We are left with the façade of an equity market held aloft by the hundreds of billions of dollars of borrowed money companies are using to buy back stock instead of growing their business thanks to a Fed policy that encourages that deflationary tactic. The computers still bid at what appear to be pre-established points throughout the day, making our market appear as rigged as the emerging markets we used to ridicule. However, as mentioned last month, earnings in corporate America are clearly turning meaningfully south and when the news is bad enough, the affected stocks are going that way too. With equities broadly the most expensive ever, we do wonder who will buy stocks from current holders when they need to sell. We call this “running out of greater fools” just as some important warning signs begin to flash. For instance, it appears that margin debt at the broker-dealers may be rolling over and we have found that is often a key early sign of the party ending.
We continue to hunt for investment ideas, of course, but in the equity market most of the value is still on the short side if you rely on normalized free cash flow valuation. That is no surprise when the median stock trades for more than two times historic averages on a price to sales basis. What we see now are some stocks getting interesting on the long side as they have corrected meaningfully on earnings worries, but when we dig through the numbers they are just not cheap enough for us to want to hold a meaningful position.
For purchase candidates, we look for high single-digit free cash flow yields and reasonable comfort with the future revenue picture. That is tough to find mostly because market participants are too willing to assume that a return to peak revenues and margins for the many cyclicals that we have researched is right around the corner. A common thought process in the market is that revenue weakness, if due to the massive rally in the dollar, will reverse itself soon, seemingly forgetting that it was the earlier weakness in the greenback that cast a positive bias to many companies’ performance for many years. Energy producers are mostly way out of line with the current price of crude. We have added a few longs, but these are just small starter positions with one theme being that some are suppliers of equipment or services to the much maligned energy sector
We have also shorted a few more names in recent weeks in a number of sectors. We can see these stocks trading for less than half of current prices in coming years. For instance, we are now short a manufacturer of residential construction materials at over 60 times estimates for this year. In addition, free cash flow for this company has been quite paltry in recent quarters.
The Fed wants to raise rates this year just to be able to say that it did so, as if somehow that would be proof positive of its success. The weak jobs report for March was likely painful for the FOMC because it forced a deviation from its rosy script. After all, the Fed has trained the market monkeys and their computers to base any and all economic views on the high number of jobs that had been showing up in the lagging economic series known as the monthly employment report while ignoring the big picture. It has painted itself into a corner and will be loath to admit growth is softening yet again. Regardless of whether any rate hike occurs, a few hundred billion dollars of bonds is set to roll off of the Fed’s balance sheet early next year, so further dollar scarcity is “baked in the cake” to some degree and that will be a tightening of policy.
If we were to sum up the biggest fact that many analysts seem to be missing or choosing to ignore it is that the central bank mechanism of keeping rates low and printing currencies is running into the reality that the enormous debt growth that resulted from those policies is having less and less positive impact on growth. The econ geeks would describe this as money velocity shrinkage overcoming the money printing. All that cash just sits in free reserves unless a banker lends it. The banks don’t really want the cash based on the low rates they pay and high fees they charge for deposits. In Europe, borrowers are actually paid to borrow by some banks.
Talk about distortion!
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.