Tag Archives: environment

The Stock Buyback Conundrum: Will Companies Keep It Up Much Longer?

Some facts are more interesting than others. For example, Liz Ann Sonders, chief investment strategist and perma-bull at Charles Schwab, recently acknowledged that “…there has not been a dollar added to the U.S. stock market since the end of the financial crisis by retail investors and pension funds.” Let the reality sink in for a moment. “Mom-n-pop” investors as well as pension funds have not added to their U.S. equity positions during the seven-year-plus bull market. That includes the last three months in which major bank clients (e.g., hedge funds, private clients, institutional investors, etc.) have been net sellers. Since every buyer has a seller (and vice versa), what group or groups had enough of a buying presence to push the S&P 500 14.2% off of the February closing lows? Corporations. Click to enlarge The notion that corporate share buybacks have been influential in propping up stocks is nothing new. On the flip side, the extent of the influence may be much greater than previously realized. Standard & Poor’s 500 Index constituents acquired roughly $182 billion of stock in the first quarter of 2016 alone. Even today, with real yields ticking up from 0.0% to 0.4%, companies may not wish to pass up the perceived opportunity to fund share acquisitions through ultra-cheap debt issuance. Unfortunately, debt-funded buybacks present a number of challenges. First of all, total debt levels for U.S. companies have doubled since the Great Recession. While many analysts focus solely on the current ability for companies to service their debt obligations, the capacity for companies to do so changes when borrowing costs increase, free cash flow sinks and/or net income declines. Consider free cash flow after dividends. This refers to the cash flow from operating activities excluding fixed capital expenditures and dividends paid. In Q4 of 2015, companies spent 101.7% of free cash flow after dividends. 101.7%! Not only was that a sizable year-over-year jump from Q4 2014 when the ratio chimed in near 81%, but it demonstrates that S&P 500 corporations (in aggregate) are now spending every free dollar on the support of stock prices. If they continue to spend every dime to support stock prices, rather than growing respective businesses via capital expenditures, the inevitable stagnation would hinder long-term profit prospects. A second significant challenge to the buyback game? Companies that have spent more on stock buybacks are underperforming relative to those that have spent less on buybacks. At some point, buyback activity may be reined in by executives who become cognizant of the underachievement, particularly if there are cash flow concerns. It follows that the stock market’s only buyer would require another major group to step up its participation, or the selling pressure would overwhelm current prices. There is a third, more ominous complication associated with debt-funded buyback activity. Specifically, what would happen if credit conditions tightened? Even a modest tightening similar to what transpired in the first few months of 2016 would lead to trouble for corporations looking to finance and acquire shares. Whether spreads between treasury bonds and corporate bonds (e.g., investment grade, high yield, etc.) widen, or whether global growth concerns slam the world’s financial institutions again, it is not far-fetched to imagine easy money access becoming a little less easy. One way that a few folks are evaluating the current climate for stocks as well as the liquidity of corporations is by addressing the “Buyback to Free Cash Flow Ratio.” The higher the ratio, the more troublesome the environment. Unfortunately, at the current moment, the ratio is dangerously high – near the highest levels since the Great Recession ended (58.3%). And since corporations haven’t really slowed their insatiable appetite for buybacks just yet, the rising ratio represents aggregate free cash flow (S&P 500) dropping 9.5% on year-over-year basis. Translation? Stocks could fizzle out from their effervescent levels. Click to enlarge Total debt levels rising, net income declining, free cash flow falling, CEO realization of stock underperformance, higher borrowing costs/credit access issues. Any combination of these items is likely to inhibit the buyback support to overvalued S&P 500 equity prices. Granted, there are eternally bullish advocates like Liz Ann Sonders who claim that retail investors and pension funds will pick up the slack when corporations stand down. (Really? These groups will suddenly add substantially to their stock allocations after seven years?) Ms. Sonders also believes that a softening in buybacks would simply morph into capital expenditures, and thereby boost corporate growth prospects going forward. The problem with that assumption? “Core CapEx” has rarely looked worse at a time when the Fed is not considering additional emergency easing measures. Click to enlarge For roughly one year, our tactical approach to asset allocation has called for a defensive bias. We downshifted our moderate growth-and-income clients from 65%-70% diversified growth (e.g., large-cap, small-cap, foreign, etc.) to 45%-50% high-quality stock. Appropriate ETFs in this arena include iShares MSCI Quality Factor (NYSEARCA: QUAL ), PowerShares S&P 500 Quality (NYSEARCA: SPHQ ) and/or iShares MSCI Minimum Volatility (NYSEARCA: USMV ). We lowered moderate clients from 30%-35% diversified income (e.g., investment grade, higher yielding, foreign, etc.) to 25%-30% investment grade bonds. Appropriate ETFs for investment grade assets include SPDR Nuveen Municipal Bond (NYSEARCA: TFI ), iShares 7-10 Year Treasury (NYSEARCA: IEF ) as well as Vanguard Total Bond (NYSEARCA: BND ). The resulting 20%-30% cash/cash equivalent allocation has buffered against several volatile 10%-plus corrections (i.e., August-September and January-February). We anticipate putting the cash back to work at lower prices when the S&P 500 reaches a bearish low-water mark (1705) and/or the Federal Reserve announces a fourth iteration of quantitative easing (QE4) . Indeed, we concur with the assessment that the expansion of the Federal Reserve’s balance sheet has been responsible for 93% of stock gains since the bull market inception in March of 2009. Click here for Gary’s latest podcast. Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.

The Placebo Effect

I’ve had four or five true migraines in my life, mostly from getting whacked on the head with something like a baseball or a sharp elbow in basketball, and I honestly can’t imagine how horrible it must be to suffer from chronic migraines, defined by the FDA as 15 or more migraines per month with headaches lasting at least four hours. So I was happy to see a TV ad saying that the FDA had approved Botox as an effective treatment for chronic migraines, preventing up to 9 headache-days per month. That’s huge! But in the fast-talking coda for the ad, I heard something that made me do a double-take. Yes, Botox can knock out up to 9 headache-days per month. But a placebo injection is almost as good, preventing up to 7 headache-days per month. Now 9 is better than 7 … I get that … and that’s why the FDA approved the drug as efficacious. Still. Really? Most of the reports I’ve read say that the cost of a Botox migraine treatment is about $600. That’s just the cost of the drug itself. So what the FDA is telling us is that a saline solution injection (costing what? $2) is almost 80% as effective as the $600 drug, so long as it was presented to the patient as a “true” potential therapy . If I’m an Allergan (NYSE: AGN ) shareholder I’m thanking god every day for the placebo effect. And not for nothing, but I’d really like to learn more about why Botox was NOT approved for migraine sufferers with fewer than 15 headache-days per month. If I were a gambling man (and I am), I’d be prepared to wager a significant amount of money that Botox significantly reduces headache-days at pretty much any level of chronic-ness, from 1 day to 30 days per month, but that at lower migraine frequencies a placebo is just as efficacious as Botox. In other words, I’d bet that ALL migraine sufferers would benefit from a $600 Botox shot, but I’d also bet that ALL migraine sufferers would benefit from a cheap saline shot so long as the doctor told them it was a brilliant new drug, and they’d get as much or MORE benefit from the cheap saline shot than from Botox if they’re “just” enduring eight or nine migraine headaches. Per month. Geez. Of course, there’s no economic incentive to provide the cheap placebo injection nor the unapproved (and hence unreimbursed) Botox shot if you have fewer than 15 headache-days per month. Bottomline: I’d bet that millions of people who don’t meet the 15 day threshold are suffering from terrible pain that could absolutely be alleviated at a very reasonable cost if it weren’t criminally unethical and (worse) terribly unprofitable to lie about the “truth” of a placebo treatment. Of course, we have no such restrictions, ethical or otherwise, when it comes to monetary policy, and that’s the connection between investing and this little foray into the special hell that we call healthcare economics. The primary instruments of monetary policy in 2016 – words used to construct Common Knowledge and mold our behavior, words chosen for effect rather than truthfulness, words of “forward guidance” and ” communication policy ” – are placebos. Like a fake migraine therapy, the placebos of monetary policy are enormously effective because they act on the brain-regulated physiological phenomena of pain (placebos are essentially useless on non-brain-regulated phenomena like joint instability from a torn ligament or cellular chaos from cancer). Even in fundamentally-driven markets there’s a healthy balance between pain minimization and reward maximization. In a policy-driven market? The top three investing principles are pain avoidance, pain avoidance, and pain avoidance. We’re just looking to survive, not literally but in a brain-regulated emotional sense, and that leaves us wide open for the soothing power of placebos. I get lots of comments from readers who don’t understand how markets can continue to levitate higher with anemic-at-best global growth, stretched valuation multiples, and an earnings recession in vast swaths of corporate America. This week I’m reading lots of comments post the failed Doha OPEC meeting that oil prices are doomed to see a $20 handle now that there’s no supply limitation agreement forthcoming. Yep, that’s the real world. And there’s zero monetary or fiscal policy in the works that has any direct beneficial impact on any of this. But that’s not what matters. That’s not how the game is played. So long as the Fed and the ECB and the BOJ are playing nice with China by talking down the dollar regardless of what’s happening in the real world economy, then it’s an investable rally in all risk assets , and oil goes up more easily than it goes down, regardless of what happens with OPEC. The placebo effect of insanely accommodative forward guidance that has zero impact on the real economy is in full swing. Oil prices are driven by forward guidance and the dollar, not real world supply and demand . Every day that Yellen talks up global risks and talks down the dollar is another day of a pain-relieving injection, regardless of whether or not that talk is “real” therapy. Does this mean that we’re off to the races in the market? Nope. The notion that we have a self-sustaining recovery in the global economy is laughable, and that’s what it will take to stimulate a new greed phase of a rip-roaring bull market. But by the same token I have no idea what makes this market go down, so long as we have monetary policy convergence rather than divergence, and so long as we have a Fed that loses its nerve and freaks out if the stock market goes down by more than 5%. So long as the words of a monetary policy truce hold strong, this isn’t a world that ends in fire and it isn’t a world that ends in ice. It’s the long gray slog of an entropic ending . Anyone else intrigued by the potential of a covered call strategy in this environment? I sure am. But wait, Ben, isn’t a covered call strategy (where you’re selling call options on your long positions) the opposite of convexity? Haven’t you been saying that a portfolio should have more convexity – i.e. optionality, i.e. buying options rather than selling options – rather than less? Yes. Yes, I have. But optionality isn’t the same thing as owning options. In the same way that I want portfolio optionality that pays off in a fire scenario (a miracle happens and global growth + inflation surges forward) and portfolio optionality that pays off in an ice scenario (China drops a deflationary atom bomb by floating the yuan), so do I want portfolio optionality that pays off in a gray slog scenario. That’s where covered calls (and covered puts for short positions) come into play. It’s all part of applying the principles of minimax regret to portfolio construction , where we don’t try to assign probabilities and expected return projections to our holdings, but where we think in terms of risk tolerance and minimizing investment pain for any of the market scenarios that could develop in a politically fragmented world. It’s all part of having an intentional portfolio , where every exposure plays a defined role with maximum capital efficiency, as opposed to an accidental portfolio where we just slather on layer after layer of “quality” large cap stocks . The Silver Age of the Central Banker gives me a headache. I bet it does you, too. Let’s take our relief where we can find it, placebo or no, but let’s not mistake forward guidance for a cure and let’s not forget that sometimes pretty words just aren’t enough. The truth is that the global trade pie is still shrinking and domestic politics are still anti-growth in both the US and Europe . Neither math nor human nature gives me much confidence that the currency truce can hold indefinitely, and I still think that every policy China has undertaken is exactly what I would do to prepare for floating (i.e. massively devaluing) the yuan. It’s at moments like this, though, that I remember the short seller’s creed: if you’re wrong on timing, you’re just wrong. I don’t know the timing of the bigger headaches to come, the ones that words and placebos won’t fix. What I do know, though, is that an investable rally in risk assets today gives us some breathing space to prepare our portfolios for the even more policy-controlled markets of the future. Let’s not waste this opportunity.