Key drivers of this cycle keep fading in strength in spite of the media narrative that things are just swell. We are seeing a number of stocks simply fall under the weight of unrealistic expectations and buyer exhaustion. That has not been prevented by the efforts of the powers that be.
Paying 20-30 times EPS when most of the EPS growth is generated by stock buybacks with little or no actual growth in revenue or net income can be just as risky as paying those high multiples for companies that are truly growing organically. A more typical multiple for non-growers that manage EPS with consistent share repurchases might be in the 10-15 range. That is why we do not have a hard time imagining many of our short positions being cut in half. Picking the mid-points of the above P-E ranges gets us there. Usually all it takes is a revenue miss or two and thus endeth the love affair because that causes investors to question the P-E multiple abruptly.
Historically, reality tends to intervene rather suddenly as investors discover that a “bond-like” stock that paid a decent dividend is really an equity in spite of all the rhetoric to the contrary. Based on what we are seeing, we think the market may be in the process of realizing this on more names despite the ETF craze which can mask overvaluation for a while. In the end, a lot of ETF’s are chock-full of stocks which are subject to the same gravitational pull of the underlying math. That risk cannot be diversified away.
As we have mentioned in prior letters, U.S. consumer spending on autos and things at stores across numerous types of goods has run into a wall in 2017. The retail sales figures for May and June were negative prints. Most retail stocks have been decimated to multi-year lows. Auto parts sold at places like O’Reilly and Harley-Davidson motorcycles appear to be the latest trouble spots.
The often conflicting rhetoric of the global central banker crowd now goes back and forth between sounding resolute about tightening policy to backing away from that stance when the mood strikes them. Yellen’s Congressional testimony last week did come across as a bit of backtracking on tightening. She made pretty clear that she does not see the need for a large number of future hikes because she thinks growth is and will remain soft by historic measures and inflation remains contained. The overall message is actually quite sobering if you think about it. She sees the current stagnation as normal. Equities reflect future expectations for the best growth ever when we are enduring the worst.
The big problem is that over time more investors will figure out that maybe they did not really understand what has been taking place in the markets for the last nine years. It’s simple. Companies bought back a bunch of stock by borrowing trillions of dollars and that created an illusion of prosperity.
Given the low growth landscape they faced, companies did not spend on capital equipment. They used what cash they had and borrowed more to buy their own stock which, by no coincidence, propped the stock and pushed management’s call options into the money. When so much of the market valuation is predicated on this slow-motion “LBOing” of Corporate America wherein fake growth is confused for real growth, there is a problem. Corporate credit measures have been pushed to the limit in the process.
Investors are normalizing the current landscape without fully understanding the precise mechanism. The 34% increase in new accounts at Charles Schwab this year, the most since 2000, explains a lot of what is going on in stocks. BlackRock, the ETF giant, pulled in over $100 billion last quarter. To top it off, margin debt levels are alarming.
Let’s just say sentiment is high.
The views expressed on this blog are the opinions of the authors. This information is not intended as investment advice or to recommend the purchase or sale of securities. More information on Strategic Balance, LLC may be obtained by contacting investor relations.