Buybacks And The Bear: Don't Buy The Hype

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Includes: NFLX, QQQ
by: Long-Short Manager

Summary

Investors took the S&P to 2930 based on corporate tax cuts and a “goldilocks” economic scenario, with index earnings per share estimated to rise to $163 for 2018.

They belatedly began to factor in the rising yields that would come from the economy, rising budget deficit & QT, resulting in two corrections of rising intensity.

Many commentators are counting on a resumption of corporate buybacks after earnings season to put a floor on the decline.

I am deeply skeptical based on both macroanalysis and fundamentals.

Introduction

The Feb correction took the index down to 2581, failing to breach the 200 day SMA (Figure 1).

Figure 1: SPX Index One Year Graph

Source: Bloomberg

The October correction breached the 200 SMA and the S&P 500 hit a low of 2641.

What happens next?

One theory is that once buybacks resume (Figure 2), the inflow of corporate buying will put a floor on further price drops, and seasonal factors (such as the January effect) will resurrect the bull market.

Figure 2

Source: Yardeni

With buybacks running at an annual pace of over $640 billion, the amount of cash available is clearly larger than the amount of money being extinguished by QT (which is at its peak rate of $600 billion now, but likely to decline slightly as mortgage paydowns on the MBS portfolio slow down due to higher mortgage rates causing a slowdown in refinancing). So on the surface, we really shouldn’t worry too much about QT leading to further declines in the broad market, right? But just to be sure, let’s dig a little deeper, looking at both macro foundations and index fundamentals.

Deeper Dive – Macro View

Let’s start by looking at how much we as a country save annually (Figure 3). All domestic corporate or retail buying of stocks has to come from this money, whether it is in the form of corporations buying back their own stock (with pre-tax profits), dividends paid from after-tax profits being reinvested, or new purchases from money saved from income by individuals.

Figure 3: Personal Savings

Source: Personal Saving Rate

At a 6.2% personal savings rate (which includes the portion of dividends individual investors receive but do not spend), and a disposable personal income of $15,651 trillion, this means $1 trillion is available per year from individual savings. On the corporate side, while corporations are generating $1.2 trillion a year in operating earnings, they are spending the majority of it on dividends (already counted in the trillion above) and buybacks, with about 20% available for future investment (retained earnings). Adding the personal savings and the corporate profit not going to dividends, we have a total pool of $1.6 trillion in annual savings available for investment (note that governments usually do not save money).

Now let’s turn to the demand side: we have $600 Billion in QT (money being withdrawn from the money supply), $800 Billion in Treasury net issuance (subtracting out the QT portion only from the Treasury holdings side so as not to double-count), and $300 Billon in annual corporate non-financial borrowing. I leave out banks borrowing money from individuals in the form of deposits, CDs, etc because they turn right around and invest those savings in other forms of debt, so it would be double-counting demand for debt to include financials.

We are already at $1,700 billion; this assumes no growth in mortgage, student loan, auto, credit card or other consumer debt. Expanding the Federal budget deficit by a factor of 2 has created an acute shortage of domestic savings, and there are two ways to fill the gap: increase domestic savings, or attract more foreign savings. So far the growing gap has been filled by a bit of both.

Indeed, a natural question is what happened the last time that the federal deficit was this high – where did the extra money come from? Figure 4 shows that during the run-up to and immediately after the financial crisis (when MBS sucked in a huge amount of foreign money in the run-up, and Treasuries sucked in a huge amount in the aftermath as the US fought a recession using borrowed money), China and Japan were significant funders of the US current account deficit. Additionally, back then, oil prices were relatively high, so that oil exporters like Russia and Saudi Arabia were also heavy net buyers of US debt using their oil earnings.

Figure 4: Funding our Deficits – China & Japan

Figure 5: Funding our Deficits – Oil Exporters & Germany

Source:World Bank Data

As Figure 5 shows, the current account surpluses of Saudi Arabia and Venezuela have collapsed (Saudi Arabia is actually a net borrower itself now, and Venezuela stopped providing data in 2014, but given the economic collapse in that country, we can safely assume it is not exporting enough oil to buy US Treasuries), Russia is now in a low current account surplus and the remaining powerhouse exporter of capital is Germany. Similarly, rather than investing in US assets, China appears to be investing much more domestically or in Asia & Africa now (as part of its Silk Road initiative). Germany, given the problems in Greece, Italy and the EU Zone itself, is also likely to have demands on its funds that it did not have 10-15 years ago. Therefore, it is reasonable to conclude that this time around, the US is going to have to lean on its domestic savers a bit more, or pay other countries a fair amount more than they are getting on their other investments to attract more money.

Indeed, as we can see in Figure 6 the price changes required to fund our massive deficit have already started to occur.

Figure 6: Yield & Spread Moves So Far (1 year)

Source: Bloomberg

Intermediate term Treasuries have risen well over 100 bps while the long end of the curve has risen a bit under 100 bps. Investment grade (BBB) debt yields have risen 100-125 bps while junk debt (B) yields have risen over 150 bps over the last year.

Going forward, without a substantial change in the US budget picture or to QT, these trends look to continue for at least another year if not several. We can expect the rate and spread rise required to fund the growing deficit and other corporate needs to be much greater than during the crisis as there were a dearth of investment alternatives at that time. Now we have a combination of lower savings from oil producers together with a lot more alternative options for what to do with investable savings as much of Asia continues to grow at 4-7% rates and company and equity valuations there are at recession prices without an actual recession in sight.

Deeper Dive - Equity Fundamentals

Let’s start by looking at what kind of equity discount rate the US market (using the S&P 500 as proxy) was using a year ago, using the median analyst earnings estimates for the next two years, and decreasing those earnings growth estimates out to a 5-year horizon to 7%. After 5 years, the year 6 value is calculated applying an average long-term PE of 14. The interest rate that is required to discount the earnings to arrive at the 2860 S&P index level that existed a year ago is 8%. Now that market interest rates are a full percent higher, assuming that the projected trajectory of earnings does not change (to isolate the pure discount rate effect of higher interest rates) we discount the same set of earnings by 9%. This gives us an S&P Index value of 2720, quite close to the last close in the first figure we started with, from November 2. So, assuming rates do not rise further, and earnings forecasts are unchanged, the equity market drop we have just had appears sufficient to account for the 100 bps increase in rates we have had on a fair value basis (assuming the 8% was a fair discount rate to begin with). But can we assume earnings will not be affected by higher rates, or that rates are not about to go even higher, given the current account picture we just reviewed in the macro section?

In addition to borrowing rates going up, we need to consider corporate margins. As Figure 7 shows, wage growth is now over 3% a year, higher than any post-crisis data point, and with low unemployment, bound to go higher. We have been in a historically high corporate margin period. Additionally, tariffs are also pressuring some corporate margins.

Figure 7: Wage Growth

Source: Bloomberg

Therefore, in our equity “what if” valuation analyses, we add two additional scenarios, one where we take 10% off of current profit margins (which are close to all-time highs), and another one where we layer in that drop in margin with another 100 bps rise in interest rates. The results of our four scenarios are summarized in Figure 8.

Figure 8: Equity Valuation Scenario Analysis

Scenario

End 2017

Rate Rise

Margin Drop

"+ 100 bp"

Discount

8%

9%

9%

10%

Margin

Same

Same

-10%

-10%

Value

2860

2720

2451

2339

Vs Now

2720

2720

2720

2720

Percent

5%

0%

-10%

-14%

Source: Author Calculations

The row labeled “Value” shows our estimate of S&P Index valuation assuming no change in the equity risk premium and only factoring in the rate rise until today (second column), a small contraction in margins consistent with wage growth and other sources of cost increases (third column) and another 100 bps increase in rates on top of the margin contraction (final column). The results show that on a fair value basis, the 5% drop from last year fully accounts for the rate rise to date, that a margin drop implies a 10% drop from current levels to 2451 and another 100% rate increase on top of this would imply a 14% drop from current levels. None of these columns assume any slowdown in sales growth or rise in equity premia (the additional discount rate above risk-free rates used by investors), which would impact fair value through the numerator or denominator of the DCF analysis further.

Conclusion

The equity market level is not solely determined by buy-back flows, which are part of a large pool of global capital and complex interactions of supply and demand for capital. Prices are set on various uses of this capital by competition and they are uniformly rising across the globe. An acknowledgement of this re-pricing suggests that to date, the S&P correction merely reflects the interest rate rise that has already occurred. Further rises due to the need for additional government borrowing as well as margin pressures from wages quite easily leave room for another 10-14% downside. Fears of economic growth faltering, growth actually beginning to falter, etc are additional downside risks that our analysis did not even consider. Those types of recession bear markets are more well-known and tend to result in 30-50% declines across the board.

This simple analysis has focused on the index level. Individual companies susceptibility to a correction based on yield and margin levels can vary greatly. For example, a stock like NFLX, which is junk rated and relies on debt to grow like a plant relies on phosphorous and nitrogen, is clearly going to be more susceptible to the headwinds we looked at than the average stock. Companies whose cost structure rely more on labor or tariff-affected inputs would be more susceptible to margin pressures. Additionally, not all stocks have enjoyed the same equity risk premium – there are signs that stocks with very high growth rates such as the FAANG complex were previously being discounted as if their growth streams were as certain as the earnings stream of the index as a whole. In general, the higher the growth rate being assumed (and the longer the period that growth rate is being expected to hold for), the higher an equity risk premium we would expect to use as a value investor, as there is much greater uncertainty being modeled.

There are early signs the market is starting to do such things again after a long period of abandoning traditional (or “dinosaur”, depending on your perspective) practices. Extreme caution is warranted before accepting simple explanations such as equity buy-backs. Corporate treasurers may well become more cautious with their cash as year-end liquidity concerns, de-leveraging highly leveraged balance sheets (the average US corporation having recently become 'BBB' rated) or attractive alternative investments result in less of that corporate cash hoard used for buybacks than previously authorized. Even if buy-back dreams are realized at a full 100% of authorized, the demand for funds produced by QT and the budget deficit will result in "sell-backs" as well, wherein money that had no place else to go went into equities during QE. Now there are places for that money to go that actually pay something and this will be increasingly true over the next year.

Disclosure: I am/we are short NFLX.

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.