S&P 500 ($2,100, $210): The Perfect Short by Teddy Vallee, Pervalle
The world is back to normal. The S&P is ~1% from its high, China is stabilizing, the U.S. is adding jobs, average hourly earnings are rising, and Dennis Gartman is ever so slightly long crude. This change in sentiment from the August lows led to the largest point rally in history, significantly weakening bear sentiment among individual investors, asset managers and the boys/girls with leverage, shown below.
While the vicious upward move shook a lot of bears, including myself on the second leg, the concerns voiced during the sell-off are still present today, if not worse; however, the market seems to be operating under the assumption that everything is normal again given its recent price action, bringing me to one of my favorite graphics (note “return to normal.”)
Yours truly, the S&P.
So here we are, hovering around all-time highs with:
- Valuations at their highest levels in over a decade on a price/book, price/sales, and price/cash flow basis
- The largest amount of non-gaap adjustments as a % of total earnings since 2009
- Buy backs / M&A now representing 70% of all buying volume
- The highest amount of corporate leverage in history
- Companies issuing debt to buyback record amounts of stock (’00, ’07)
- Two quarters of negative earnings growth
- 80% of IPO’s with no earnings (last seen in 1999)
- A dollar that is breaking out
- 9.6 trillion of foreign debt denominated in dollars
- The highest sales/inventory levels since 2008
- Declining market breadth
- Eerily similar price action to 2001 and 1937
- And A Fed that “is definitely raising rates” in December
With this as the backdrop, my view is that the path of least resistance is to the downside. I see an 8% chance that we break the previous highs. If that is that does manifest, a blow-off top may be in the cards.
I detailed in my previous post on gold that the current market multiples across a series of valuation metrics are the highest we have seen in 10+ years. This is by no means an indication that the market will go down, as something overvalued can become additionally overvalued, but should be used as an indication of how far the market could move under a perception change, which I believe we are currently undergoing given two quarters of negative earnings growth. As you can see below, the S&P currently trades at a price-to- EBITDA multiple of 10.4x, roughly in-line with the tech bubble. That turned out well.
In a recent interview, Ray Dalio sat down with Tom Keene and Michael McKee to talk all things markets. While the headline news was Ray calling for additional easing (QE4), his comments on buying volume were just as interesting.
DALIO: American businesses right now are the number one thing is they’re flush with cash. And as a result, the biggest force in the stock market right now is the buy backs and mergers and acquisitions. So something like 70 percent of the buy, the buying in the stock market, is along those lines.
So the largest buyers of stocks are corporations themselves. Think about this for a minute. 70% of the buying volume is coming from corporations not market participants.
Companies typically buy back their stock for a few reasons:
- The stock is cheap, i.e. $AAPL
- There is a lack of investment opportunity/uncertainty
- Artificially inflate EPS
With that being the premise, lets look at the current environment. Stocks are clearly not cheap, although value can still be found ($AAPL). The domestic economy according to many economists and pundits is doing “fine,” so there should be plenty of investment opportunities. So by process of elimination, companies are levering up to reduce shares out, in turn artificially inflating numbers and making their stocks look cheaper than reality.
If companies are deploying capital to buy their stock at 16-17x non-gaap earnings (30+x gaap), the return over the following year would need to be 17% (30%+) to justify the investment. What we are witnessing is one of the most value destructive deployments of capital in history that will reemerge in future earnings, or the lack of.
Corporate Leverage / Buy Backs / Cash Usage:
The process of levering up to buy back stock is a direct effect of ZIRP and lack of corporate discipline, as companies allocate cash to please shareholders rather than invest in the future of their businesses. Goldman Sachs details this in the chart below. As you can see, buy backs as a percentage of total cash use has doubled since 2009 when stocks were arguably the cheapest. The percentage of cash used for CAPEX is 30%, or 2% off the lowest level seen in the past 16 years. Cash used to invest in growth is also near the lowest levels seen since 1999, while cash returned to investors nears an all-time high.
Due to the abundance of short-termism, corporate leverage, buy backs and debt issuance are at or near the highest levels we have seen in 25, shown below. This is in the face of back to back quarters of declining sales and earnings growth, according to FactSet. Excessive leverage is akin to running a marathon with a 100 pound weight on your back. That said, earnings growth in the face of a stronger dollar, global slowdown, wage inflation, corporate leverage, higher rates, and diminishing CAPEX leads me to believe the past two quarters of declines are just the beginning.
Wall Street analysts currently see earnings growing substantially over the next year as FactSet highlights below. While this is completely possible, I’m not sold given the trends that we are seeing today.
Friday’s jobs report showed the strongest average hourly earnings y/y growth since 2009, reinforcing corporate comments on wage inflation. Barbarian Capital had a great post recently highlighting restaurant wage pressure, which he views as a good proxy for the following reasons:
- “The US food service labor market is probably the deepest and most liquid labor market in the US. At the entry level, there are no entry barriers either in terms of credentials or task skills (people already make sandwiches and wash dishes at home).”
- “The labor force in the industry is big: 14 million people, or about 10% of the labor force”
- “Employee turnover is very high: it was 66% in 2014 and 81% in 2007 (chart at the bottom of the linked article). So at the entry level, 100%+ turnover is likely the norm. This means that employers, as a whole, pay the market rates: there is no lag or scheduled increases (ex of local min wages), unlike professional or unionized industries”