Cutting Through the Noise - a financial blog by Bill Martin, CFA
...The incredible levitating market
This month we investigate the forces that drive the stock market higher in spite of weaker corporate earnings:
- Lower interest rates help discount a company’s future earnings to look more attractive than the rates investors can get on their cash and bond holdings. Thus, lower rates encourage investors to pay higher multiples for each dollar of current earnings.
- Corporations are buying back their own stock at record levels… this helps lower the number of shares outstanding and increase earnings per share over a reduced number of shares.
- Merger and Acquisition activity increases demand for remaining shares, while reducing supply.
Last time, we looked at how earnings have been impacted by a slow and maybe even stagnating global economy. Indeed, the 2nd quarter earnings are now in the books and have declined for five quarters in a row when compared with the prior year. The last time this happened was during/following the great recession. Although most people remember that one, it seems most investors have forgotten it.
Yet, the market still wants to go up… what gives? Well, there are actually a few very logical explanations for the market’s rise, and these market dynamics could continue to play out for some time. In the interest of showing both sides of the same coin, and putting aside the many reasons a professional investor might be skeptical, we will peer into the market’s bag of tricks to see what has been behind its impressive levitating act.
OK, this one is Math, not Magic—Lower Rates Raise Equity Valuations more than earnings!
When rates go down, the multiples that investors are willing to pay for each dollar of earnings goes up. This relationship is built into the math of equity valuation, so it is a causal and deterministic relationship. In some ways it makes intuitive sense—you’ll forego low rates and pay more for future earnings when inflation is low, and pay less for future earnings when inflation is high. You can see this relationship in the chart below by Robert Shiller. The red line is the yield on the 30-year Treasury and the (blue/green?) line is the Price/Earnings multiple, calculated with the last ten years’ earnings.
We can clearly see how the run up in interest rates in the early 1980’s negatively impacted investors appetite for stock market earnings. Conversely, the resulting decline in interest rates has largely increased the amount investors are willing to pay for a dollar of earnings. The relationship between the valuation of all assets and the risk-free interest rate for US Treasury bonds is among the strongest in markets.
Declining interest rates have had a huge positive impact on equity valuation and equity returns. Of course, rates don’t fall forever. The (9/21/2016) 30-year Treasury’s yield is 2.39%, which is at least a half percent below the long-term rate of inflation, while inflation has been below the Fed’s target of 2.0% for most of the last four years. Buying Treasury’s is like putting your paper cash in a high-priced safety deposit box or taking $100 out of an ATM machine that charges a 75 cent fee. It is, of course, supposed to be an investment that attracts investors because it accrues interest at a rate higher than inflation. Rates are likely to be a headwind for equity valuation if inflation increases above 2%, and the headwind transforms into a gale force wind if inflation falls below 0%. That narrow range means the positive impact of declining rates on equities is relatively bound. Only zero inflation or deflation (falling prices) is likely to drive rates lower, while deflation would also put a major dent in corporate earnings prospects.
"Buying Treasury’s is like putting your paper cash in a high-priced safety deposit box or taking $100 out of an ATM machine that charges a 75 cent fee."
The Buyback Trick
With record low interest rates helping to make equities appear undervalued relative to bonds, the corporations are getting in on the game of buying back their stock at record levels. Buybacks achieve a few things—they increase earnings-per-share by retiring shares, they create demand in the market when they buy their own shares, and they reduce the supply of shares outstanding, which means higher prices if demand is constant, all else equal. All of those beneficial effects can occur without selling a single good or service, which was the raison d' être for corporations. It is among the stranger side effects of the Fed’s aggressive interest rate policy. Move over David Copperfield, these CEOs are making their shares outstanding disappear faster than the Statue of Liberty.
Not only are corporations buying their stock with retained earnings, but also borrowing to buy their stock. We can see from the dark blue line in the chart above that approximately 30% of all share buy backs are now funded through debt. Debt-financed buybacks will not be sustainable as rates begin to rise, but it sure gives the market a nice goose in the meantime. As we discussed a couple months ago, wouldn’t it be nice to see these companies have opportunities to invest in their own businesses, as opposed to just buying back their own stock?
“Move over David Copperfield, these CEOs are making their shares outstanding disappear faster than the Statue of Liberty.”
Who’s Buying this Bull?
In the below chart titled “Bull Market’s only Buyer”, we see that bars centered on the “0” line, which represent natural equity buyers, have been predominantly negative for the past two years. In fact, outside of a brief buying spree in 2013, mutual fund investors have been net sellers of equity since the bull market began in early 2009. If that’s the case, why have stock prices tripled in value since then? Well, to answer that question, the white line demonstrates that the corporations themselves have been the buyer behind this bull market. As long as they have cheap debt or free cash flow they will continue to drive their stock prices higher. Of course, the fact that they spent the better part of the last decade buying their own stock instead of investing in their business may mean that the decision to buy their stock at relative highs could make their businesses less productive and less competitive in the next ten years. The last time buybacks were this high was just prior to the financial crisis in 2008.
“Of course, the fact that they spent the better part of the last decade buying their own stock instead of investing in their business may mean that the decision to buy their stock at relative highs could make their businesses less productive and less competitive in the next ten years.”
Making Two Companies into One: the Oldest Trick in the Book
Mergers and acquisitions (M&A) have been another driving force behind the market’s ‘growth’. The level of M&A activity has picked back up to record levels. These types of transactions can be very supportive to the market because they provide demand for shares from the buying firm, while removing supply by reducing the number of companies available for investment. What’s more, plenty of empirical evidence demonstrates that companies with aggressive acquisition strategies are capital destroyers. This is no cheap sleight-of-hand trick. This is on the level of the legendary magic of Harry Houdini. When you can’t buy any more of your own stock and don’t have any attractive growth opportunities for your own company, it’s apparently time to buy-up your competitor’s stock instead.
“This is no cheap sleight-of-hand trick. This is on the level of the legendary magic of Harry Houdini.”
The Case of the Disappearing Stock
You don’t have to be Sherlock Holmes to see what’s going on here—the supply of available stocks has also fallen precipitously. Our final graph shows the number of companies that are actually available for investment. Some of the decline is due to a slow pace of Initial Public Offerings(IPO) and tech firms choosing to remain private because they have cheap access to capital and lower regulatory hurdles. The total number of stocks has been cut in half in less than twenty years, hitting a 40-year low.
“Many investors still see the US as the cleanest dirty shirt in the closet, or if you will allow, the skinniest horse in the glue factory.”
Can all these tricks continue? You bet they can. Markets typically overshoot. Many investors still see the US as the cleanest dirty shirt in the closet, or if you will allow, the skinniest horse in the glue factory. The US stock market can continue to win this relative valuation game.
Will it end well? Probably not. While US equities look cheap vs other assets on a relative basis, they can and will look expensive on an absolute basis if earnings continue to stagnate or interest rates back up to their more “normal” levels. We may be approaching a fulcrum…if earnings pick up, then rates will likely rise and that can’t be good. If earnings decline further, then rates will decline, adding support to valuations; however, the Fed will need to find a new bag of tricks to battle an all out earnings or economic recession.
Next time, we’ll leave the magic jokes behind and dive into market valuation to see if we can get a sense for how much longer this market might be able to levitate.