is just that people are making enough money that they don’t really care to look too hard. Regardless, just like with subprime in the US a decade ago, there are real problems.

Second, those problems will have consequences; investors should expect spillovers. As excesses in the country are unwound, the slowdown in Chinese economic growth will be felt around the world. China has driven global growth for at least a couple of decades. Further, residential real estate, with its strong economic multiplier and high degree of speculation, has been the rocket fuel for that growth. Reversal of those trends will feel like a substantial headwind. Further, lest US investors feel smug at the prospect of Chinese troubles, David Rosenberg warns [here],

“There is not a snowball’s chance in hell [the Chinese weakness] will not flow through to the US stock market.”

Where does all of this leave Chanos?

“Interestingly, we’re less short China now than we have been in eight years in our global portfolio. Because the rest of the world’s catching up. Although China’s been on a tear recently, Chinese stocks over the eight years are basically flat. And I’ve noticed that some of the other stocks have sort have tripled.”

Fundamentals are important, but so are prices paid.

A major complication of figuring out China will be determining the degree to which it’s domestic policy agenda influences actions on tariffs and trade and currency. Almost Daily Grants reported the findings of Anne Stevenson-Yang, co-founder of J Capital Research, on July 27, 2018:

“China’s credit-saturated economy … is the primary force behind the recent gyrations in FX. The reality is that China’s currency is most intimately connected, as with any currency, to the domestic economy – debt, asset prices, real estate prices, and efficiency gains and losses rather than just trade.”

In other words, don’t get distracted by the smaller stuff.

Despite all of these challenges, investors are not without tools to monitor the situation, however. Russell Napier reports [here],

“In general the copper price provides a good lead indicator to the market’s assumptions in relation to global growth. When it [the copper price] weighs the negative impact from an RMB devaluation and the positive impact from a Chinese reflation … the current indications are more negative for global growth than positive.”

The FT goes even further [here]:

“The metal [copper] is giving western investors a clear signal to sell risk assets or at least reduce their portfolio weighting.”

Perhaps the biggest lesson of all is that increasingly we live in a world of debt-fueled growth that shapes the investment proposition of financial assets. That means business cycles are increasingly overwhelmed by credit cycles. It means wider swings in financial assets — from euphoric highs to catastrophic lows. When the debt spigot turns off, it means the only “safe” assets are cash and precious metals. When the sparks fly, it’s hard to tell where they might land. And it means that whichever market has the highest debt and the fastest credit growth will be the “most important asset class in the world”.

Right now, that is Chinese residential real estate.

The Elephant In The Room: Share Repurchases

In a famous Indian parable [here] a group of blind men encounter an elephant. Since each blind man encounters a different part of the elephant (e.g., the tusk, the leg), there is a great deal of disagreement as to what the elephant is. The moral of the story is that “humans have a tendency to project their partial experiences as the whole truth.”

Projecting partial experiences as the whole truth has become standard practice in the arena of investing. Explanations for continued strength in stock prices range from strong economic growth to contained inflation to lower taxes to technology. It all depends on the partial experiences of the observer. There is, however, a different and yet dominant influence on stock prices that rarely gets the attention it deserves. That proverbial “elephant in the room” is share repurchases.

Of course no-one is claiming that economic factors are not critical determinants of share values — there is no disputing that. Actual prices, however, are determined by markets and as such, represent a form of competition between buyers and sellers. When buyers compete more aggressively, prices go up, and when sellers dominate the prices go down. In short, stock prices, like so many economic goods, are determined by supply and demand.

Based on this relationship and on recent positive price action, it is easy to infer that the bulls are winning. Further, it is tempting to associate this positive result with strong economic growth (at least in the US), low unemployment, low inflation, and lower corporate taxes. All of this feeds an alluring narrative: Finally, things are getting back to normal.

But the bears are not unworthy competitors. As John Authers reports in the Financial Times [here], trends in the expected return assumptions used by pension plans are a good indicator of sentiment towards the markets. Here the evidence is decidedly pessimistic: “Every single year of this young millennium, assumed pension returns have fallen — from 9.2 per cent in 2000 down to 6.5 per cent a year.” He adds that, “AQR publishes regular forecasts for five- to 10-year returns, and predicts real returns of 4 per cent on US equities and 4.7 per cent on emerging markets. Other assets would be weaker.” Other credible estimates are even lower.

As a result, there seems to be something of a paradox. Despite what seems to be a fairly evenly matched competition between bulls and bears, the market has continued to rise since its decline in February. Why would market prices keep going up even when it seems like supply and demand are pretty evenly matched?

The answer is partly illuminated by an old economics lesson. Markets do a pretty good job of determining prices based on the important assumption that there is a fairly diverse group of buyers and sellers and that each acts in its own economic self-interest. In real life, however, this is not always the case. In a prior blog post [here], for example, I pointed out that central banks have been buying significant quantities of stocks for purposes of public policy rather than as an effort to realize attractive financial returns.

While central banks have certainly distorted stock prices with their purchases, their impact pales in comparison to that of companies repurchasing their own shares. The scale has been mind boggling. As the FT notes [here],

“Between 2012 and 2015, US companies acquired $1.7tn of their own stock, according to Goldman Sachs.”

Calcbench also conducted a survey of common stock repurchases over 25 quarters of data through Q1 2018 [here] and calculated over $3 trillion was spent over that time.

By way of comparison, the $3 trillion amount comprises a significant 10% of the $30 trillion current value of the entire US stock market. Further, assuming repurchase trends continue through 2018, the FT reports [here],

“That would lift the total since 2010 to over $5tn, bigger than the Fed’s entire $4tn quantitative easing programme.”

Share repurchasing is not just notable for its massive scale, but also for its increasing trend. The FT reports [here],

“The almost $437bn in buyback plans announced in the three months to June 30 eclipsed the previous quarterly record of $242bn, which was set just three months earlier, according to TrimTabs, an investment research company.”

The FT also reports [here] that the latest annual estimate by Goldman Sachs is for “a record $1tn in share buybacks this year.”

As a result, share repurchases are doing a lot more than just “tipping the scales” of supply and demand. David Kostin, chief US equities strategist for Goldman Sachs summarized it best:

“[share] repurchases remain the largest source of demand for shares.”

Indeed, Bank of America observed [here],

“in the first half [of 2018], corporations were the only net buyers of stocks.”

Repeat: “the only net buyers of stocks.”

This highlights a startling characteristic of today’s market: It’s not even remotely a balanced competition between buyers and sellers. Kostin also observed that:

“most other ownership categories [households, mutual funds, pension funds] are net sellers of stocks.”

Bank of America reported that “institutions and hedge funds have been net sellers throughout 2018.” Harley Bassman summarized [here],

“In fact, away from Corporations purchasing equities (buy-backs or mergers), it is unclear who else is supporting the stock market against the relentless demographic tide of Baby Boomers rebalancing their portfolios away from equities and into bonds.”

One might expect corporations to be more judicious in their share repurchase activity, but that is not what the evidence suggests. Zerohedge reports [here],

“Corporations are not particularly price sensitive — buybacks tend to rise with the market”.

In addition, a report by Andrew Lapthorne of Societe Generale summarized in the FT [here] reached a similar conclusion:

“the correlation between a stock’s quality and its propensity to buy back stock is negative, and has been for most of the time since a brief period post-crisis.” In fact, he goes on to say, “Buybacks can be a ‘tell’ of a poorly run company, not just a company with few good growth opportunities.”

While the sheer volume of share repurchases has affected markets, its seasonal nature has had an impact as well. As noted [here]:

“August tends to be the most popular month for companies to execute their share repurchases, with the month accounting for 13 per cent of annual activity.”

Given typically low summer volumes, August share repurchases also increase the chances of producing a disproportionately beneficial impact on share prices.

In addition, seasonality of share repurchases also comes in another form. They tend to decline during the “blackout periods” before and immediately after companies report earnings. Chris Cole states bluntly on RealvisionTV [here]:

“I don’t think it’s any coincidence that the worst drawdowns in equity markets — we’re talking about the period in 2015 or January 2016 or this recent February drawdown — I don’t think it’s a coincidence that they’ve occurred during the five week share buyback blackout.”

Cole is not alone in this assessment; the same conclusion is also reached [here] and [here].

Another interesting feature of the share repurchase trend has been the degree to which it has been financed by debt. It so happens that the total amount of increase in corporate debt has almost perfectly coincided with the amount of share repurchases. This fact was highlighted by Zerohedge [here]:

“And as we first pointed out over two years ago, all net debt issuance in the 21st century has been used to pay for stock buybacks…”

An excellent example was provided by Horizon Kinetics in their analysis of how

“The McDonald’s share price appreciated by 90% over 7 years.”

The explanation features two main components:

“One thing that happened is that McDonald’s P/E ratio expanded from 16.9x to 24.6x. That share-holders were willing to pay more for the same earnings accounted for about half of the stock return. Another thing that happened was that interest rates dropped; for 10-year Treasuries, from 4.08% at the beginning of 2008 to 2.30% at year-end 2015 (and to 1.77% now [Q1 2016]). This permitted McDonald’s to finance a massive share repurchase program that would have been unaffordable but for these artificially low rates, which is why its interest expense only rose by 22% even as its debt ballooned by over 6x this amount.”

Viewing market activity through the “lens” of share repurchase activity not only creates some extremely important implications for investors but also provides some clear prescriptions as well. For starters, since share purchase activity is dominated by price insensitive share repurchases, stock prices reveal little information content about underlying economics. This helps explain why neither inflation fears nor trade wars nor emerging market chaos nor increasing rates have been able to rein in stock prices to any great degree. This also explains how a great deal of pessimism about stocks can co-exist with rising prices and bullish narratives.

Another consequence of large scale share repurchase activity is that it has facilitated excessively high stock valuations. This creates a dangerous trap for investors. While high valuations may appear, superficially, to validate underlying economic strength, they are really just temporarily masking the darker reality of “the relentless demographic tide of Baby Boomers rebalancing their portfolios away from equities and into bonds.” In other words, despite appearances, there is likely to be a big drop in stocks in the not-too-distance future. After all, if conditions were really so good, why would market participants such as “institutions and hedge funds” be net sellers?

An important consequence of a market of artificially inflated prices is that it creates winners and losers by effectively transferring wealth. Artificially inflated prices today mean lower returns tomorrow. That is good for investors who want to sell today and bad for those who need to realize future returns in order to achieve investment goals.

One key group of beneficiaries includes retirees (and others) who have been rebalancing their portfolios away from stocks. They are benefiting from a remarkable coincidence of artificially inflated stock prices at exactly the same time they want to de-risk their portfolios. As luck would have it, there could hardly be a better time to cash out.

Of course corporate executives are also benefiting in the form of higher (share-based) compensation and an attractive opportunity to dispose of their share holdings. Zerohedge reported,

“there’s a dirty little secret lying just beneath the surface of this ‘different this time’ ramp in stocks. Insiders are dumping their shares to retail investors at an almost unprecedented manner…”

Grants Interest Rate Observer also reports in its June 15, 2018 edition that some repurchase announcements appear as if they are designed to create “cover” for insider selling:

“U.S. Securities and Exchange Commissioner Robert Jackson complained that management teams are using buybacks to pad their own income. According to number-crunching by SEC staff, insiders increase the amount of stock they sell by five times in the eight days following a share repurchase announcement.”

Unfortunately, just about everyone else loses. Artificially inflated prices force everyone with a longer investment horizon to make very difficult decisions on an ongoing basis. It forces people to determine whether factors such as large scale share repurchases will persist long enough to provide an attractive exit within the time frame of their investment horizons. Wait too long to sell and you face a big drawdown that could take a long time to recover from. Sell too soon and you aren’t earning the returns you need to meet retirement goals.

Younger investors are hurt because low expected returns on stocks discourages them from doing one of the best things they can do for themselves — start saving early. While such people still have plenty of time to save for retirement, every year prices are inflated and future returns are suppressed is one less year they have to reach their goals.

Perhaps the greatest risk is to investors who are nearing retirement or are recently retired and still have significant exposure to stocks. These investors run the risk of not selling stocks before prices drop down to more sustainable valuations. The risk here is of suffering a significant drawdown at exactly the wrong time. Such an event could either substantially defer retirement or redefine it altogether.

Because the consequences of diminished share repurchase activity are so severe, it behooves investors to monitor conditions that could cause such a change. The biggest factor is arguably the ability of companies to continue funding share repurchases at such high levels. With unemployment near record lows and profit margins near record highs [here], cash flows are more likely to get worse than better. It would be dangerous to extrapolate such favorable conditions very far into the future.

Harley Bassman also points out some debt-related factors to watch:

“So clearly higher rates driven by the FED could reduce buybacks funded by debt.”

Bassman also suggests that any twists in tax policy could also have a negative effect:

“if tax reform were to include a provision to reduce the tax advantage of corporate borrowing, that would raise the effective cost of debt, and may be the catalyst for reducing share buy-backs.” Bassman also hypothesizes, “or if the companies themselves reach up against a level where they may face downgrades or limits to their debt loads.”

The FT also reported a recent warning by BCA [here]:

“Dwindling balance sheet flexibility will become a serious constraint underscoring that the tailwind from buybacks is ending and could [change] into a headwind next year if cash flow does not recover.”

In addition to keeping an eye on what could cause share repurchases to decline, it also makes sense to keep an eye on when. Remembering that share repurchase activity is seasonal and tends to decline during blackout periods, late September, just before most third quarter earnings come out, will be a good time to observe what happens to stock prices when the impact of share repurchases is diminished.

In conclusion, most investors catch only glimpses of what happens in the markets if they catch anything at all. As result, much like the blind men and the elephant, it is easy to experience only partial truths rather than the greater whole. The challenge for investors is made even greater because self-interested market commentators don’t even need to lie in order to deceive; they can simply distract with agreeable narratives. Resist the tendency to extrapolate partial truths. Manage to your investment horizon. And focus on the things that count most by keeping your eyes on the “elephant in the room”. Right now that is share repurchases.

Cliff Asness On Buybacks – Boosting Returns or Liquidating Companies?

Asset manager Cliff Asness recently wrote an op-ed piece in the Wall Street Journal wondering if those who decried companies buying back their stock didn’t suffer from “buyback derangement syndrome.”

Asness allowed that net investment, normalized by total assets or total market capitalization, was recently lower for companies in the Russell 3000 Index than it was in the 1990s, “but positive and much higher than during the 2008 financial crisis.”

It seems strange to crow that investment is better now than during the financial crisis.

And Asness offers no opinion or interpretation on why investment should be lower now than in the 1990s, especially given that low interest rates after the financial crisis were supposed to stimulate investment. Granted, his purpose isn’t to comment on Federal Reserve policy, but one might think he’d have something to say about lower investment immediately after a financial crisis – when investment is most needed. Asness also doesn’t say how much lower investment is now. That’s strange, given that he will conclude by asserting the buyback arguments amount to “innumerate nonsense.”

Asness mentions that companies aren’t shrinking away by buying their stock, because they are also borrowing a lot of money. “Think of this as a debt-for-equity swap,” he says – again neutrally or flatly. Is it good or bad – and for whom? — that companies are exchanging equity for debt? Asness doesn’t say. Moreover, later Asness will defend the argument that buybacks are indeed a form of liquidation.

Next, Asness argues that investors do not spend the money paid out in buybacks frivolously. Instead, investors buy other stocks and bonds with their buyback bounty, thereby shifting capital from companies that don’t need it to those that do. But that’s a little too neat. An investor buying stock on the secondary market isn’t giving money to a company in exchange for shares. Rather the investor is buying from another investor a claim to profits on capital already raised by a company previously.

Then things get stranger in Asness’s article. He argues that there’s no way to tell how much buybacks have boosted stock market returns since the financial crisis. And returns have been prodigious – around 15% annualized. But in making this argument Asness admits that it’s possible buybacks have boosted stock returns. Yet when turning to arguments about Apple – that the firm is a scam fueled by buybacks – he relies on the argument that buybacks are a form of liquidation that reduce market capitalization.

So do buybacks boost stock market returns or reduce market capitalization? It’s hard to know what Asness thinks. Clearly reducing share count and elevating earnings-per-share – the obvious immediate effects of buybacks — should increase the share price. But Asness doesn’t say whether a higher share price should compensate for fewer shares precisely and keep market capitalization stable, or whether it should alter market capitalization.  He only says that it’s difficult to know if buybacks have boosted stock market returns, but also that it’s crazy to think Apple’s market capitalization shouldn’t be reduced instead of elevated by share buybacks.

Perhaps Asness is consistent is asserting that buybacks probably haven’t boosted market returns and certainly haven’t boosted Apple’s market capitalization. But he doesn’t think it’s impossible that buybacks have boosted stock returns, leaving himself vulnerable to the charge that he is confused about whether buybacks boost returns (and market capitalization) or amount to a liquidation and shrinkage of market capitalization.

Ultimately, Asness is upset that people are examining what corporations do with their profits when Americans have so many other things to debate. But when profit margins are so persistently high and a higher percentage of profits are returned to capital, perhaps he shouldn’t be so naïve to think a political debate wouldn’t commence about corporate profits and share buybacks. Moreover, despite calling the buyback arguments “innumerate nonsense,” it seems Asness has some thinking to do about whether buybacks boost market returns or are a form of liquidation.