Falling number of shares a key factor behind the market rally

By: Raul Elizalde
today's photoWhen a stock pays a dividend rate higher than the interest at which the company can borrow money, it makes sense for that company to issue debt and buy back its own stock. This is exactly what happened as interest rates fell to historic lows. We believe that the retirement of equities is a key factor in the stock market rally, making them look “expensive” when compared to traditional measures of value, but not when considering their shrinking supply.

We measured changes in the number of outstanding shares of about 350 stocks with an aggregate market capitalization of $17.4 trillion (the total market is currently around $28 trillion). We found that since the beginning of 2011, the number of shares dropped by about 8%. If those shares had not been retired, this group would have a $1.7 trillion larger market capitalization. This extrapolates to a $2.8 trillion shortfall for the total market of US equities due to corporate buybacks.

image 1This estimation is remarkably similar to the $3.0 trillion retired equities calculated by the Federal Reserve. In addition, the Fed tallies the value of shares retired due to mergers and acquisitions, which adds up to another $2.3 trillion, for a total of $5.3 trillion in that period. This was only partially offset by $2.9 trillion of new issues coming to market. On balance, therefore, corporate America retired $2.4 trillion of equities value, which is on par with the GDP of the United Kingdom.

image 2This has vast implications. Stock prices go up disproportionately to the number of shares retired, meaning that a 1% reduction in supply causes a price appreciation much larger than 1%. More precisely, the marginal change in price due to the marginal change in supply is very high. This effect is not easy to isolate and measure, but it is undoubtedly present, and we believe that it is an important factor behind the market rally.

It also helps explain why equities seem expensive against traditional measures of value, such as P/E ratios. A corporation finds value in buying its own stock if it reduces its cost of capital, regardless of what those indicators show. The fact that top management compensation is often linked to the price of their stock may also play a role in a company’s decision to repurchase stock.

As long as this activity continues, the market will continue to seem “expensive”, and it may become more so if the Trump administration’s attempts to reduce the corporate tax rate eventually succeed.

Many US corporations with profitable global operations have not brought back those funds because they are subject to taxation once they come in. According to Moody’s, non-financial US companies hold close to $2 trillion abroad. If a corporate tax cut persuades companies to bring back their overseas profits, the likelihood is that they will be used to repurchase company stock. It is quite doubtful, as proponents of the tax cut argue, that they will be invested in their respective lines of businesses. Given that businesses have easy access to historically cheap credit, money sitting abroad does not seem to be a hindrance to financing any investments that seem promising.

Most recently, both our numbers and the Fed’s numbers show a slight decline in the pace of equity retirement. It could be “noise”, or it could be due to the modest interest rate rise of late last year.

It is reasonable to assume that if interest rates or equity prices go up much further, the economic benefits of retiring shares will end. The danger of higher rates is small, in our view, because it is difficult for the Fed to justify lifting rates much more when inflation has been falling further and further away from its target. As much as the Fed wants to “normalize” monetary policy, hiking rates when inflation is falling is risky.

On the other hand, earnings-per-share have been climbing, both on a trailing and (especially) on a forward basis. Moreover, Europe looks stronger and global GDP projections have improved. These fundamental factors support higher equity prices everywhere, regardless of the impact of corporate demand for equities.

These fundamental factors could make equities seem less expensive in the medium term when compared to traditional measures of revenue and earnings, and could well spur a new wave of demand from retail investors who, because of low interest rates, have few other places to go for returns. The market rally will end one day, but the combination of corporate demand, improving fundamentals, benign outlook for rates and a potential for growing retail demand are pushing that day further into the future.

What now?
We are a Registered Investment Advisor held to a fiduciary standard of care. We believe that our portfolio management process, focused on measuring and managing risk, can be very effective at creating a sensible balance between risk and return, partly by measuring financial and investment conditions often and adjusting portfolios through a well-defined process. We implement this process for our clients and we tailor it for their specific circumstances, and we always put their interests first. That means we do not profit from transactions or by selling any products. Our only compensation is based on the assets we manage, which goes a long way of aligning our interests with yours. We can also help you evaluate your current goals and establish an investment plan aiming at achieving steady, long-term returns while managing downside risk. You can download our report describing our investment methods and goals, or contact us if you would like to know more about how Path Financial’s investment process can work for you. We’ll be happy to set up a confidential meeting to discuss your path to financial success. Read more.

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Raul cropped for facebookRaul Elizalde is the Founder, President, and Chief Investment Officer of Path Financial, LLC. He may be reached at 941.350.7904 or raul@pathfinancial.net.

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IMF Financial Stability Report Says Debt Binge Leaves US Corporate Assets Exposed

IMF says debt binge leaves US corporate assets exposed (ft.com)

IMF says debt binge leaves US corporate assets exposed (ft.com)

A debt binge has left a quarter of US corporate assets vulnerable to a sudden increase in interest rates. This is an issue Path Financial has been watching and writing about since 2015 (read our most recent analyses on this topic here (“Beware the Mountain of Debt” and here (“This is Where the Next Debt Crisis Will Come From“).

In its twice-a-year Global Financial Stability Report released earlier this week (April 19, 2017), the International Monetary Fund warns that the ability of companies to cover interest payments, by one measure, is at its weakest since the 2008 financial crisis. Historically, the scenario of large debt accumulations, combined with rising interest rates, rarely ends up well. Investors should be paying close attention to these red flags.

At Path Financial, our portfolio management process is focused on measuring and managing risk — a strategic and effective approach in creating a sensible balance between risk and return. Contact us to learn how we can help safeguard your investments: 941.350.7904.

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Beware the Mountain of Debt

mountain of debtBoth interest rates and stocks soared after the US election. This is because everyone seems to agree that the new US administration will spend a lot, collect less in taxes, and cut back regulations.

This is a mix that could fuel the economy and be good for stocks. Not so with bonds: It will likely lead to higher interest rates as inflation rises, the Fed fights it with higher policy rates, and firmer economic activity pushes market rates higher.

It could also backfire on stocks if high inflation and higher wages actually drag economic activity down. Furthermore, higher US rates relative to rates abroad are sure to push up the US dollar, hurting exporters and manufacturers. This could also weaken the economy, bring down corporate revenue, and dim prospects for stocks.

This would be a worst case scenario of higher nominal rates and a decelerating economy. It is known as stagflation, and it has a reserved spot next to deflation as a nightmare scenario for policymakers.

Also, the economic policies that the new administration has so far hinted at are radically different from what has been the norm in the past few decades. This guarantees that they will face strong headwinds before they can be implemented, including congressional opposition. There is a chance that the consensus scenario may never materialize, may be watered down, or may take far longer than the market is willing to wait. So the optimism about stocks can prove to be short-lived.

Regardless of whether stocks go up or down, it is quite likely that Interest rates will remain above the historically low levels of last year, or climb even higher. This could exacerbate vulnerabilities in the economy that have so far gone relatively unnoticed.

One such issue, and a well-known trigger of past crises, is a large accumulation of private debt.

Debt is a key factor in lubricating economic activity: Households use it to buy homes or cars that could not otherwise afford, businesses use it to finance investments or fulfill orders in advance of payment, municipalities use it to pave roads and lay out utilities, and so on. Without debt, growth would be slow, halting, and ultimately impossible.

Households, businesses and governments always carry debt on their balance sheets, and constantly take new debt to replace the one that comes due. When rates go up, the cost of rolling over debt goes up as well. That is why higher rates tend to dampen economic activity, which is a normal swing in the business cycle.

But when indebtedness becomes too large, the balancing act of renewing old debt with new one becomes more difficult to pull off for reasons other than cost. Lenders start questioning the sustainability of the process, especially if rates go up sharply, and sources of funding dry up. Large debt accumulation then leads to a liquidity crisis, just when access to financing is needed the most.

The last few years of ultra-low interest rates sparked a massive increase in US business debt. The opportunity to borrow at some of the lowest rates in recorded history was too good to pass up.

But the new debt has not been used primarily to invest in the economy: much went to build cash reserves, and some more to buy back stocks or increase dividends. In the last couple of years private domestic investment has gone down while the stock of private debt continued to grow.

The earnings-to-net-debt ratio for S&P 500 corporations – a key measure of borrowers’ ability to reduce their debt levels – is at its lowest level in at least a decade, according to the research firm Factset. And while some analysts find comfort in the fact that corporate cash is also very high at $1.75tn, the reality is that much of it is concentrated in just a few technology companies: Google, Apple, Microsoft, Cisco and Yahoo account for a third of all US corporate cash.

We showed the chart below in various newsletters in the past and we updated it with the latest numbers. The chart shows that there has never been a larger or faster 4-year accumulation of non-financial business debt. Not surprisingly, prior surges of indebtedness ended in tears.
graph

This is not solely a US problem. China, most pointedly, has seen an explosive ballooning of private, non-financial corporate debt that just reached an eye-popping 170% of GDP.
Some early signs of a brewing debt crisis would include an increase in corporate credit rating downgrades, Chapter 11 restructurings, liquidity problems in the bond market, and so on. So far, these symptoms are not evident, but conditions could turn optimal for a debt crisis if interest rates rise quickly, budget deficits get out of control, and economic activity does not pick up.

Even without a sudden crisis, it remains to be seen how the mountain of global corporate debt can be gracefully wound down without anyone getting hurt. History shows that large debt accumulations rarely end up well. Close attention to any early warnings will be crucial to navigate through the rest of 2017 and beyond.

What now?

We believe that our portfolio management process, focused on measuring and managing risk, can be very effective at creating a sensible balance between risk and return, partly by measuring financial and investment conditions often and adjusting portfolios through a well-defined process. We implement this process for our clients and we tailor it for their specific circumstances. We can also help you evaluate your current goals and establish an investment plan aiming at steady, long-term returns while managing downside risk. Please send us a request for a copy of our most recent whitepaper describing our investment methods and goals, or contact us if you would like to know more about how Path Financial’s investment process can work for you. We’ll be happy to set up a confidential meeting to discuss your path to financial success. Read more.

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As we were saying – “Fed should wait with liftoff to see firm inflation signs: IMF note” [Reuters]

“The U.S. Federal Reserve should wait to see firm signs of rising inflation as well as a stronger labor market before hiking benchmark interest rates, an International Monetary Fund paper said on Thursday.” (November 12, 2015)

This is according to Reuters, and agrees broadly with our October newsletter, “Low inflation should keep the Fed on hold.” (October 27, 2015). Inflation remains low, and yet the market seems convinced that the Fed will hike rates soon, and Fed officials seem poised to do just that. We remain unconvinced that this is the right move.

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No reason to fear the Fed

One day, the Federal Reserve’s long-running stimulus will  end. This means that  interest rates will start to go up and that the Fed will  begin to sell trillions of dollars’ worth of securities it bought during Quantitative  Easing, or QE.

The market is afraid that interest rates could go up a lot, or  that the Fed will dump the securities quickly, or both. Either scenario could be  quite disrupting. Fortunately, those fears are overblown. Read the full report

Written by Raul Elizalde

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Don’t sell your bonds yet: weak wages will keep rates low

While headline employment numbers have been good, a darker picture comes into view once you dig a little deeper. Wages are weak, and Fed boss Janet Yellen has repeatedly indicated that this ranks among her top concerns. It follows that under her guidance the Fed will keep monetary policy loose for a long time to come, most likely longer than people expect.

The question is whether the Fed’s easy monetary policy has made any progress towards bringing up wages. Some say that its only effect has been to inflate asset prices. If they are right, Yellen’s efforts to improve employee compensation – and therefore reduce “inequality” – may well be self-defeating.

Yellen can’t be blamed for the limited impact of monetary policy. There are reasons for this, and it means that the environment of low rates – and high asset prices – may stay for longer than people think possible. Read the full report

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