Societe Generale strategist and unfailing bear Albert Edwards has returned from his summer holiday just in time to see the S&P 500 (INDEXSP:.INX) top 2000, but the focus of his latest brief isn’t so much that the stock market is overvalued (he’s covered that ground plenty of times) as it is an explanation for how the end of QE is already pulling the carpet out from under high stock prices.
“QE has been an essential driver for the equity market, providing the fuel for the heavy corporate bond issuance being used for share buybacks,” he writes. “Companies themselves have been the only substantive buyers of equity, but the most recent data suggests that this party is over and as profits also stall out, the equity market is now running on fumes.”
Companies have used cheap debt to buyback expensive stocks, says Albert Edwards
His argument is that while cash flow has been sufficient to cover capex and dividends, most companies relying solely on the money they bring in wouldn’t have enough left for buybacks used to keep investors happy and management well compensated. But low yields and plenty of demand for corporate debt has made that a non-issue, companies can issue cheap debt to buy their expensive stocks, as they did in both the run up to 2008 and started doing again a few years back.
“In retrospect there can be little doubt that QE has washed through the financial markets and elevated share prices via this route. The problem is that this pro-cyclical event has a habit of stopping suddenly for the usual reasons – i.e. recession or a closure of the credit markets,” he writes.
But Edwards’ colleague Andrew Lapthorne has argued that the Q2 slump in share buybacks (both a sequential and an annual drop) is because of tapering, and that when QE finally ends the buybacks that have been supporting stock prices will end with it.
That might be fine if the recovery had been strong enough that the extra cash was no longer needed, but here again Albert Edwards is skeptical. He notes that GAAP earnings are still pretty unimpressive and argues that the only reason corporate debt doesn’t have people more worried is because the current high market caps make the debt look manageable. Meanwhile the ratio of long-term debt to assets had diverged from long-term debt to market cap in way not seen since the late 90s.