Could Financial Engineering Backfire?

 |  Includes: AGG, DBC, GLD, IWM, QQQ, SPY
by: Chris Ciovacco

Experienced investors know we are in an era where central banks are playing a much larger than normal role in the financial markets. The Fed has openly talked about money printing and asset prices during their unprecedented three rounds of quantitative easing (QE). The European Central Bank (ECB) offered unlimited three year loans to financial institutions to kick the European debt crisis can down the road in late 2011. The financial engineering has also found its way onto the balance sheets of U.S. corporations. From Bloomberg:

"As companies are less and less able to deliver earnings growth through internal efficiencies and top-line growth, and at the same time shareholders are pushing for increased rewards, they're turning to financial engineering to push returns," said Alan Shepard, an analyst and money manager at Madison Investment Advisors Inc., which oversees about $16 billion in Madison, Wisconsin. "Borrow the money at low rates to finance repurchases and you can drive earnings-per-share growth."

Similar To 2009

With the Fed and ECB holding interest rates at artificially low levels while pumping unprecedented amounts of freshly printed money into the global financial system, it is fair to say pricing has been skewed in almost every asset class. Rising interest rates could not only spook stock and bond investors, but the negative effects could spill over to corporate debt loads. From Bloomberg:

Company debt loads in the U.S. are approaching the highest level since the aftermath of the financial crisis as borrowing to finance mergers and shareholder payouts exceeds earnings growth. Debt levels have increased faster than cash flow for six straight quarters, boosting the obligations of investment-grade companies in the second quarter to 2.09 times earnings before interest, taxes, depreciation and amortization, according to JPMorgan Chase & Co. That's up from 2.07 times in the first three months of 2013 and compares with 2.13 in the third quarter of 2009, when it peaked after the deepest recession since the Great Depression.

Slowing Momentum

High debt levels on corporate balance sheets will most likely not pose any problems unless they are provoked by a weakening stock market and/or economy. The stock market may be up to the task. In June, we noted the similarities in the popular momentum indicator (MACD) to the October 2012 correction. The updated version of the chart below continues to paint a concerning picture for stocks.

Steeper Decline Than Expected

Central bankers hope low interest rates will entice buyers to step up to the 30-year mortgage plate. We do not need to be a Nobel prize winning economist to understand rising interest rates can discourage would-be home buyers. From Reuters:

Contracts to purchase previously owned U.S. homes fell for the second straight month in July, a sign that rising mortgage rates are taking the steam out of America's housing market recovery. The National Association of Realtors said on Wednesday its Pending Homes Sales Index, based on contracts signed last month, decreased 1.3 percent to 109.5. That was a steeper decline than most analysts had expected, and could provoke added caution at the U.S. Federal Reserve over plans to reduce a bond-buying economic stimulus program.

Investment Implications - Risk Reduction

Our market model called for the fourth round of risk reduction Tuesday. Our cash position is now basically on par with our exposure to stocks (NYSEARCA:SPY). We still have exposure to technology (NASDAQ:QQQ) and small caps (NYSEARCA:IWM), but they have more cushions in the form of rising money market balances. If stocks cannot find their footing, we will consider adding some exposure to gold (NYSEARCA:GLD), commodities (NYSEARCA:DBC), or bonds (NYSEARCA:AGG). Risk-off assets have not shown enough yet to warrant purchases, but they are on our radar. If the Fed hints at no taper in September, we can migrate back to a more fully invested equity allocation. The bulls have some work to do before we can prudently scamper back toward stocks.

Disclosure: I am long QQQ, SPY, IWM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.