Acid reflux about to burn the market that ate itself

Here is a question to which the answer may come as a surprise. Who have been the largest buyers of shares in the US stock market since 2009? It’s not investors; it’s listed companies buying their own shares.

In the past five years non-financial companies have bought back more than $2 trillion (£1.5 trillion) worth. A slug of those share purchases are the result of mergers and acquisitions, but the biggest buyers have been businesses purchasing their own shares. As noted in my April column, this does not mean companies are in rude health. Far from it, as demonstrated by a persistent lack of productivity and revenue growth outside of a select group of companies.

Share buybacks can make a company’s earnings per share look better than they really are and also serve the interests of corporate executives, whose stock incentive plans are mostly linked to rising earnings per share.

Buybacks have been funded mainly by the cheap money that quantitative easing (QE) has created. Companies have been bingeing on cheap debt and selling corporate bonds to fund their buybacks and, in turn, enhancing the bonuses executives receive from their stock options and other such incentive plans.

However, the US Federal Reserve’s flow of funds report shows that US buybacks actually peaked in the first quarter of 2016 and have been falling since. According to a recent report from consultancy Longview Economics: ‘As prior cycles/bear markets show, share repurchases tend to peak just ahead of, or coincident with, the start of bear markets. Companies are, of course, typically pro-cyclical – buying high and reducing share buybacks into the recession/bear market, in order to conserve cash.’

So why hasn’t the US stock market been following the historical script? Since the beginning of April 2016 the S&P 500 index has risen 20 per cent, and more than three quarters of that gain has occurred in 2017. That doesn’t seem particularly bearish.

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An index of this size, listing 500 of the world’s largest companies, masks what is really happening. Gains this year have been intensely concentrated among highly rated technology stocks, particularly the so-called Faangs: Facebook, Apple, Amazon, Netflix and Google (now Alphabet). According to the website Investopedia: ‘As of 9 June 2017, the market capitalisation of these companies has risen to $2.41 trillion, which is about the size of the entire economy of France and 13 per cent of the size of the US economy.’

Skewed US market

These five shares alone have also been responsible for more than 30 per cent of the rise in the S&P 500 index this year. Clearly tech is having a major influence on US stock market returns, and arguably their performance is masking the concern that US corporates are not as healthy as the index suggests.

There are signs that investors are getting the jitters. According to investment bank JPMorgan, in July retail investors pumped $445 million into exchange traded funds that track the Vix index, the ‘fear gauge’ that represents volatility in the S&P 500.

But as the S&P 500 index continues to record fresh highs the mood is mainly one of unabashed exuberance. Investors seem unwilling to heed a rash of warnings from the world’s central bankers that markets have become complacent and are ignoring a host of risks that threaten global economic stability. The political risks are clear, ranging from a beleaguered president Trump to a bellicose North Korea, a furious president Putin enraged at fresh US sanctions against Russia and a UK cabinet at odds over Brexit policy.

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Burgeoning levels of corporate and personal debt, particularly in the UK and US, also have central bankers worried that even a gentle rise in interest rates from current levels will be difficult to stomach. Perhaps this is what the big market participants are banking on: that frothy equity valuations and ultra-low bond yields can be maintained for a while yet, because central banks will not want to risk financial and economic stability by raising rates and shrinking their QE-bloated balance sheets.

Bearish banks

It looks very much like a high-stakes game of bluff between central banks and investors. But bankers are doing their best to talk markets down. Federal Reserve chair Janet Yellen has noted that stock market valuations ‘look rich’ by historical standards; the Bank for International Settlements (the central banks’ bank) has warned of ‘irrational exuberance’; and the Bank of England more drily notes that ‘very low long-term interest rates make assets vulnerable to a re-pricing, whether through an increase in long-term rates, adjustments to growth expectations or both’.

Even Alan Greenspan, the ex-Federal Reserve head who many blame for the era of ultra-low interest rates that is the main cause of the financial system’s current problems, reckons the stock market is vulnerable. He contends that this is not the result of excessive valuations, but of a bubble in the bond markets. In an interview with Bloomberg, Greenspan joined the ranks of commentators and investors who believe a bond market collapse will presage a rout in stocks.

‘By any measure, real long-term interest rates are much too low and therefore unsustainable,’ he said. ‘The real problem is that when the bond market bubble collapses, long-term interest rates will rise. We are moving into a different phase of the economy: to a stagflation not seen since the 1970s. That is not good for asset prices.’

It may seem counter-intuitive to say that a bond market collapse would also hit equities, because conventional investment theory says that holding a diversified portfolio of stocks and bonds provides balance and should protect against weakness from one or the other asset class. The problem with that argument today is that QE has distorted and seriously weakened the diversification argument.

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About the only technical indicator saying that stocks are not overvalued is the big differential in the earnings yield (the inverse of the price/earnings ratio) of the S&P 500 and the inflation-adjusted yield on 10-year US Treasury bonds. The differential today amounts to 4.7 per cent, 21 per cent higher than the average over 20 years, which goes some way towards justifying elevated equity prices not only in the US but in other major developed markets.

Storm warning

When that differential starts to narrow as real long-term interest rates rise (when investors sell bonds and their yields increase), it will quickly remove one of the stock market’s supportive planks. And if, like me, you worry that share buybacks and other financial engineering techniques are masking the poor underlying quality of earnings, we have a potential double whammy of negative indicators for stocks.

Central bankers tend not to employ emotive language when commenting on the current or implied price of assets. But they are sending some pretty clear warnings, which investors would do well to heed. ‘Don’t fight the Fed’ is an old saying worth repeating, because the Federal Reserve is likely to call the market’s bluff and press on with its plans to ‘normalise’ interest rate policy and taper its QE-bloated balance sheet.

This phased withdrawal of the liquidity punchbowl that investors have come to rely on will not play well with either equity or bond markets. The US, the market that ate itself through buybacks, looks ripe for a severe bout of acid reflux. Other markets will not be immune.

Looking good for emerging openings

It might seem odd to say this in an era of heightened equity market risk, but Asian and other emerging markets should hold up relatively well, particularly from a valuation perspective, compared with developed markets.

Emerging markets usually trade on a relative discount, but due to the higher risks associated with the asset class, valuation disparities look unusually wide compared with developed markets, according to consultancy Capital Economics. At an average of around 11.5 times, the forward price/earnings ratio for the MSCI Emerging Markets index compares favourably against nearly 16 times for the MSCI World ex EM index.

However, the rapid escalation of debt levels in China, and the potential for that credit bubble to pop, tempers enthusiasm somewhat. For far-sighted investors, Asia and other emerging markets look quite attractive. They will look even better should a flight from developed markets be magnified in developing markets. But it will be crucial to avoid the pitfalls and traps, so having an experienced fund manager on your side should be beneficial. Asia and other emerging markets are already recovering well from a period in the doldrums.

Over one year (to 4 August), the MSCI EM index is up 22.8 per cent, punctuated by a big surge in July. Asia has led the charge, with the MSCI AC Asia index up 27.4 per cent. Both readings compare well against gains of 16-17 per cent in the US and the UK. Europe has bettered that though, with the FTSE Europe ex-UK index matching the emerging markets’ return.

The best Money Observer Rated Fund providing broad market exposure to the Asia-Pacific region is Hermes Asia ex Japan Equity, which is up 33 per cent over the year. Single-country funds in the Asia equities group that focus on China and India have performed better.

For broader emerging markets exposure, the best performer among the 13 Rated Funds in the emerging markets asset group is Hermes Global Emerging Markets, up 32 per cent, although the regional specialist trust BlackRock Emerging Europe has gained 35 per cent.

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