The current economic and stock market cycles are unusually long in duration and this leads to obvious questions about what will be the cause of its ending.
There are several oft mentioned candidates: protectionism, a fall in historically high margins, a strong dollar and interest rates or some combination of these factors.
Students of stock market valuation over time are liable to point to how highly valued equities are and this is hard to dispute.
To our minds, the biggest threats to the US stock market lies within the international (non-US) outlook combined with shifts in demand for equities and their valuation.
The valuation observation is notoriously difficult to narrow down in a causal sense and apply to time frames. Current high valuations are a pointer to sub-normal returns over the medium term but not the short term. Specifically, they tell us something, in a probabilistic sense, about how returns will pan out over a seven-year time frame, not a one-year time frame. (This is what our own testing has shown).
Considerations of the net-demand for equities is thinly trampled terrain for the equity market analyst. It is common place in bond circles to speak of such things – they are more readily predictable, especially in the government sphere. For countries have to re-finance their existing stock of debt (the majority of which has known maturities) as well as its budget deficits, items that are forecast with great care.
Seldom is the subject of demand for equities spoken of with any degree of assurance. However good clues lie when the sources of demand are characterised.
Who is the largest buyer of US equities today? The listed companies themselves. Goldman Sachs estimated in 2017 that aggregate share buy backs in the US would reach US$590bn this year. More recent data from Trim Tabs shows that US$436bn was bought back in the second quarter of 2018 alone, suggesting that the full year total could crest US$1tn. The second biggest purchaser of equities are ETFs at an estimated US$400bn for 2018. Foreign investor activity net of sales of US active equity funds are expected to sum to a meagre US$25bn.
What can be seen at a glance is that the largest segment of demand lies in the hands of company buy-back schemes and ETFs.
Our view of these groups is that they are essentially blind in the sense of undiscriminating. ETF buying is a consequence of inflows, which itself is a function of a) the general switch from active to passive and b) the market continuing to rise. The second factor at least partially drives the first. Active fund managers are trained to take punishment from their clients in the event of poor performance. Investing in ETFs allows less room for blame apportion – a financial intermediary may be on hand for an ear bashing but no comfort can be had from a inky-dink web site or self-directed investment.
Share buy-backs have been a feature in a larger study we are doing on US corporate indebtedness and this study is yielding notable conclusions.
The phenomenon of buy-backs is not by any means new – it is, though, reaching its apotheosis.
The underlying rationale and practices have morphed overtime. The “classical model”, if we can call it this, for buy-backs suggests that company boards face decisions as to whether to expand via investment, buy assets or competitors and – if no such profitable avenues exist – consider buying back their shares if those shares are undervalued or at least not overvalued. For all we know, this example of decision tree modelling is still at work in some boardrooms.
The “modern model” is more pragmatic and is driven by the tax efficiency of returning capital to shareholders via buy-backs as against the “tax inefficient” method of paying dividends that would be subject to income taxes. By reducing the share count, earnings per share rises and continuing shareholders own proportionately more of a company (as long as uncancelled bought back shares are ignored). Not surprisingly, CEOs with pockets stuffed with share options, are keen on this too.
Warren Buffet was, until recently, intriguingly ambivalent on the subject. He is on record for being in favour of buy-backs in Berkshire Hathaway held companies but restricted Berkshire in buying back its own shares. He loosened his belt on the subject just two months ago by permitting buybacks in Berkshire when the board “believe that the repurchase price is below Berkshire’s intrinsic value, conservatively determined.” Prior to this, his board was restricted to buying back shares only when the stock price were no more than 20% premium to book value.
In one fell swoop, Buffet has migrated from the classical model to the modern. With cash of US$64bn in the holding company and debt to equity of just 26%, he may have a lot of buying to do. The average debt to equity of the non-financial universe within the S&P500 is 130%. With a market cap of US$523bn and a book value of US$358bn, Berkshire’s first repurchase will signal his and Munger’s thoughts about where intrinsic value may lie. Berkshire’s share price will doubtless rise on the news.
If you cast your eyes over the balance sheets and cash flow statements of a representative number of large US listed companies it becomes patently clear that the buy-back trend has become a reflexive action of US CFOs – not just deploying all surplus cash but adding leverage to do so. Triple B bonds entail a financing cost of 4% and the average S&P constituent has a Return on Equity (RoE) of 12% so the very action of buying back adds value up until the leverage becomes dangerous.
Even before that point comes, any deterioration in US cash flows will halt the tide (as corporate cash flows are fairly fully committed) and we have the prospect of a buyers’ strike were ETFs to go into net redemption mode, as they would be likely to do.
Which brings us back to the cause of that deterioration.
The problem with the winner-takes-all approach to trade that has roosted in White House policy is that the blow-back effects are considerable and not well understood by the incumbent of the White House. 46% of sales of the S&P500 are non-US and interruption of trade flows via tit-for-tat tariffs weakens the global growth picture.
To our minds, it is waning global demand which presents the greatest threat, exacerbated by a strong dollar, weakening of the Chinese economy and trade friction. These are hardly imaginary events. The US stock-market is a loop and when that loop gets broken we should expect a nasty bear market.
Within the multi-asset portfolios in our charge, we have responded to these risks by moderating equity allocations (cycle peak of 72% and now at 50%), adding generic put option protection on broad equity indices and US Treasuries and maintaining balance sheet emphasis within held companies. Debt-equity ratios within Global Leaders constituents are a more moderate 58% on average.