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”
- “Publicly traded restaurant companies generally report direct labor costs in their filings, unlike retail establishments (another large liquid labor market). My impression is that this fosters labor discussions more often than in retail.”
Here are a few of the many examples of wage inflation outlined on recent conference calls:
Historically, SG&A has been ~17% of sales, COGS ~66% of sales, interest and taxes ~5% of sales, depreciation and other ~5%, leading to a 9% EBIT margin (note this is as of 2013.) Over this period, yields, the employment cost index, and effective corporate tax rates have all fallen, providing a tailwind to operating earnings.
While the the quality of gains in the jobs report are debatable, it is clear that the risk is to the upside on wage inflation, which will clearly have an adverse effect on operating income. And given the fact that Bernie Sanders is somehow in the presidential race, who knows where corporate tax rates will be. I am assuming that taxes remain around current levels and spreads widen (outlined below), which will further reduce the operating earnings.
Below are the Wall Street margin assumptions that get you to $128 in earnings power for FY16. While the trend looks like it is about to roll over, people much smarter than I are forecasting continued expansion. I’ll take the other side.
As I previously stated there is clearly some wage pressure being felt by corporations. At ~17% of sales (likely lower given additional items in SG&A), that alone puts material pressure on margin expansion, but price and COGS are the real levers here.
Price – COGS (66%) = Gross Margin. I’m no economist, but when there is demand for goods, a seller is likely able to raise prices at a faster clip than the costs of those goods, in turn increasing margins. That being said, below is a chart of the personal consumption expenditures deflator showing that inflation is near post crisis lows and almost negative.
Core PCE is much stronger, but again minimal signs of inflation given its current downtrend.
So as prices of goods and services continuously trend lower, how is it that margins will expand from here if Price – COGS = GM, especially given the recent dollar strength and a 70% chance of a hike in December. In addition, it will be very difficult to raise prices given current inventory levels. The inventory to sales ratio shown below was last seen during the financial crisis. Forced liquidations and falling orders is likely not good for margins.
To recap, we have the highest valuations in the past 10+ yrs, multiple factors are putting downward pressure on margins, and record amounts of corporate leverage is being used to purchase stocks at nose bleed valuations. This brings me to the leverage part of the equation.
As shown below, the median debt-to-EBITDA ratio for both investment grade and high yield bonds is at the highest level since 2005, which is being accompanied by rising default rates. I am not an economist nor a credit analyst, but given the trends I’ve highlighted above I can make a pretty strong case for why this will likely deteriorate further.
Rising spreads will have an adverse effect on earnings and make it increasingly difficult to refinance given that ~30% of the aggregate S&P debt matures in the next three years.
As you can see below, junk bonds are rolling over again even as the market nears all-time highs. The same is true for investment grade corporates. I will put my money on bond market here.
Under the surface the S&P is losing steam, as the leadership of the market has narrowed substantially over the past few months. This has been evidenced by the difference between the S&P and the equally-weighted ETF, the RSP. As you can see the RSP:SPY ratio is breaking down to 2 year lows.
Here is a chart from @ that further illustrates the discrepancy.
In addition, the number of stocks above their 200 day moving average and the current downtrend is indicating waning breadth. This further illustrates to me that the path of least resistance is to the downside.
The Fed And The Dollar:
The Fed’s recent commentary strengthened my view that their credibility, like the market’s breadth, is waning. From the press release: “household spending and business fixed investment have been increasing at solid rates in the recent months.” What are they looking at?
The committee then states the “pace of job gains has slowed,” and longer term inflation expectations remaining stable. This is clearly not the case as illustrated by the PCE deflator above. But fear not, the committee, “expects inflation to rise gradually toward 2% over the medium term as the labor market improves further” from its recent slowing.
The illustration below from @NotJimCramer gives you an idea of the Fed’s talk and lack of action.
The first thing that came to my mind was:
The Fed got their wish last Friday with a blowout jobs number, sending the Fed Fund futures probability of a December hike to 70% and moving the dollar up with it.
In my opinion, the last thing the world needs right now is a stronger dollar. There is roughly 9.6 trillion of foreign debt denominated in dollars, 3 trillion of which has been added by emerging markets since Lehman. With global demand slowing, sovereigns are forced to devalue their currencies, in turn strengthening the dollar without the Fed’s move.
It is my view, that there are currently multiple reflexive relationships that will force the Fed to hold off on hiking rates. Should the Fed hike, which the market and participants seem to believe is a foregone conclusion based on a jobs number that under the surface was not great, the dollar will:
- Hinder the repayment of emerging market debt
- Further reduce commodity prices, which will in turn hurt earnings and likely result in an abundance of defaults given the amount of debt tied to commodities
- Make U.S. goods less attractive, in turn further reducing sales and earnings
That said, I am sticking with my view that the Fed is trapped in a corner and the next move will be to ease or cut rates, which has recently shown up in their verbiage.
In turning to history as a guide of the future I looked at 2001. The blue line is the S&P from 10/16/1998 to 12/20/2000 and the red line is the S&P from 10/10/2014 to present. As you can see the price action is almost identical. The next leg is clearly lower and should manifest over the next two weeks.
Nautilus provides an additional analog comparing 1937 to today. Note the 93% correlation.
Based on the evidence provided above, it seems the path of least resistance is to the downside. My thesis will be wrong should the following manifest:
- The dollar weakens significantly, aiding commodity prices, U.S. sales, and earnings
- Short-term: the market moves to all-time highs on increasing breadth
- Inflation increases significantly
- Wage pressures dissipate
- Spreads tighten
- Corporations halt buybacks and invest in the future at similar historical levels. (Although this would cut the current bid)
- The market fails to follow either analog sequence
I am agnostic to the Fed in relation to my short thesis on the S&P. I believe a hike from them would be extremely detrimental to the macro economy, but the failure to hike can be as destructive.