The 'Weakest Link' in the Market Today

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Regular Digest readers know U.S. companies have been buying their own shares like there's no tomorrow. And this buyback spree has been one of the biggest drivers for stocks this year. As Porter noted in the July 15 Digest...

Financial-research firm FactSet explains exactly what's driving this market forward, despite all of the economic warning signs. So far this year, 41 different companies have spent more than $1 billion buying back their own shares. So far this year, U.S. corporations have spent a total of $166 billion on share buybacks. That's a 15% increase over last year... and sets a new record annual pace for share buybacks.

Unfortunately, there are a couple of big problems with this trend.

First, as we've discussed many times, corporate managers are notoriously bad investors. They tend to buy back tons of shares near market tops (when shares are expensive), and buy few to none near market bottoms (when shares are cheap).

Second, it's completely unsustainable. As Porter noted, it should be obvious to everyone that if earnings keep falling – and they've now declined for five consecutive quarters – it's only a matter of time before this trend grinds to a halt.

Aswath Damodaran, a professor at New York University's Stern School of Business, agrees. He believes the inability of companies to continue "paying off" their investors is the single biggest risk to the market today. As he put it to the Wall Street Journal in a report this weekend...

This is the weakest link in this market... We know cash flows will go down. What we don't know is what the market is pricing in.

In particular, Damodaran notes S&P 500 companies spent a mind-boggling 112% of their earnings on buybacks and dividends through the first two quarters of the year. This is the highest level since 2008, and more than 80% higher than the average over the past 15 years.

This is concerning enough... but again, it happened at the same time earnings have been falling for more than five straight quarters.

Of course, this trend could become even more extreme before it finally ends, but there is no doubt it will end badly. And there are some early signs that a reversal may have already started...

According to TrimTabs Investment Research, new stock-buyback announcements slowed to their lowest level in four years last quarter. The total dollar value of announced buybacks through the first half of the year is also down 21% from one year ago. As TrimTabs CEO David Santschi told news service Reuters earlier this month...

Buyback activity has been disappointing in earnings season... It's not a good sign [for the stock market]. Buyback volume has a fairly high correlation with stock prices.

In other news, food giant Mondelez International (MDLZ) has officially dropped its bid to purchase Stansberry's Investment Advisory holding Hershey (HSY) after Hershey rejected its latest, more competitive offer. As the Wall Street Journal reported last night (emphasis added)...

Oreo cookie maker Mondelez International Inc. ended its pursuit of Hershey Co. after the famed chocolatier rebuffed its latest acquisition offer, putting an end to a months-long takeover campaign that would have created the world's largest candy company...

Mondelez said in a statement late Monday there was "no actionable path forward" to buy Hershey, which confirmed that there were additional communications with Mondelez but wouldn't comment further.

Mondelez's failure to pull off the takeover, which would likely have been valued at upward of $25 billion, will likely reinforce the notion among analysts and investors that Hershey is unattainable as an acquisition target in light of its majority ownership by a trust that for years has been reluctant to sell.

While Mondelez executives were apparently surprised by the outcome, regular Digest readers surely aren't...

As we reminded readers when the deal was announced, the Hershey Trust controls 80% of the company's voting rights, and is essentially forbidden from selling its shares by the state of Pennsylvania.

Finally, yesterday we discussed the recent declines in gold and silver...

In short, while precious metals have pulled back a bit over the past several weeks, there is no reason to panic.

Yes, gold has fallen a little more than 3% from its recent July highs, silver has fallen a little more than 10%, and gold stocks – as tracked by the VanEck Vectors Gold Miners Fund (GDX) – are down about 25%. But even after these recent declines, all of these assets are still doing incredibly well for the year. Gold is still up 25%... silver is still up more than 30%... and GDX is still up more than 100% (though many individual mining stocks are up even more).

Remember, mining stocks provide leverage to the prices of gold and silver. This means they can soar when precious metals rally... but it also means they can fall much more when precious metals pull back. This is why we repeat ourselves again and again about risk-management strategies like appropriate asset allocation, proper position sizing, and trailing stop losses. These ideas are always important, but they are absolutely critical when buying volatile gold and silver stocks.

Again, corrections are a normal and necessary part of every bull market. Gold and silver have rallied for most of this year without significant declines, so it's not surprising to see them pull back here. The recent declines may or may not be the start of the first significant correction since the rally began. But if they are, we would consider now to be a great potential buying opportunity, not a reason to sell.

Our friend Dr. Richard Smith – founder and CEO of our corporate affiliate TradeStops – agrees.

In a blog post last week, he highlighted just how insignificant the "mini panic" in precious metals has been so far.

Before we share his thoughts, a quick explanation... If you're not familiar with Richard's TradeStops system, you may not recognize some of the terminology. That's OK...

All you really need to know is that his Volatility Quotient (or "VQ") is a measure of an asset's expected volatility. In simple terms, it tells you what kind of volatility you should expect in a particular asset in the course of normal trading. And his low-risk buy zones and stop losses are based on that expected volatility. Here's Richard...

A mini-panic settled in on the precious metals markets this week. The Wall Street Journal even ran a headline, "Gold Hits Fresh One-Month Low Ahead of Fed Gathering."

Gold's "one-month low" was a drop of just 3.2% from its early July high. The current VQ on gold is 12.8%... Meaning gold has corrected about a quarter of the way to its stop loss. Here's the latest chart on gold...

Again, gold's VQ of 12.8% tells you gold can rise or fall by nearly 13% without signifying anything important about the current trend. In other words, Richard says the recent pullback we've seen in gold is nothing unusual so far... and says it's a similar story for silver and gold stocks, too...

The corrections in silver and in the mining companies were a bit more severe... but not when you look at them in the context of the kind of volatility you should expect for these assets.

Silver is down about 10% from its peak. That's about half of its 19.3% VQ. Silver's correction was the most dramatic, but it's not even to its low-risk zone yet.

GDX, the exchange-traded fund that tracks the performance of the larger precious metal miners, was down 14% from its recent high. The VQ on GDX is currently 36.6%. GDX is only about one-third of the way to its stop loss, which currently sits at $19.87.

Richard says it's too soon to know if the recent pullback is simply "noise" or the start of an overdue correction. But like us, he remains a long-term bull...

I am expecting a correction in gold and its related assets. It's possible that this week was the start of that correction, but that remains to be seen. What we've seen so far can hardly be called a correction... and seeing panicky headlines being written about this minor event bodes well for the eventual continued upside.

New 52-week highs (as of 8/29/16): Becton Dickinson (BDX), Berkshire Hathaway (BRK.B), CME Group (CME), Cisco (CSCO), Drew Industries (DW), Western Asset Emerging Markets Debt Fund (ESD), iShares Core S&P Small-Cap Fund (IJR), Procter & Gamble (PG), Gibraltar Industries (ROCK), ProShares Ultra Semiconductor Fund (USD), and Invesco High Income Trust (VLT).

A light day in the mailbag. How are you weathering the "mini panic" in gold? Let us know at feedback@stansberryresearch.com.

Regards,

Justin Brill
Baltimore, Maryland
August 30, 2016