Last week, I started a new weekly series entitled "3 Things Worth Thinking About." The focus here will be three things, ironically enough, that are worth considering with respect to your portfolio and related investments. As I have discussed many times previously, focusing only on "bullish" commentary when markets are rising is really of little use as it creates a "blind spot" to related investment risks. The same goes for when markets are falling. These cognitive biases get in the way of making logical and disciplined investment decisions to not only garner returns when markets rise, but avoid depletion of capital when they don't.
1) Effect Of Buybacks On Earnings & Revenue
Let me start by saying that I do not disagree that improving earnings and revenue have indeed been important to the rise of the markets over the last 5 years. However, impact of a surge in corporate borrowing in order to reduce outstanding shares has begun to distort the level of actual profitability of corporations. The chart below shows how share purchases have elevated both operating and reported earnings as well as revenue per share.
The bullish argument used to support inflated asset prices has been the sharp improvement of "operating" [what would have been earned before all of this other stuff] earnings. While this is not incorrect, it is also important to understand the "quality" of those earnings as well. An increase in earnings by reducing outstanding shares did not increase the number of dollars actually earned.
This is an important concept because there is a major difference between what is happening at the bottom line of the income statement and the top line. While earnings can be inflated through the use of a myriad of accounting tactics, share manipulation and tax avoidance, (for more on this issue read "4 Tools Of Corporate Profitability") there is little than can be done to boost actual sales. As shown in the chart below, sales per share growth has grossly lagged both earnings and the inflation of asset of prices. As you can see, sales per share, has only risen by a little more than 5% annually since 2009, while the earnings have run between 34% and 46%.
The primary reason that companies have resorted to stock buybacks so heavily since the beginning of 2011 is because the beneficial effects of cost cutting, increasing productivity and reducing employee counts has been almost entirely exhausted. However, with sales growth slow, which is a representation of real economic strength, corporations remain reluctant to increase costs or employment any more than what is required by population growth.
Without a pickup in actual sales growth in the quarters ahead, which would require significant improvement to economic growth caused by rising wages and production, the lofty expectations for continued earnings expansion will likely disappoint. This is a significant risk to the ongoing bull market thesis.
2) Employment Report
Tomorrow brings another employment report with all eyes focused on the headline number. It will not be surprising to see a print above the 200,000 level which, as it has been over the past 48 months, remained roughly in line with working age(16-54) population growth. However, from the beginning of 2009, employment has been outpaced by population growth overall.
This factor alone brings into dispute the 6.1% unemployment rate which would suggest that 93.9% of the working age population is gainfully employed. The problem with that assumption is that while total employment has grown by 5.4% since the beginning of 2009, the number of individuals that are no longer counted as part of the workforce has grown by over 14%.
However, the most important aspect to watch tomorrow will be the number of "full-time" jobs created. As I have discussed previously, it is only full-time employment, which provides higher wages and benefits, that fosters household formation growth and higher levels of consumption. This is crucially important to an economy that is almost 70% driven by consumption alone. As shown in the chart below, the number of full-time jobs as a percentage of the working-age population has failed to improve much at all. This is the effect of corporations reducing high-cost employment in order to boost profitability.
This is also an issue that fails to support the idea that the economy is set to come "roaring" back to life. While GDP did print 4% for the second quarter, the decline in final sales and income suggests that the bounce back from the dismal first quarter report is likely transient. (read here for more analysis on Q2 GDP)
3) High Yield Debt Default Risk
Earlier this week I discussed the "Misunderstandings Around The End Of QE" in which I made the following statement:
"I think the real risk lies in the 'high yield' space where yields are at historic lows and complacency reigns. Anything that upsets the delicate balance of confidence could lead to a panic based selloff that would resemble the 2008 financial crisis."
At that time, it was just a speculation that was only beginning to take shape considering the very narrow spread between "junk bond yields" and government bonds. Such abnormalities in rates can not last indefinitely and will eventually revert to more normal levels. The negative consequences to holders of such securities when that occurs can be devastating. It also means that the companies that issued the "junk bonds" to begin with will likely default on those debts during increase in rates that cuts off their ability to finance their survival.
Today, Fitch warned that the "high yield" default rate is set to jump. To wit:
"A potential bankruptcy filing from another struggling giant, Caesars Entertainment Operating Co., would propel the trailing 12-month US high yield default rate to 3.4% from its June perch of 2.7%, according to Fitch Ratings. With its $12.9 billion in bonds in Fitch's default index, the gaming company's impact on the default rate is pronounced - similar to Energy Future Holdings' (EFH) April bankruptcy. Caesars also adds to notable trends of busted LBOs and the exclusive camp of serial defaulters.
There have been 10 LBO related bond defaults thus far in 2014, compared with nine for all of 2013. The failed LBOs affected $21.8 billion in bonds this year and 26% of all bond defaults since 2008. Caesars would bring the latter tally to 29%. In addition, a Caesars filing would follow two prior restructurings via distressed debt exchanges (DDEs). Since 2008, 24% of issuers engaged in DDEs have subsequently filed for bankruptcy.
June defaults included Affinion Group, Allen Systems Group, MIG LLC, and Altegrity Inc., bringing the year-to-date high yield default tally to 20 issuers of $23.7 billion in bonds versus an issuer count of 19 and dollar value of $8.4 billion in first-half 2013. July defaults have so far included Essar Steel Algoma and Windsor Petroleum Transport.
At midmonth, approximately $33 billion in high yield bonds were trading at 90% of par or less - a relatively modest 2.9% of the $1.1 trillion in bonds with price data."
From an investment standpoint, a crisis in the high-yield market that spurs an investment panic could spread rapidly through the financial markets. With investors having "chased yield" to a massive extent over the past 5 years, the panic to exit the space could be overwhelming.
This is an area that should be monitored closely.
As I started out by saying, bullish and bearish arguments are great. However, they do not help us manage risk unless they can be put into some context. My goal each week will be simply to pick out issues where potential risks might be overlooked and bring those to light for you to consider.
With our portfolio models currently fully allocated, I admit that I am just a little more than uncomfortable at present. However, the technical trends of the market remain broadly positively which forces me to keep assets invested with risk reduction being accomplished through asset allocation and proactive rebalancing. Importantly, there are early signs of technical deterioration of market internals that have historically only been prevalent before short to intermediate term market correction. I am watching those indications closely and will alert you should anything more substantial develop.