In December 2015, I downgraded equities to 2 stars at 2085 on the S&P 500 Index, arguing in YIELDING TO HIGH YIELD that equity markets needed to adjust valuations to take into account the higher risk environment that was then explicit in the high yield market and that
downside to the 17.5 range on the Rule of 20 is quite possible as a result. At current earnings and inflation levels, this would take the S&P 500 Index down to 1825, 9% below current levels.
Two months later, after the Index troughed at 1811, I went back to 3 stars (at 1866), arguing that:
- Equities were undervalued and a change in investor psychology could result in a good rally given that the S&P 500 Index was then nearly 10% below its 200-day moving average of 2035.
- Investors could again be reassured in the following weeks/months if:
- U.S. recession fears abate;
- oil prices strengthen;
- China does not implode and stabilizes growth.
- Such events would likely more than offset the weak earnings trends in the first half of the year, building expectations for a better second half.
On March 28, I uncharacteristically reverted back to 2 stars at 2050 as valuations had again reached elevated levels without any apparent renewed support from earnings nor the economy. Equities went sideways for 3 months, only to jump 10% after Brexit. Why?
Everything seems to have changed on June 24. While equity markets initially got scared, fixed income markets jumped as yields collapsed across the world.
Then we started to hear the talking heads explain how equities were cheap compared with everything else boasting a yield across the world. And, by the way, the economy has begun to surprise positively which is why oil was back to $50 and copper was recovering, yaddi yaddi yadda…
No doubt central bankers would become even more benevolent post Brexit, keeping money cheaper than ever and buying bonds almost indiscriminately.
Since the Brexit vote, 9 central banks have cut rates globally, culminating in the BoE’s dramatic move on August 4. So encouraged, investors have accepted the new buzzwords “lower for longer” and even “longer forever”. And so equities yielded as well.
Meanwhile, the yield hunters discovered emerging markets bonds…
…and are feverishly pouncing on their ETFs. This is mad!
The hunt for yield is also reaching deeper into the quality spectrum…
…even as fundamentals are deteriorating as Moody’s demonstrates:
(…) The now chronically faster growth of corporate debt relative to net revenues has hoisted nonfinancial-corporate debt up from Q2-2012’s cycle bottom of 81.0% to Q2-2016’s estimated 93.0% of net revenues. The latter far exceeds where the ratio stood immediately prior to the starts of the three latest recessions. Corporate debt approximated 87.4% of net revenues in Q4-2007, 84.1% in Q4-2000, and 80.5% in Q2-1990.
Lenders must be betting that operating margins will remain elevated and that interest rates will remain depressed. Yet, margins (ex-Energy) peaked 18 months ago and have declined back to their 2011-13 level which was also the peak in 2007.
Yet again, the Fed has clearly indicated its intention to normalize (i.e. raise) interest rates ASAP so the cost of debt will likely increase at least in sync with economic activity (i.e. revenue growth).
Corporate America is highly levered at this late stage of the cycle when margins generally begin to decline and interest rates start their ascent, a recipe for lower profits and deteriorating credit quality. No doubt that financial markets are pricing in these obvious risks. Well, think again as Moody’s explains:
The once fairly tight relationship between the high-yield bond spread and the ratio of corporate debt to net revenues has broken down. For one thing, the high-yield spread has been narrower at each ratio of debt to net revenues when compared to the past. Moreover, the high-yield spread recently defied convention and narrowed despite a higher ratio of debt to revenues.
What might explain the break from trend? For starters, markets may be convinced that a powerful rejuvenation of business sales impends. However, such an explanation presupposes a great deal of naivety on the part of market participants.
Even more so when considering that “lower for longer” does not rhyme with accelerating economic growth.
Another possibility centers on a higher ratio of corporate debt carrying an investment-grade rating. However, investment-grade’s share of the dollar amount of US corporate bonds has eased from the 81% of 2002-2007’s upturn to the 79% of the current recovery. (…)
The suppression of net interest expense by the current recovery’s extraordinarily low benchmark borrowing costs has diminished debt servicing risks at all levels of indebtedness. Nevertheless, this argument assumes the ease of refinancing maturing debt and, thus, downplays the historical reality of those occasional episodes where systemic liquidity is severely diminished.
The last argument also eludes the dynamic nature of the corporate P&L. When rates get normalized, margins will also normalize. The interest expense ratio troughed at 2.7% of revenues in the previous 2 cycles but debt was then 74-77% of revenues. It’s now 93%! If interest expense is near 3.5% of revenues with rates near zero, where will it be after the Fed has its way given current indebtedness. A 75-100 bps negative swing in margins looks like a minimum. This would reduce aggregate net after tax corporate profits by some 5-8% minimum, solely from the rate normalization process, let alone its impact on the economy.
For companies with a high debt leverage, the impact will be much larger than average, both on profits and debt ratings.
But in their blind rush for yield, investors won’t consider adverse scenarios at this time, even though history is not friendly.
Real GDP’s yearly increase slowed from Q1-2016’s 1.6% to Q2-2016’s 1.2%. The latter was the smallest such gain since the 1.0% yearly increase of Q2-2013. All else remaining the same, even if real GDP’s annualized quarterly increase averages 3% in 2016’s second half, the real GDP’s annual increase would still slow from 2015’s 2.6% to 1.6% for 2016.
According to the long-term statistical relationship, yearlong real GDP growth of 1.6% has been associated with a yearlong average of 635 bp for the high-yield bond spread, which is wider than the recent high-yield spread of 584 bp. Unless real GDP accelerates considerably, not only will any narrowing by the high-yield spread be limited, but a wider spread may be unavoidable.
The high-yield market now bets on faster economic growth for 2017. The latest consensus forecast expects 2017’s real GDP to grow by 2.2% annually, where the latter has been statistically associated with a 580 bp midpoint for the high-yield bond spread.
But we can’t have our cake and eat it, too. Faster economic growth could help the top line but what about inflation? Higher inflation should push nominal yields up, making debt more expensive. But who cares about inflation nowadays? Even though…
(For more on the Sticky-Price CPI, click here)
The Atlanta Fed has an Inflation Dashboard to help visualize recent inflation measures in the context of longer-term trends. Notice how expectations remain low even if trends point clearly upwards.
Hmmm… Every man can see things far off but is blind to what is near (Sophocles).
Back to our discussion on leverage and credit, companies are also trying to offset slow growth with M&A and share buybacks.
The impact of M&A on US credit rating revisions varies with the stage of the M&A cycle and the importance of debt or cash to the funding of M&A. Early in the cycle, M&A tends to supply more upgrades than downgrades as weaker credits benefit from being acquired by stronger credits, where the credit standing of the latter is still solid enough to withstand the funding of an acquisition. Also, lower quality credits tend to pay down debt with funds raised via divestments earlier in the cycle.
(…) since the end of September 2013, M&A has entered into far more downgrades (288) than upgrades (188), where the biggest deterioration applied to high-yield, whose 197 M&A-related downgrades since September 2013 exceeded the 153 upgrades. Meanwhile, the M&A-linked revisions of investment-grade ratings revealed a wider gap between 91 downgrades and 35 upgrades.
For the year-ended June 2016, 60 net US downgrades stemmed from M&A, that is, 124 M&A-linked downgrades less 64 upgrades. The 60 net downgrades at least partly ascribed to M&A were the most of any yearlong span since the 75 of calendar-year 2002. An extended slide by the dollar value of M&A would eventually help to form a peak for the number of net downgrades linked to M&A.
Lastly, share buybacks also tend to cut into corporate credit ratings:
The moving yearlong sum of US credit rating downgrades at least partly attributed to shareholder compensation rose from March 2015’s 32 and December 2015’s 48 to 61 for the span-ended March 2016. The yearlong sum of downgrades ascribed to either equity buybacks or dividends last climbed to 61 in early 2007.
Meanwhile, the yearlong sum of upgrades stemming from infusions of common equity capital (including IPOs) sank from the current cycle’s peak of 48 for the span-ended September 2010 to the 14 of the span ended March 2016, where the latter matched its current cycle low from the 12-months-ended September 2012 and December 2012. Regarding the previous upturn, the moving yearlong sum of equity-infusion upgrades sank from a June 2005 high of 57 to the 31 of December 2007.
The climb by shareholder compensation downgrades suggests corporations are increasingly compelled to take extraordinary measures in order to support equity prices. When companies are willing to return capital to shareholders even at the cost of a credit rating downgrade, managements implicitly admit to the difficulty of achieving a satisfactory return from business assets. (Moody’s)
Not only are corporations taking “extraordinary measures in order to support equity prices”, they are doing so using extraordinary ways, i.e. debt, as Bloomberg reveals:
As earnings fail to rebound, companies looking to charge up their stock returns with repurchases are turning to debt markets like no time since the Internet bubble. The proportion of buybacks funded by debt rose above 30 percent in June for the first time since 2001, data compiled by JPMorgan Chase & Co. and Bloomberg show.
And while all these M&A and debt-funded buyback activities are going on amid a profit recession, insiders are busy selling their company stock:
The number of officers and directors of companies purchasing their own stock tumbled 44 percent from a year ago to 316 in July, the lowest monthly total ever, according to data compiled by The Washington Service and Bloomberg that goes back to 1988. With 1,399 executives unloading stock, sellers outnumbered buyers at a rate that was exceeded only two other times. (…)
With equities setting records, insider purchases are dwindling, with two buying for every nine that sold. At 0.23, the buy/sell ratio is about one-third of what it was in February and last August, and compares with an average of 0.69 over almost three decades. (…) (Bloomberg)
Meanwhile, these trends are not friendly to credit ratings and bank profits:
In all, everything is converging towards higher credit spreads. Keep in mind that credit ratings don’t care about trends in earnings per share which contribute nothing to interest coverage and capital repayment. The reality is that S&P 500 companies’ aggregate operating profits have declined 14.5% from their Q3’14 peak while GAAP earnings have dropped 18.7% per S&P IQ data.
This corporate squeeze is confirmed by this chart from the U.S. national accounts showing corporate profits per unit of revenues (also called profit margins) which have dropped precipitously from 12.5% at their peak in Q4’14 to 10.6% in Q1’16.
By Q4’15, profit margins had collapsed 19.2% YoY. The good news is that this has historically been the bottom of the range. The bad news is that such bottom has generally been reached just before recessions, suggesting that corporations tend not to tolerate larger deteriorations in margins and aggressively cut costs to stabilize profits.
Margins did recover somewhat in Q1’16 but Moody’s is cautious going forward:
(…) the difference between the annual growth rates of the yearlong averages of corporate gross-value-added less unit labor costs offer insight regarding the state of the business cycle. The record shows that economic recoveries are better served the faster corporate gross-value-added grows vis-a-vis unit labor costs. To the contrary, recessions have been near, if not actually present, each time unit labor costs outpaced corporate gross-value-added over a year-long span.
Thus, the recent equality between the 2.5% annual growth rates for both corporate gross-value-added and unit labor costs during the year-ended March 2016 weighs against being too confident about the longevity of the current recovery. Nevertheless, if the ongoing slowdown by corporate gross-value-added, or the net revenue proxy, is mostly the offshoot of the energy recession, the faster growth of unit labor costs relative to the net revenue proxy may overstate the risks of a cyclical downturn. Still, the longer unit labor costs outrun net revenues, the greater is the risk of a recession.
Autumn brings changing climates. It also brings the annual corporate budget exercise when CEOs and CFOs call on their executives to adjust their business plans according to specific company parameters and objectives for the following year. This year, the message is likely to be: “Folks, we have a margins problem and neither increased demand nor higher prices will bail us out in 2017. Accordingly, costs must be reduced in order to protect profits.”
The surprise is likely to be that employment growth slows down considerably since labor is the largest cost item in just about every business. The other surprise is that this drive to cut costs will reverberate throughout the economy since one’s cost saving is someone else’s revenue loss.
Based on the payroll survey, employment growth has levelled off below 2%, actually slowing down in recent months:
Corporate hires (JOLTS) have also levelled off in the past year…
Mrs. Yellen’s own LMCI Index, derived from 19 labor market indicators, has been pretty weak recently, even with strong payrolls in June and July:
In the real world of small business owners, traditionally the most important job creators in the U.S., margins are getting seriously squeezed as worker compensation keeps rising faster than revenues. Overall profits have only been saved by the gigantic decline in energy prices but this is no longer contributing. Yet, demand is so weak that they can’t even think about raising prices. So they must revert to cost cutting. The latest NFIB survey reveals that 15% of biz owners planned to increase employment in July, down from 18% in June and 22% in May.
Another sign that corporations are already into cost control mode comes from the corporate travel industry, often among the first cost items to get axed by CFOs. Hotel management comments on earnings conference calls after Q2’16 uniformly complained about the softness in corporate demand. Occupancy is down 0.3% YtD (Smith Travel Research) and -2.0% during the first half of Q3. Raymond James calculates that U.S. hotel demand slowed from +2.9% in 2015 to +1.5% during the last 3 months and +0.6% in July. Airlines are also feeling the pinch with business travel down and getting worse as the year progresses.
The restaurant industry may also be starting to feel the corporate controller pinch with real sales growing 2.5% YoY in the 3 months to July, down from +4.7% in Q1’16 and +3.5% in Q2. The National Restaurant Association Performance Index has been weakening all year and went negative in June.
Back to declining margins on the S&P 500 Index, many think this is all energy related but Moody’s is says otherwise:
Extracting energy sales, broad estimates of business revenues still show sluggish growth. Take an estimate of core business revenues set equal to the sum of the sales of manufacturers, retailers, plus wholesalers less sales of identifiable energy products: Despite advancing by 0.7% from May 2016, June’s core business sales rose by only 1.4% from June 2015. Core business revenues slowed from H1-2015’s annual gain of 3.0% to the 1.5% of H1-2016.
This is at a time when unit labor costs are growing 2.5% annually. Factset calculates that the blended earnings decline for the S&P 500 in Q2’16 is –3.2% in total and +0.4% ex-Energy. The blended sales decline for Q2 2016 is -0.2%, +2.5% ex-Energy. With and without Energy, quarterly profit margins declined again in Q2 after having peaked in Q2’15.
Moody’s points out that such margin squeeze usually results in a widening in high yield bond spreads, contrary to what is currently happening:
Meanwhile, the recent drop in profits has boosted the dividend payout ratio to 45%, a level previously reached only during recessions. The hunt for yield is thus likely to get more challenging as fewer companies can justify raising their dividend rate.
This just when higher dividend payers are the darlings of investors. YTD, the S&P 500 Index boasts a total return on +7.8%, boosted by the +18.3% total return by high-dividend shares (SDY). The 720Global blog sums up how the hunt for yield has impacted U.S. equities YTD:
Bernstein Research has this P/E chart (via The Daily Shot):
Let’s focus on the Utility sector to see if we can find some fundamental support to its current valuation of 21x EPS (charts from CPMS/Morningstar).
- The dividend yield is at the bottom of the range with a 16-year high payout ratio:
- Debt/assets is at an historical high with return on assets reaching new lows at 2.9%.
- Cashflow has grown along with debt but CF/Debt has been trending down and is now near historical lows. What will happen if CF declines or interest rates rise? Or both?
- Admittedly, electric utilities’ margins have expanded tremendously in the past 2 years as coal and natural gas prices have collapsed. But this is a regulated sector, isn’t it?
- Yield hunters are thus chasing stocks of utility companies which collectively are achieving historically low returns on their highly levered assets even though the operating and financing conditions are near optimum. The cashflow coverage of their debt is historically low and their dividend payout ratio very high. God forbids a significant rise in coal or gas prices, let alone interest rates. What if regulators wake up and order lower electricity prices for their constituents? Or if solar panels become much more affordable and popular?
The Utility sector currently sells at 2.4x book value. Since 1993, its PB has ranged from 1.4x to 2.5x (excluding the flare ups to 3.0x in 2000 and 2.7x in 2007-08). A high PB ratio could be acceptable if ROE is also high. But the Utility sector’s ROE currently stands at 11.0%, a historical low. It had reached the 16% level during the bubble years of 2000 and 2007-08. One can also wonder if regulators will continue to allow current rates of returns if interest rates are really lower for longer.
All in, there is no better example of the high level of risk currently blindly taken by yield hunters.
One more thing: 39% of Utility companies missed their Q2 EPS estimate, worse than any other sector and twice the S&P 500 average. The miss on revenues was a huge 89%! These are utility companies…yet, their revenues declined 2.4% YoY on a –6.7% surprise factor. And this has been the best S&P 500 sector YTD with a 17.2% return.
The yield hunt has become very crowded and now has a very narrow exit door, unbeknown to most investors. CLSA’s Greed & Fear points out the extraordinary liquidity risk facing fixed income investors:
Remember that the ratio of corporate bonds owned by US mutual funds and ETFs, relative to brokers and dealers, has surged from 1.7x to 31x since 2007. This
liquidity issue will also be made worse by the extent to which emerging market debt is owned by open-ended mutual funds. Net assets in global emerging market bond funds and ETFs totalled US$401bn at the end of June, according to EPFR Global.
When money starts to flow out, as it inevitably will, selling through the narrow door will be painful.
To sum up,
- The worldwide hunt for yield since the Brexit vote has boosted valuations of most higher yielding securities and narrowed spreads across the board even though most recent economic and financial trends would normally dictate higher spreads.
- Corporate Indebtedness as a percent of revenues has risen to the point where it now exceeds its level at the start of the last three recessions.
- This is happening while revenue growth is slowing and profit margins are declining.
- Mergers and acquisitions, as well as share buybacks are adding to corporate leverage and causing accelerating credit ratings downgrades.
- Aggregate profits have declined 14.5% for operating profits and 18.7% for GAAP earnings since Q3’14, compounding the leverage problem.
- Corporations have already begun to reign in their expenses but the trend will likely accelerate in coming quarters as annual budgets need to take account of the increasingly challenging environment.
- Four consecutive declines in quarterly earnings have brought dividend payout ratios to 45%, a level normally seen only during recessions.
- This while higher dividend stocks are pulling equity markets higher into overvalued territory, even though corporate fundamentals are deteriorating.
SIRP (Safety and Income at a Reasonable Price) investing because of TINA (There Is No Alternative) has now reached a point where TINROS (There is Nothing Reasonable Or Safe). TWEB (This Will End Badly) and, once again, investors, including the little guy, will be severely hurt by central bank experiments.
When and how will “adverse consequences” happen? Dunno! It could be a black swan erupting from the very slow economies as often happens. It could be pain from rising interest rates (e.g. LIBOR). It could be poor earnings. It really does not matter. Remember what Forrest Gump said!
What is important is to understand that investors are currently accepting not being paid to carry a rising level of risk. This is the time to go on a long trip, start intensive golf lessons, get seriously into painting. Importantly, raise cash, reduce beta and forget about the market for a while.
- A baby boomers’ yield bubble! Demographics can be a powerful force behind financial markets. There are about 75 million baby boomers in the U.S. only and these people must be getting pretty worried just looking at two tables side by side: the mortality tables and the yield tables. Turning 65 and contemplating living through 90 with “safe” interest rates below 1% can be terrifying. For them, “lower for longer” means “poorer forever”. Many will keep working longer, even a few hours a week greeting people at Wal-Mart, but many others are now reaching for yield to boost their monthly revenue streams. The Fed is well aware of that as expressed in the July FOMC minutes:
Several [members] expressed concern that an extended period of low interest rates risked intensifying incentives for investors to reach for yield and could lead to the misallocation of capital and mispricing of risk, with possible adverse consequences for financial stability.
After having created the problem, the Fed thinks it can absolve itself simply issuing the warning.
Investors must be very careful. Losing money on a house when you are 30, 40 or even 50 is painful but leaves many years to hope to make it up. Losing capital at 65, 70 or 75 is downright ruinous. At such age, return of capital is much preferable than return on capital.
- A stabilization of high-yield credits thanks to a continued bull run:
Equity market performance matters greatly to corporate bonds, especially those rated less than high-grade. The strong performance by US equities since early 2016 has facilitated a notable stabilization of many high-yield credits and has helped to trigger credit rating upgrades.
Regarding the latter, the high-yield credit ratings of seven issuers from the hard-hit oil & gas industry have been upgraded thus far in the third quarter because of infusions of common equity capital, mergers, or asset divestments. These financially-driven upgrades received considerable support from a firmer equity market regardless of whether market valuations are fundamentally sound. (Moody’s)
Higher oil prices would help energy companies but would have adverse effects on all other sectors, either directly through higher operating costs or indirectly through reduced revenues as consumer disposable income would be diminished.
SHOULD WE BAIL OUT?
What is the downside risk?
- -6.0% to the 200-day moving average (2050 on the S&P 500 Index). Simple mean-reversion. The 2050 level also happens to be “fair value” on the Rule of 20 scale.
- -11% to 1940 at 19 on the Rule of 20, a level which has held on several corrective occasions since 2014.
- -19% to 1770 or 17.5 on the Rule of 20, the low touched in January 20, 2016 and again on February 11, 2016. While inflation is unchanged since, trailing EPS are 1.8% lower.
So, unless the earnings fundamentals deteriorate further, no bear market risk at this time.
- Since 1960, in all 7 instances when the Rule of 20 P/E crossed above 20, markets have gone on to reach at least 22.2 on the Rule of 20 scale. With current data on inflation (2.2%) and trailing EPS ($115.20), that gets the S&P 500 Index up 5.5% to 2300.
- In all but one, equities reached 23.1: +10.4% to 2400.
- Four out of 7 touched 24: +15.2% to 2510.
These assume that core inflation and trailing EPS are stable from here, two conditions that will likely not happen.
Inflation has ranged between 1.6% and 2.3% since 2012. Going back towards the lower end of the range would be positive for valuations but could also mean a weaker economy.
Profits are forecast down a little in Q3 but a normal beat could keep them stable. Current Q4 estimates are +8.3% on higher margins AND an acceleration of revenue growth from +1.5% in Q2 to +2.4% in Q3 and a heroic +4.8% in Q4. Unlikely in my view.
On balance, slightly more downside than upside
Market fundamentals (inflation + EPS) are not providing much tail wind, if any, over the next 3-6 months. Central banks are the only major supports for equities nowadays but do they really know what they are doing? Given the large number of potentially adverse factors, I would not place many chips on the upside table at this point in time.
Further tilting me towards the downside table are these facts:
- Economic surprises seem to be reverting to negative.
- Investors are pretty positive.
- Insiders are not acting positive.
- Brexit? Dunno. China? Dunno. Libor? Dunno.
- Elections? How bad would a surprise be? How bad would a non-surprise be? Dunno.
I anm staying negatively tilted with 2 stars. Not bailing out entirely because recession not in sight, yet, and a bear market seems unlikely, for now.