Staying Away From 'Junk' Pays Dividends

| About: SPDR S&P (SPY)

Going into the Brexit vote last Thursday, the latest polls implied that Britain would vote to remain in the European Union (EU). That expectation sparked a major market rally, along with a huge reserve of cash on the sidelines waiting to pour into stocks in Europe and around the world on the conclusion of the vote.

However, the British polls turned out to be very wrong. The final Brexit vote came in with only 48.1% wanting to stay in the EU versus 51.9% voting to exit. British Prime Minister David Cameron then fell on his sword and announced that he would resign in three months, necessitating another British election.

As a result of Britain’s decision to leave the EU, the British pound plunged over 10% intraday, reaching its lowest level against the U.S. dollar in over 30 years. The euro also fell 2.35% to the dollar, which has emerged as the world’s “safe haven” currency. The Bank of England and the European Central Bank (ECB) both pledged to maintain stability, so I expect that the currency chaos should diminish soon.

I’ll cover the stock market repercussions later on, but I also need to flag the fact that U.S. voters are also getting restless. On Friday, the University of Michigan reported that consumer expectations declined to 82.4 in June, down from 84.9 in May. This negative outlook could be due in part to the dismal choice between Trump and Clinton for our next President. Rather than promising everything and anything to get elected, they are in full attack mode. This must eventually change, since it is hard to inspire confidence by being entirely negative. If they turn positive, I expect that consumer sentiment will improve and rub off on investor sentiment, which is why the stock market has historically rallied in Presidential election years.

The U.S. Treasury yield curve continues to flatten, crushing big banking and financial stocks. Concerns about potential currency losses are also now haunting many major banks, especially in Europe. A surging U.S. dollar is also crushing many commodity prices, so energy and other commodity related companies are also under pressure. Gold is the only commodity that is now prospering due to the lack of confidence in major central banks and the negative interest rate environment that has enveloped much of the world.

Multinational companies that are hindered by a strong U.S. dollar are also under pressure. As a result, U.S. domestic-based stocks were much more resilient during the market’s carnage on Friday. On days like Friday, I’m proud that we have avoided the “junk” stocks that seemed to do so well earlier this year.

The simple fact of the matter is that the algometric traders that try to front-run the HFT order flows for hedge funds have been endlessly jerking around the financial, energy, and materials sectors this year. They had no defense on Friday, since they were dealing with fundamentally inferior stocks, like money center banks and energy and commodity related stocks that are characterized by largely negative forecasted sales and earnings. Many portfolios benefited if they have virtually no exposure to large money center banks (which have been crushed by a flattening yield curve and rising currency risk), or energy & commodity related stocks (which are hindered by a strong U.S. dollar and worries about global growth).

Low Rates Fuel Record-High Corporate Stock Buy-backs

Fed Chair Janet Yellen’s Congressional semi-annual testimony on Tuesday was painful for me to watch, as she is seemingly always playing defense and does not seem naturally confident in the labor market or the U.S. economy. In fact, Yellen warned Congress that the U.S. economy faces “considerable uncertainty” due to slower domestic activity and the Brexit vote. Not only did Yellen say that Brexit could send shockwaves that would impact global financial markets, but she signaled that the Fed has become less optimistic about U.S. growth near-term and would proceed with great caution before raising key interest rates. Translated from Fedspeak, Yellen does not plan to raise rates in July, since she is very concerned about the economy.

Regarding the labor market – which is Janet Yellen’s expertise as a labor economist – she says, “The latest readings on the labor market and the weak pace of investment illustrate one downside risk…that domestic demand might falter.” Yellen noted that a number of prominent economists have argued that slow productivity growth in the U.S. will continue, dampening overall growth. Furthermore, Yellen also said that as long as other domestic weaknesses persist, like slow household formation and slow business investment, the Fed needs to hold rates ultra-low “to keep the economy operating near its potential.”

One obvious consequence of low interest rates is an escalation in stock buy-backs. The Wall Street Journal reported on Wednesday that companies in the S&P 500 spent $161.4 billion on stock buy-back programs last quarter, the second highest quarterly stock buy-back pace on record. Compared to the first quarter of 2015, S&P 500 stock buy-backs rose 12%. In the past 12 months, stock buy-backs in the S&P 500 hit a record $589.4 billion, barely surpassing the previous record of $589.1 billion in 2007.

In addition, cash reserves in the S&P 500 are now at a record $1.347 trillion, surpassing the previous record of $1.333 trillion at the end of 2014. Adding dividends to stock buy-backs, these two shareholder-friendly outlays hit a record $257.6 billion in the first quarter and $974.6 billion in the past 12 months.

Since 2005, companies have spent approximately $5 trillion on stock buy-backs and there is no doubt that this pace is rising as companies continue to issue corporate bonds at ultra-low yields, often using those funds to aggressively buy back their respective stock. This is why the S&P 500 seems to rally after each earnings announcement season when the buy-backs often pick up. Clearly, companies with low price-to-earnings ratios are leading the stock buy-back parade. Overall, the stock market, based on the S&P 500, is slowly shrinking due to share buy-backs, while international capital keeps pouring into the U.S., flattening the yield curve.

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