The Hidden Driver Behind This Historic Bull Market
The hidden driver behind this historic bull market... How cheap money led to another bubble... Turning a bad decision into a disastrous one...
Editor's note: Digest editor Justin Brill is out this week, so we're running a five-part guest series from some of Stansberry Research's top minds. (In the meantime, we encourage you to keep up with the latest market action through our free Stansberry NewsWire service.)
So far this week, we've heard Stansberry Alpha editor Alan Gula's thoughts on bitcoin and Stansberry Portfolio Solutions Portfolio Manager Austin Root discuss the enigma that is Netflix (NFLX). Today, Stansberry's Credit Opportunities editor Mike DiBiase talks about the hidden factor that has kept this historic bull market alive...
Is this the end of the longest bull market in history?
It's the question on most investors' minds today.
No one is looking forward to the next bear market. We all remember the last bear market in 2008-2009, when stocks fell almost 60% from their peak. Today, every little tremor or correction in the market – like the one we've experienced recently – reignites that fear.
Today, I (Mike DiBiase) want to share some insight into why the bull market has been able to last this long. But more important, I'll share what will keep it going a little longer... and ultimately bring it to its end.
Let's start with what has been propelling the market higher for so long...
We all know the Federal Reserve's easy-money policies have propped up the stock market since the Great Recession. The Fed slowly lowered interest rates until they were near zero and it couldn't lower them any further.
These artificially low interest rates made fixed-income investments like bonds less attractive and made stocks more attractive. Plus, the Federal Reserve's "quantitative easing" program created massive amounts of new money that eventually made its way into the stock market, creating a rising tide that pushed stock prices higher.
But the Fed's monetary policies had another unintended impact on the stock market. It created another strong, but lesser-known, tailwind to the bull market... one that has been blowing especially hard in recent years.
I'm talking about stock buybacks...
Companies have used the Fed's artificially low interest rates to gorge themselves on debt. And many have been using this money to buy back their own stock. Regular Digest readers have heard this story before... Porter has written about stock buybacks many times, most recently in the September 21 Digest.
In short, when a company buys shares of its own stock, its stock price usually rises. Most buybacks are done in the open market, just like when individual investors buy shares.
When companies buy back large amounts of their own stock, they bid up prices... pushing their stock prices higher and higher. It's a classic case of supply and demand. Buybacks increase demand for shares, while at the same time reducing the supply of shares available in the market for other investors.
You might not realize how much of a tailwind buybacks have been to this bull market. In the aggregate, companies buy back billions of dollars' worth of shares every quarter. They are the single largest source of demand for U.S. stocks. By some estimates, the number of shares bought as part of corporate buybacks is more than two times larger than exchange-traded funds (the second-largest source of demand) and six times greater than the number of shares bought by mutual funds.
But it's not just the added demand that pushes stock prices higher...
Buybacks make each share more valuable, because each remaining share ends up controlling a larger percentage of the company. And in theory, that makes them more valuable. It's like cutting a pizza into six slices instead of eight. The pizza is the same size, but each slice is now bigger. That's why buybacks are considered a return of capital to shareholders, like dividends. It's another way companies reward shareholders.
But the truth is that most buybacks aren't done for the benefit of shareholders. They're done for the benefit of management.
Buybacks are hugely popular among CEOs and CFOs of publicly traded companies for two reasons...
For one, they increase a company's earnings per share ("EPS") without any increases in earnings. By reducing the number of shares outstanding, management can increase EPS without any changes at all to its profits. It's accounting magic.
Let me give you an example... Say a company called Acme Corporation has $2 million in annual earnings and 1 million shares outstanding ($2 in EPS). Acme management buys back 200,000 shares of its stock the following year, so there are now 800,000 shares outstanding. If earnings remain the same, the company's EPS jumps 25% to $2.50 per share without anything else changing ($2 million in earnings divided by 800,000 shares).
This is important because EPS is one of Wall Street's favorite financial metrics. Companies are often rewarded with higher stock prices when their per-share earnings jump. Buybacks make meeting – and beating – Wall Street's estimates much easier.
That leads to the second reason why executives love share buybacks: A huge part of their compensation is tied to their companies' stock prices.
Let's look again at our hypothetical example with Acme and assume the stock market valued the company's equity – or its market cap – at $50 million before the buybacks. That means each share would be worth $50 ($50 million market cap divided by 1 million shares). Its price-to-earnings ratio would be 25 before the buybacks ($50 share price divided by its $2 EPS).
After buying back its shares – assuming the stock market continued to value the company at the same $50 million valuation – each share would now be worth $62.50 ($50 million divided by 800,000 shares outstanding after the buybacks). The company's price-to-earnings ratio would remain the same at 25 in this example, so the stock wouldn't look any more expensive ($62.50 share price divided by its $2.50 EPS).
Top executives earn millions of dollars with bonuses and stock options tied to EPS and share prices. In other words, they have plenty of incentives to buy back their shares quarter after quarter.
By now, you can see why management loves buybacks. Increasing a company's EPS and share price without having to increase profits sounds pretty good, right?
Don't get me wrong... Under certain circumstances, buybacks can be a good thing. But like any good thing, they can be abused if taken to excess. Far too often, they're nothing more than nifty financial engineering.
The truth is, most stock buybacks are terrible investments...
Fortunately, we can tell whether a buyback is a good or bad investment...
First, consider that companies can finance buybacks in one of two ways: They can use the excess cash on their balance sheets, or they can borrow the money. (More on that in a moment.)
Using its own cash is by far the better choice. But even doing that can be a bad decision. When a company buys back its shares with its own cash, it's electing to return the cash to shareholders instead of investing it elsewhere.
This suggests that the company has nothing better to do with that money... like investing in research and development or new long-term projects, buying other companies or technologies that will help it grow in the future, or paying down debt.
You get the point. Companies could use its cash in a number of ways that are likely to be much better investments than buying back its own stock.
Here's the other part of the equation to consider...
Usually, buying back shares only makes sense when a company's stock is cheap.
The reality is, most executives buy back their own shares at the worst possible times.
The following chart compares the value of the S&P 500 Index with stock buybacks of the companies in the S&P 500 since 2002. You can clearly see that companies buy back the most shares at market peaks, when stock prices are most expensive. Those are, of course, the worst possible times to buy back shares. They did it in 2007, and they're doing it again today – and with even greater intensity...
You can also see that buybacks (the gray bars on the chart) have been on a tear since the end of the last financial crisis.
They've increased nearly every year since 2009. This tailwind has been the hidden driver behind the current bull market... But if you weren't paying attention, you might not have even realized it.
Last quarter, U.S. companies set a record for share buybacks. And this year, buybacks are expected to top $1 trillion, shattering the previous record of nearly $600 billion. (The large spike this year is partly due to lower corporate tax rates and incentives to bring overseas cash back to the U.S.)
In fact, companies are on pace to spend more on buybacks this year than on capital expenditures for the first time since 2007. In other words, instead of investing more in capital projects that will benefit shareholders in the future, corporate executives are using buybacks to make themselves richer.
But buying back shares when they're expensive isn't corporate America's worst offense...
The worst offense is buying them back using debt.
Some companies, like iPhone maker Apple (AAPL), have loads of excess cash to buy back shares. But most don't... And borrowing money to do so can turn a bad investment decision into a disastrous one.
The table below shows some of the biggest offenders of the past eight years – eight of the companies that have bought back the most shares using debt...
Stay away from these companies and any company that uses debt to buy back shares, for that matter. It's almost never a good investment.
These companies are exchanging their valuable equity for debt. Remaining shareholders are left owning a more indebted company.
Remember how the subprime mortgage crisis ended when people levered up by borrowing against the equity in their homes?
Companies today are essentially doing the same thing. They're levering up their balance sheets like private-equity corporate raiders... Only instead of buying other companies with debt, they're buying themselves.
This can't continue forever...
Many companies have seen their debt loads grow to unsustainable levels. Taking on more debt will put them in danger of going broke.
Corporate debt in the U.S. totals $9 trillion, the highest it has ever been. As you can see in the following chart, it's up nearly 50% from the end of the last financial crisis...
Measured against our gross domestic product (GDP), corporate debt is the highest it has ever been at 46%.
And it's not just the amount of corporate debt that's concerning... It's also the quality. Today, $3 trillion of debt is rated at the lowest level of investment-grade debt – by far the most than at any other time in history. These companies are teetering on the edge of becoming junk credits. By taking on more debt to buy back their own stock, they risk a credit rating downgrade and much higher interest costs.
Not only that, the cost of debt is increasing, too. After a decade of artificially low interest rates, rates are on the rise once again, making debt-funded buybacks more expensive. Many companies are bloated with debt and can barely afford to pay the interest today.
For now, buybacks will continue to propel the market forward. Companies spent close to $600 billion on buybacks over the past three quarters. I expect they will spend around $400 billion this quarter, setting a new quarterly record. The bubble will get larger before it pops.
But the end is near. Beginning next year, I expect we'll see buybacks decrease for the first time since 2009. As the pace of buybacks slows, one of the biggest forces behind this bull market will disappear... And that could lead to the end of the longest bull market in history.
New 52-week highs (as of 11/27/18): Blackstone Mortgage Trust (BXMT), Cracker Barrel (CBRL), and Walgreens Boots Alliance (WBA).
In today's mailbag, two readers chime in on yesterday's Digest about Netflix. Let us know if you're enjoying this week's guest series – and share your thoughts about the Internet streaming giant, cryptocurrencies, and stock buybacks – by sending us an e-mail at feedback@stansberryresearch.com.
"[Austin], this was a really good Digest. I have traded Netflix options for a couple of years and owned the stock on and off. Knowing what I know you are right on about all that you said. Thankfully, I have consistently made money. But as you said their business model stinks and everyone needs to know that. Thanks for sharing." – Paid-up subscriber Jeff S.
"I appreciate analysis like you've done on Netflix." – Paid-up subscriber Anthony V.
Regards,
Mike DiBiase
Atlanta, Georgia
November 28, 2018