Avalon Asset Management Company
Avalon Asset Management Company
Shades of the Roaring 20's
by Kevin Flynn, CFADespite the Dow’s disappointing stumble in the week of April 27th, investors could still take heart. Although the venerable index could only manage a meager gain of 160 points or so, it did provide some comfort by rising for the 19th trading day in the last 21, a streak last seen in the 1920’s. This provided some cozy company to some other recent data harkening back to that roaring decade, namely the news that we have returned to levels of income inequality not seen since those times. Can spats be far behind?
“If you wait for the move, you’ll miss the move.” Thus spake not Zarathustra last week, but one of the uber-man’s latest and greatest incarnations, the equities trader. Or perhaps we ought to say, uber-trader (and if you think I’m distorting things, you may have a point. Traders are not really that modest these days). After one of those completely inexplicable down days to start the week, the market was hit on Tuesday by bad news in existing home sales, the worst report in oh, eighteen years or so. Along with this was a larger-than-expected dip in consumer confidence. Now, the recent pattern for the markets in the face of all this boringly repetitious bad news on the economy has been to waste an hour or so going sideways or even dipping a little before resuming its rightful upward course. However, in the new age of the uber-Trader, waiting for the move means missing it, so the crowd has been getting understandably anxious about hustling in there to buy the dip before it’s too late. Tuesday only took thirty minutes. So what if housing was down, way down, much worse than expected? “Yes Melissa, but the real news is that the Dow is marching back towards 13,000” spoketh the CNBC goddess of glad tidings. Verily, Melissa, let’s not be wasting time on trifles like the economy when there’s money to be made.
One of the drivers of the market on said Tuesday was the announcement that IBM is going to borrow a large chunk of change to buy back $15 billion worth of shares. That’s not exactly how they put it, of course. What they did announce was a 33% increase in the dividend and a new $15 billion stock buyback. That news turbocharged the stock price, which had been languishing since the company’s earnings report the week before. It seems that IBM had admitted that U.S. business capital spending was weak, that March sales were weak, and U.S. revenue was weak. Although they were quick to point out the growth in international sales, the company was meanly not given the same free pass on weak domestic operations as the other Dow stocks, probably for not making sufficiently rosy revenue projections for the second half. So the market was treated to the odd spectacle of a Dow stock actually going down. When the decline stretched out to three days in a row, management’s hand was forced.
It seems that IBM was “very underleveraged,” according to its treasurer Jesse Greene. While the company was coy about the amount of borrowing it would have to do to pay for the buyback, the market showed its appreciation for IBM’s understanding of the new paradigm by sending the stock up over $6 to a new 52-week high. It’s now up a breathtaking 40% since last July’s lows. One doesn’t often see a company with a $150 billion market cap pull off a 40% move in only nine months.
IBM’s conclusion that it was ‘underleveraged’ is emblematic of a much larger trend. Since September of 2005, U.S. companies have bought back about $630 billion of shares, according to Thomson Financial. Barron’s, one of many publications in the last ten days or so to note this development, ran this story along with another advisor’s calculation that the majority of this year’s meager earnings growth is from lower share counts. Given that the estimates of the impact of foreign currency translation adjustments on S&P 500 earnings – i.e., the weaker dollar is inflating the value of results from overseas –are running from 25% to as high as 40% of earnings, there isn’t much room left over for earnings growth that is actually coming from genuine improvements in demand. Certainly not in the U.S., where going by the last two quarters of results, sales growth has essentially been flat.
Across the board, the larger American companies have been reporting domestic growth that ranges from little to none. In real terms, it’s often less than that. The earnings growth that we have has been coming from a combination of growth in overseas demand, the weakening dollar, and stock buybacks. The stock market has been vigorously celebrating these “surprisingly strong” earnings (they are neither, but we’ll come back to that), but hang on a minute. Let’s put some of this in perspective.
Suppose you were a CEO of one of these companies. Your average tenure is about six years long, so you don’t have a long time to keep up with the Nardellis or Joneses. Profits overseas are growing nicely. Profits at home are going nowhere. Are you going to take those earnings from overseas, where business is good, and reinvest them here? No, you’re not, not if you want to grow earnings, and by extension your own compensation. You’re going to leave those overseas earnings right where they are to invest in more overseas operations. In the U.S., interest rates are relatively low, credit is easy and financial buying fever is high, but product demand is slow. So you’re going to do what your peers are doing, and borrow money to buy stock. Either yours, or somebody else’s. So long as Wall Street is willing to reward this strategy, you’d be silly to do anything else. If you were still wondering why domestic business investment is slowing, one very good answer would be that investing in financial assets is more rewarding. Better earnings, better bonuses.
It may occur to you to wonder how long we should keep bestowing lavish amounts of compensation on our CEO’s to borrow lavish amounts of money to buy stock. It certainly has to me. In case you haven’t heard, Lewis Fink, who runs Black Rock and oversees about $1 trillion in investments, warned last week that we are getting into a credit bubble. The great money river that flowed out of real estate is still in relentless search for returns, propping up leveraged loans, buyouts, buybacks and financial assets. On Wednesday last, the new home sales numbers were announced. The street was waiting for this number with quite a bit of anticipation, no doubt because it was thought that this number would be pretty good and wash away some of the bad taste of the much larger existing home sales number from the day before. Although the number came up quite a bit short, only half of expectations, the dip lasted but fifteen minutes.
In the short run, the liquidity river and focus on financial engineering is keeping stock prices up. It must be acknowledged that this can have a positive economic effect, as the wealth effect from increased stock prices can have positive effects on consumer spending. Share buybacks do put cash back into shareholder’s hands. Buyouts do remove stock from the market, decreasing the supply of stock available. When public companies are taken private and borrow huge amounts of money to pay huge ‘dividends’ and fees to the transaction syndicate, national income does rise. But when credit activity is dominated by ways to move cash from one pocket to another at the expense of real investment in the economy, in the end the real economy is going to be left with the bill.
Wall street bulls are saying the party won’t be over until the retail investors and foreigners come in – in other words, the so-called ‘dumb’ money. I have to admit that it’s been my experience that when foreign buyers start to show up in droves, it’s been a sign that the stock market will soon be emigrating in the direction of due south. They haven’t really shown up here yet, which is no surprise given that the ongoing decline in the dollar has meant scanty returns for foreign investors, and there isn’t a whole lot of belief out there that the dollar is going to rally anytime soon. At the same time, a new credo being passed around the street to justify the close-your-eyes-and-buy philosophy of the new uber-Trader is that we’re all trading in the global market now, so if the global markets are rising then the U.S. must rise too.
But there’s a curious non sequitur in all of this. You must have noticed that every single money manager that’s willing to be interviewed and every single financial advisor who can succeed in getting interviewed is agreeing on one thing: buy foreign stocks. This maxim has made its way to the front pages. And we’re listening, according to Trim Tabs, which tracks cash flows in and out of funds. We’re putting money into global equity funds at about five times the rate that we’re taking it out of domestic equity funds. But if we’re the foreign money in these markets – and we are – then shouldn’t that be the signal that the foreign markets are topping out? And if the foreign markets are topping out and we’re all trading in the global marketplace now, then by the same logic above, shouldn’t that mean trouble for U.S. equities? Just thought I’d point that out.
We close with the silly and wise sayings of the week, respectively. The silly saying of the week, and definitely a contender for the monthly award as well, was Treasury Secretary Paulson’s statement that the Treasury favors a Strong Dollar. The dollar is at an all-time low against the Euro, a 25-year low against the pound, and very nearly at a 35-year low for the trade-weighted dollar index, and this guy’s running around trying to pretend we have a strong dollar policy. I’ll bet he’s got some solid theories on alien abductions, too.
For the wise saying of the week, we attend to the latest annual report of Berkshire Hathaway and the words of the world’s richest man and most successful investor, Warren Buffet: “in financial markets: Be fearful when others are greedy, and be greedy when others are fearful.”
Last week we featured Apple’s (AAPL) upcoming earnings, and they had quite a fine quarter, with very strong increases in net margins. One mystifying aspect of this was why the margin expansion was such a surprise, given that drastically falling memory prices have been a daily story in the business press for months. In addition, Apple has steadily been opening retail stores that have been doing great customer traffic and of course doubling Apple’s margins on goods sold. Couldn’t anybody connect the dots on that one?
In terms of price action, the stock of the week was Amazon (AMZN), up nearly 50% in one week in a squeeze of the short-sellers that was positively bloodthirsty. While it was nice to see Amazon make some money for a change, they were aided by a significantly lower tax rate and a decision to cut investment spending that will boost margins for a time, but ultimately will probably have to be turned back on. I don’t see Amazon’s revenue growth as indicative of an increase in overall consumer demand, any more than I see Google’s (GOOG) strength as indicative of an increase in the demand for advertising. They’re both cases of changes in expenditure patterns rather than levels.
A hot market ignores the bad and exaggerates the mundane out of all proportion. A cold one will do the same in the other direction. While there is hardly any proof needed that we are in a hot market, the report from UPS (UPS) last week was a good example of stocks gone wild. The company’s stock shot up on earnings that came up short of expectations and in spite of the fact that U.S. business was (as usual this quarter) weaker than expected. The rocket fuel that lifted the whole stock market was provided by the story that UPS was saying on their conference call that U.S. business had troughed in the first quarter. A turning point! Time to buy! Dear reader, we listened to said conference call. Alas, the story wasn’t what it seemed. UPS did say that they thought that the small-package business in the US had troughed during the quarter, but not because of anything to do with economic growth trends. In fact, they specifically stated that they were not predicting a reaccelerating economy. Rather, they felt that the ongoing shift to online shopping (cf. Amazon, above) and trends in just-in-time inventory management would lead to a resumption of trend growth in small-package shipment demand. The stock faded the rest of the week as people realized what they had actually said, but the stock market simply went on to the next hot story.
At the last read, earnings growth for the first quarter was coming in at about a 6% rate, and may well end up at the 7% level that was the unofficial estimate at the end of March. This is 1.5 points below the January estimates. But the street has been doing such a job of pounding out the story of the victory over the bogus 3.5% number that the general press has slowly been adopting the “strong earnings” story at face value. These earnings have been neither surprising nor strong, and given the recent economic data and what companies have been saying themselves on conference calls, earnings are at this point likely to continue to decelerate.