We're In A Recession - And You Should Be Happy About It

| About: SPDR S&P (SPY)

Summary

One of the great debates among market participants these days revolves around the extent to which bottom line beats are attributable to corporate buybacks.

The corporate put matters - a lot.

At what cost are corporations keeping a floor under stocks?

Ok, so one of the great debates among market participants these days revolves around the extent to which bottom line beats are attributable to corporate buybacks.

Those of a skeptical persuasion are keen on emphasizing the apparent correlation between ZIRP, corporate issuance, share repurchases and the long-running equity rally.

To be sure, it's difficult to ignore the trend. Here's IG issuance (note that supply hasn't slowed down at all this year):

(Chart: Goldman)

And here're buybacks plotted with the number of companies repurchasing shares along with the S&P:

Click to enlarge

(Chart: FactSet)

Say what you will about margin expansion, you'd be fooling yourself if you didn't acknowledge the role buybacks have played it propping up the bottom line and thus, the stock market.

Of course, it's all made possible by ZIRP. The reason capital markets are as wide open as they are is because the Fed has kept a lid on rates. This herds investors out of government bonds and into IG corporates. And then on to HY corporates.

This, even as most investors have no idea that the fundamentals are getting worse. As Deutsche Bank notes, "much attention has been paid to the spike in default rates among energy sector issuers, [but] equally dramatic has been the trend toward lower qualities among even the highest-rated issuers."

"For example," the bank continues, "53% and 45% of AA and A-rated issuers, respectively, moved one letter-rating lower in the year through May 2016."

Check this out (this a great graphic):

(Table: Deutsche Bank)

Clearly, that presents a problem in terms of what happens when everyone wants to sell, but liquidity isn't what we're talking about here, so let's get back to the buybacks.

The thing is, when you're buying back shares, you're not investing in productive capacity. That creates issues in terms of labor productivity. Here's why that matters via Deutsche (emphasis mine):

Whether productivity can recover from its current doldrums and do the same is one hope against secular stagnation. Productivity itself translates supply into demand via lower prices than otherwise -- prices fall and raise consumer purchasing power. The very stagnation of productivity itself has therefore not allowed price declines. The reliance of satisfying underlying demand meanwhile has exclusively rested on the shoulders of labor and hence raised unit labor costs. This has become the essence of the profit recession and is a vicious circle facing the corporate sector. As producers, there is the absence of profit growth due to high unit labor costs and as price takers, weak profits inhibit a supply led boom that creates new demand, via still lower prices. This may be a function of technology not being sufficiently disruptive to bounce out the supply curve; it may reflect an inefficiency in capital markets that has rewarded shareholders for buybacks rather than new investment.

So you're juicing EPS and thus feeding an artificial equity rally at the expense not only of long-term competitiveness, but also at the expense of the nascent US economic recovery. And it's all being funded by debt (i.e. leveraging the balance sheet) sold to those who have nowhere else to turn because the Fed refuses to normalize policy.

Want to know how much the corporate put means to US stocks (NYSEARCA:SPY)? Have a look at the following table from Goldman:

(Table: Goldman)

Net demand for equities outside of buybacks has been negative for at least four years! Corporations are the only game in town.

If you're heavily invested in US stocks, ask yourself what happens when the cost of capital rises (or when balance sheet leverage simply reaches a ceiling) and the corporate bid dries up.

I could go on ad nauseam, but let me close, for now, with one last chart which shows that since 1954, there have only been two other occasions when capex growth has flat-lined outside of a recession.

(Chart: Deutsche Bank)

So if you're long stocks, you should be happy we're in a capex recession. It's apparently keeping a floor under your holdings.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.