Stocks are behaving pretty much as I expected:
- In early September I said strategists were “disturbingly bullish” and a correction would not be surprising. We did get a correction, though arguably it was not scary enough to sweep away the complacency.
- In mid October, based on very early Q3 results, I wrote, “I believe investors will conclude in mid November that third quarter profits were fairly good and better than feared.” That appears to be correct.
Most strategists are using $126 for SPX profits next year, which seems doable. If we stay at a trailing PE of 17x, we hit 2142 by year-end 2015, up 6%, with a total return of 8%. With the world awash in liquidity, short rates near zero, and the U.S. standing out as the last bastion of capitalism, it would not be shocking if stocks do better than that. A Republican Congress would improve the regulatory backdrop, which matters more than most economists and strategists recognize because they can’t plug regulatory policy into their models.
That said, you have to be worried that Japan and Europe are using monetary easing to keep their economies afloat, when the real problem is structural flaws that are impervious to monetary policy. Both regions need a Thatcher or Reagan to revive capitalism. Meanwhile the BRICs are crumbling. (The exception is India which, having already crumbled, is trying to rebuild under Modi.) Growth in China will continue to slow as the credit crunch hits real estate, which in turn restrains consumption. No Street economist wants to be the first to forecast GDP growth under 7%, which might offend the government. Brilliant independent strategist Jonathan Anderson has no such qualms; he is quoted in the FT saying,
“I’m confident we won’t see a collapse or a financial crisis in China, but, as credit conditions tighten in the next year or so, things are going to get ugly and we will have much less growth . . . . What we will inevitably have is a big shakeout on the supply side because that’s where all the credit has gone and we may see companies start going bankrupt in droves.”
Somehow that does not make me feel better—no credit crisis in China, just companies going bankrupt in droves.
Buy-backs: Funded by Debt?
When it comes to job creation, liberals need to get their story straight. Hillary says “don’t let anybody tell you, that, you know, it’s corporations and businesses that create jobs. You know, that old theory, trickle-down economics. That has been tried. That has failed. That has failed rather spectacularly.” Weirdly, Hillary claims that her husband’s time in office invalidated “trickle down” when the opposite is true. With Republicans in Congress restraining Federal spending and (with Bill Clinton’s approval) cutting capital gains taxes in 1997, we had a technology boom, a stock market boom, a briefly balanced Federal budget, a plunging unemployment rate, and rising real wages across the income spectrum. It was the best time for low-income workers since the mid-1960s—even though inequality increased sharply.
Anyhow, many liberal pundits writing in the NYT and FT disagree with Hillary. They are criticizing companies for buying back shares instead of investing in their business and creating jobs. And it’s not just pundits who hate buy-backs. Many stock market bears argue that one of the channels by which central banks’ “easy money” inflates stock prices is companies borrowing heavily to finance share buy-backs. This is not “real growth,” the bears argue, but unsustainable “financial engineering” that will be derailed by an eventual rise in interest rates.
DJIA Buy-backs
I decided to find out for myself whether companies really are leveraging up to fund share buy-backs. I examined the 30 Dow Industrial companies to answer, for each individual company, two questions:
- Did the number of shares outstanding decline between 2010 and 2014?
- Did the debt / equity ratio increase between 2010 and 2014?
The short answers: Yes and No.
Yes, buy-backs were pervasive among these thirty “blue chips.” Between 2010 and 2014, share counts declined for every company save two (JNJ and VZ). The median share count decline over the four years was 8.6%, implying that buy-backs boosted earnings per share by around 2.2% per year—a lot when the secular EPS growth of the S&P 500 is 6%. The companies with the biggest share count declines were HD (-19.3%), IBM (-19.8%), PFE (-21.4%), TRV (-24.1%) and V (-25.3%).
On the other hand, No, companies did not load up on debt to finance these buy-backs. The median debt / equity ratio rose only very slightly, from 38.1% to 39.7%, even though companies had ample incentive to borrow more as the economy improved and interest rates stayed low. Six companies, four of them financials, slashed their debt / equity ratios dramatically while only two (HD and IBM) increased their leverage ratio substantially. It’s true that IBM should have been doing fewer buy-backs and more investment in its business; it has fallen behind the cloud curve. But IBM is very much the exception, not the rule.
Rational Cash Use Supports Stocks
Hefty share buy-backs by the corporate giants in the DJIA is bullish, not bearish. Many of the problems of big, mature firms are self-inflicted—excessive capex, dumb expansion overseas, stupid acquisitions. Such mistakes are likely to be fewer and smaller if companies pay a decent dividend and boost EPS growth with buy-backs.
More broadly, one reason why bearish deflationists have been far too bearish on profits is that companies have figured out how to deliver an 8-10% total return to shareholders through a judicious combination of organic growth, acquisitions, share buy-backs (which collectively generate, say, 7% EPS growth) plus a dividend yield of 2%. That’s mighty attractive when treasuries yield 2.3%.
Copyright Thomas Doerflinger 2014. All Rights Reserved.
