Stocks and Shares

Is the market’s debt orgy reaching its climax?

In recent years, US stocks have been pumped higher and higher as investors and companies have enjoyed an orgy of debt. By any valuation measure you care to take, US stocks – as a whole – look expensive. But is the market’s debt orgy now reaching its climax? If so, it makes sense to play it safe, and use protection.

I’ve written before about the world’s debt problem (for example, see here). But today I’ll focus on a couple of debt-related areas that present particular risks for US stocks.

Interest rates and bond yields are rising, especially in the US. Last week, I explained why this could lead to disappointment in the earnings of highly leveraged companies, along with other factors such as wage inflation (see here).

Just today, the new Fed head, Jerome Powell, said policy makers may have to raise US rates during 2018 more than the three times that were previously expected.

With that backdrop, I’ll focus on a couple of specific risks facing pricey US stocks. These are debt-funded stock buybacks and the record level of margin debt currently being used by traders.

Buybacks to reach new records?

According to investment bank Goldman Sachs, stock buybacks for companies in the S&P 500 are set to reach $650 billion in 2018. That’s up from $527 billion in 2017, $550 billion in 2016 and $589 billion in 2015.

On top of that, Goldman reckons that dividend payments will reach $515 billion this year. That means total distributions to shareholders will be $1,165 billion. That’s about 4.9% of the S&P 500’s total market capitalisation of $24 trillion.

(By the way, the net shareholder yield is far less, once you take into account the issuance of stock. A lot of buybacks are done merely to transfer stock from outside shareholders to corporate insiders that have executive stock and option plans. Plus, new stock is issued to raise new capital, for investment or acquisitions, or to avert bankruptcy. Analysis I’ve done shows the combined offset typically runs to 2% to 2.5% a year. That would bring the net shareholder yield in 2018 for the S&P 500 – dividends plus net buybacks – down to 2.4% to 2.9%.)

The first big problem with buybacks, and something they have in common with corporate acquisitions, is that companies tend to do most of them at the worst possible times. That is, companies buy the most stock when it’s highly priced, and the least when it’s cheap.

Here’s a chart which shows the pattern between 1999 and June 2016.

Clearly, buying at the top of the market is throwing money down the drain. But it’s done to goose up earnings-per-share (EPS) growth figures. Financial engineering of this type is easier than actually growing the underlying businesses. It also transfers value from outside shareholders to corporate insiders, since a lot of the stock purchases end up in insiders’ hands.

Even worse than that, there’s a big link between the amount of stock buybacks and how much new debt the companies take on. Cash flows aren’t sufficient to cover all of the cash needs, including dividends, capital expenditure, acquisitions AND buybacks. Debt is typically used to make up the difference, as shown in this chart from 1990 to 2015.

This makes for a pretty toxic combination. Buybacks are mostly done at the worst time, when stocks are pricey, and using debt, which adds to corporate leverage and increases financial risk.

Which brings us on to the next problem. US corporations were by far the biggest buyers of US stocks in recent years. In fact, since March 2009 they’ve outstripped the only other large buyer, mutual funds and ETFs, by a factor of two. That’s shown in the next chart of cumulative purchases (or sales) over time.

To recap, US stock buybacks have been running at elevated levels for years. This year may see a new record. But record buybacks tend to happen at market peaks.

On top of that, a lot of buybacks are funded with new debt. But borrowing costs are rising, at already leveraged companies. This will hit earnings, but also may force companies to curtail buybacks. Given corporations are the biggest buyers of pricey US stocks, this doesn’t bode well for the market as a whole.

The other market debt problem

Warren Buffett released his latest letter to shareholders of Berkshire Hathaway (NYSE: BRK-A / BRK-B) on Saturday. It’s always on my personal, required reading list each year.

In the letter, Buffett reminds us that investors should never borrow money to buy stocks. That’s a view I totally agree with, and it’s particularly relevant this late in a long bull market.

As he puts it: “There is simply no telling how far stocks can fall in a short period.” That’s when leveraged investors become forced sellers.

He uses the example of Berkshire’s own stock price. Since 1964 the company has increased its net asset value at a rate of 19.1% a year, although it was only 10.5% a year over the past decade.

Most of the value of a stock, even one of a very solid company, is derived from far out into the future (as I recently explained here). Yet Buffett highlights four instances when his own company’s stock fell by between 37% and 59%, due to nothing more than short term market sentiment. It’s summarised in the following table.

 

Buffett runs a company with rock solid finances, and has an excellent, long-term track record. Yet even Berkshire’s stock price collapses from time to time.

Which brings me on to the other debt problem stalking US stocks: the current record high levels of margin debt. This is where traders borrow to speculate on rising stocks, hoping to goose up their returns.

The problem is that if markets turn, and prices drop sharply, then leveraged speculators become forced sellers, as brokers call in the loans (or make “margin calls”).

In other words, high levels of margin debt make stock markets more prone to fall hard. What might have been a correction of 10-20% could turn into a rout, with stocks falling 40-50%, as waves of forced selling driving down prices for a time.

(Once the dust has settled, the latter situation is, of course, the best time to scoop up some bargains.)

This next chart shows how levels of US margin debt (red line) have gone up much faster than the S&P 500 index (blue line) over time, and also how margin debt peaks coincide with stock market peaks.

According to FINRA, US margin debt reached a record $666 billion at the end of January. (If that isn’t an ominous number, then I don’t know what is…)

That, in itself, doesn’t mean much. But I’ve crunched the numbers, and it turns out the ratio of margin debt to US market capitalisation is at an all time high of almost 2%.

Investors and traders now have more margin debt, relative to the market, than at any time before. That includes during the previous market peaks in March 2000 and October 2007.

With US rates set to rise, this gives plenty of cause for concern. Buybacks and margin debt are both at record levels. High levels of both have coincided with market peaks in the past.

My view is that these factors increase the risks in an already pricey market, which continues to labour under irrational complacency.

This doesn’t mean a crash is necessarily just around the corner, although it could be. But I believe it’s a good time to be cautious, especially this late in the bull run.

So what should an investor do?

I continue to recommend a 40% allocation to stocks, but only where prices are already sensible. This means digging around for value, when it can be found. Those kinds of stocks will still do well in the medium to long run, even if a market crash disrupts their prices in the short run.

At the same time, I recommend 35% as cash “ammo” (deposits and treasury bills), to be used when bargains are more easily found. It’s a drag on returns for now, but will more than make up for it after any big correction or crash. Incidentally, Berkshire Hathaway is sitting on $116 billion of cash and T-bills, as Buffett & Co. wait for better bargains to come along.

Is the market’s debt orgy reaching a climax? There’s clear evidence that it may be. In the meantime, it makes sense to use protection.

Stay tuned OfWealthers,

Rob Marstrand

robmarstrand@ofwealth.com

 

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.