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Living In A "Gambling Society"

July 14, 2015
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Those are Larry Fink’s words, not mine ("gambling society").  Larry is the Founder, Chairman and CEO of Blackrock, the largest asset manager in the world.  Larry wrote a letter to each of the leaders of the S&P 500 companies in April of this year (2015), which included the following:

“It concerns us that, in the wake of the financial crisis, many companies have shied away from investing in the future growth of their companies.  Too many companies have cut capital expenditures and even increased debt to boost dividends and increase share buybacks.  We certainly believe that returning cash to shareholders should be part of a balanced capital strategy; however, when done for the wrong reasons and at the expense of capital investment, it can jeopardize a company’s ability to generate sustainable long-term returns.”  

“The effects of the short-termist phenomenon are troubling both to those seeking to save for long-term goals such as retirement and for our broader economy…  Since when was one year considered a long-term investment?  …U.S., tax policy, as it stands, [for example] incentivizes short-term behavior.”

2015 on pace to reach $1.2 trillion worth of announced share buyback programs (Source:  Birinyi Assoc)

 

Notice anything particularly correlative in that chart?  Companies bought back shares when their share prices were high (2007 and 2014 and certainly 2015), and they didn’t buy nearly as many shares when their shares were low (2009).  

What money are they using to buy their shares?  Debt.  They are largely issuing corporate bonds in order to buy shares in gigantic amounts.  This chart illustrates exactly why Larry Fink sent the letter to S&P 500 CEOs.

Corporate Bond Issuance 1996-2014

 

Source:  Alhambra Investment Partners – 7-15

 “Companies know the Fed is winding down easy money so a lot are running to the gates using debt to fund share repurchase programs.” – Rob Leiphart, Analyst at Birinyi Associates – May 2015

Why are they doing so?

Well for a host of reasons, but mainly three:

  1. They are buying competitors (understandably with debt at super-low interest rates), and the Fed’s asset reflation policies are causing the prices that the companies have to pay for their competitors to be exorbitantly high;
  2. Corporate bond yields have been trading below the S&P 500’s forward earnings yield since 2004, providing companies with incentive to buy back their shares and engage in M&A rather than invest in plant and equipment;
  3. They want to be able to hit short-term earnings projections so that their stock prices don’t suffer (parenthetically here:  rather than investing in their businesses for the long-term).  The bottom line:  buybacks boost earnings per share.
Estimated Earnings projections since 2000 (three periods highlighted:  2000, 2007 and current (2015))


 

The chart above doesn’t suggest that the market is headed for a collapse it simply illustrates that despite estimated earnings trajectories, actual reported earnings are sometimes much different a year or two out from those projections.  The U.S. stock market is okay for now; the “P” (Price), is just catching up with the “E” (Earnings).  We are in a brief earnings recession (U.S.), but not on the precipice of an economic recession, I do not believe.

But in the next few years, beware (see chart above), we’re in this “boom and bust” cycle. This cycle is fueled by Fed policy.  Loosen credit “boom”; tighten credit “bust”.  The current expansion is now 30 months old but with the strong ISM readings we’re seeing along with all of the other economic data (certainly with some exceptions), it’s not looking like the U.S., is anywhere close to a recession.  This is going to turn out to be a long, drawn out expansion.  The economic data broadly gets better and better each month that goes by.  We are subject, however, as I’ve previously noted to these “boom and bust” sort of periods.  And it’s all debt-related.  Shouldn’t that influence your asset allocation?  I think it should.

You see, despite all of the drama with Greece and China (and certainly more to come from other places around the globe, because that’s life), the lion’s share of the $15 Trillion U.S., economy is domestic.  The strong U.S., dollar doesn’t help certain S&P 500 components due to the affect on their earnings from exports (and this was mentioned in several earnings reports over the last few weeks).  That’s mostly why we’re in this squishy correction where the price is catching up with earnings.  Let’s not forget (lest we be short-termist), that we won’t see a bear market in equities without a recession.  I didn’t say we won’t see a correction or two or three, but we most likely won’t see a bear market in equities until we see a recession and that will most likely occur somewhere within the context of the Fed Funds rate being somewhere in the range of 2%-4%.  The Fed’s fingerprints have been all over all of the past recessions and the next one most likely won’t be any different.

Outside of the near -60% collapse in Energy sector earnings, the profit landscape is generally constructive with earnings in Healthcare, Financials, Consumer Discretionary all fairly positive.  Certainly commodities that are marginal borrowers are struggling.  For example, the entire coal industry will be in the news before too long.  There is only one U.S. domiciled company in coal that has a decent balance sheet and decent long term prospects.  These companies bought up competitors around 2007 and paid way too much money for them and so when the price of coal went down, those companies and their assets they bought weren’t worth anywhere near what they paid for them.  Does it seem like similar M&A strategies (paying way too much for a company), are being employed?  It should because history will eventually repeat itself and debt defaults will occur in other industries besides just coal and oil and debt restructurings will occur in new places besides just Detroit and Puerto Rico.

Gambling overseas variety (namely China)


 

So something happened in China in June that was fairly interesting.  For roughly 400 million Chinese who are separately not a part of the roughly 800 million agrarian population, a deal was struck to encourage them to invest in the Chinese stock market. This deal was between the Chinese government and 21 broker dealers whereby the government would permit those broker dealers to accept a person’s equity in their home as collateral for a margin loan account so that they could buy Chinese stocks.  Mmm. Chinese stock market is down 30% YTD.  Does that sound wise to you?  Sound a bit like gambling?

Discipline in our long-term strategies

Because we continue to adhere to a disciplined strategy whereby we are investing in reasonably valued dividend stocks and corporate and municipal bonds in the secondary market with higher coupons, in a laddered manner, we don’t have that 3% exposure when rates rise anyways.  We’re in the 6% camp.  Let the untested bond funds buy the 3% stuff.  We’ll pass.

The discipline of being diversified and not too heavily weighted towards an industry or sector is important of course as well.  And of course our asset allocation matters as leadership amongst sectors shifts.

“Discipline is the soul of an army.  It makes small numbers formidable; procures success to the weak, and esteem to all.”  - George Washington

Now as a kid, I was never very disciplined.  But after I became a man and as I age, I understand how important discipline is to the success of any endeavor.  When I recently re-watched the classic movie, The Alamo, with John Wayne, I was struck, at first, by how cold, calculated, and bull-headed the man who portrayed Lt. Colonel William B. Travis was at the age of 26.  When you read up on Travis in the history books (or the internet), you find that Travis lacked a great bit of personal and moral discipline and really made some horrible decisions concerning his wife and family and his personal finances (especially in the area of debt).  However, when it came to standing his ground against the Mexican army in 1836, no one could question his bravery as he died in the fight.  

Tsipras at the Greek Alamo

Tsipras (of Greece), reminds me of Lt. Col., Travis a good bit as a negotiator.  Everyone thinks the guy is an idiot, and yet, I think he is very cunning, shrewd, and maybe even brilliant.  I am not saying that his approach is right or wrong, I’m just saying he is a lot smarter than most are giving him credit for being.  When your country has a debt burden of $390 billion and your economy is shrinking and at last snapshot is only $225 billion in size, you’re in deep doo-doo.  Herr Schauble is akin to Mexican General Santa Anna (Mexican Army), and Tsipras is significantly out-armied, and here not only Schauble comes, but essentially, the entire Eurozone is understandably sick and tired of this crisis.  I mean it’s been going on for over five years right?


It’s different this time around  

“Most banks outside of Greece have been purged of their Greek credit exposures, which now look immaterial relative to bank capital” – Scott Minerd – Chief Investment Officer – Guggenheim Partners – July 8, 2015



 
Markets like certainty

“The markets like what they see thus far, in stark contrast to exactly a week ago coming off the Greek referendum.”  - David Rosenberg – Gluskin Sheff Economist – July 13’th 2015

Income plus growth to help offset your spending

That’s of course why income from stock dividends and coupons from bonds are so important.  On January 7, 2000, Microsoft’s stock price was $55 per share.  On July 8, 2015, the stock price is $44 per share.  That’s more than 15 years with no stock price appreciation.  The difference is, is that today, the stock sports a 2.77% dividend and back then it did not pay a dividend.   You have to go twenty years out on the U.S., government bond yield curve to yield 2.78% to beat it.

Further uncertainty could slow economic progress in Europe, but it is unlikely to reverse it.  Markets may experience volatility as the situation evolves.  Core Eurozone counties are very, very invested in the success of the Eurozone.  The ironic part of this current situation, is that the Eurozone was just beginning to turn the corner and showing less stagnancy and actually projecting growth in economic data such as Spain’s example of projecting 3.3% GDP growth due largely to tax cuts.

Puerto Rico update

Puerto Rico is a bit scary actually.  We have no direct Puerto Rico exposure.  The only exposure I can find is in Wells Fargo Institutional Municipal Bond sleeve which, as of July 8’th, after speaking with a team member, is 5 bps of insured exposure (or the equivalent of 0.05% of the value of the investments in that particular fund), in the intermediate sleeve, and 83 bps in the long term sleeve (or the equivalent of 0.83% of the investments in that particular fund).   Like me, Lyle Fitterer (Senior Manager of the funds), didn’t like Puerto Rico in 2013, much less in 2015.

Governor Garcia Padilla has requested that Congress extend Chapter 9 bankruptcy to Puerto Rico so that the commonwealth can continue to borrow despite its inability to repay its creditors.  Chapter 9 is available to municipalities but not to U.S. states.  The municipal bankruptcy process allows municipalities to stiff-arm current bondholders while borrowing from new bondholders.  This is why we want to own only certain essential municipal bonds in states that permit Chapter 9.  Not all states allow their municipalities Chapter 9 protection.  

“Don’t own municipal credits whose financials, credit worthiness and unfunded liabilities continue to erode.  The yield and the headline risk are not worth it.  Investors own municipal bonds to preserve their wealth, not to earn an above market return.  That’s what growth stocks are for.”  Marilyn Cohen – Chief Investment Officer – Envision Capital – Los Angeles, CA – May 2015

Update on the “burn rate” for Social Security

Social Security Deficits (burn rate), appear to be permanent and are “set to quadruple in fewer than 20 years”  (source:  Heritage Foundation 2014)

 

What’s in the shopping cart at present?

Corporate Bonds

PVH (Philips Van Heusen BBB rated), 5% (Yield to Worst), 7.75% to 2023 Senior Secured bonds trying to get them at 5%.  The recent secondary market offerings have been a bit too pricey, but we should be able to buy them soon at that level.

El Paso (KMI), closet A- rated bond (currently BBB- rated; $116 price gets you 6.2%! And then if we see 5% 10 year treasury yields, $94 gets you 8.78%)!  I think it’ll be a while before we can score those sorts of yields, but wouldn’t that be sweet!?!  How about 6.2% while you wait?

Equities

Kayne Anderson – KYN - diversified natural gas stock fund that is down 20% YTD;

Norfolk Southern stock – NSC – also down 20% YTD;

Alcoa – AA – down 31% YTD (adding to positions we bought between $8-$10);

MFS Institutional Large Cap Value Fund (ILVAX)

Random thoughts

Investing in certain credits with reasonable amounts of duration makes sense right now after spreads have widened so considerably with the Greek crisis and with the talk of the Fed raising Fed Funds later this year or early 2016.  Yes, bond prices will suffer as rates rise, but not in the ways people think…for the farmer, it’s pray for rain, from my lens, it’s pray for higher rates…!...

Plan for 5% on the 10 year…I know, I know…the 10 year is just making its way back to 2014 levels of 2.6% and it’s having a hard time piercing through the 2.5% mark and hovering there, but the Fed’s not done anything yet and they most likely will in Sep or Jan and they will most likely act with conviction and move towards 2% on the Fed Funds rate (they have said in unison that they desire to do so (from Fed minutes), they know at this point, it’s not healthy to stay at the zero bound and not move towards that target)), AND the bond traders I speak with are basically under the impression that 5% isn’t even possible – that’s why I am planning for it (contrarian).   That is also why we subject the bonds to the duration tests to see what would happen under a number of different interest rate scenarios.

If not for the Greek tragedy and the Chinese stock market beatdown and the question marks around commodities (in particular the price of oil), the 10 year yield would be around 2.75% (minimum), I believe.  But these items are in the news, and the yield is not there.  I believe that the Fed will act with conviction in 2016, however, with several rate increases unless we get a serious bolt out of the blue.  Stocks have a generally positive backdrop and high yield bonds with high coupons with reasonable risk / reward metrics and reasonable debt to asset and debt to equity ratios look very attractive on a risk/reward basis.

Stocks are not terribly overvalued at all and existing positions should be added to with pullbacks and considered buying opportunities.  Some areas of the market are too expensive for sure like certain Biotech.  Be patient and lengthen your time horizon and expectations on less expensive non-US equities.  The U.S., will continue to shine, but the clinical fact is that one shouldn’t shun several emerging market areas because they have cheaper valuations that will be rewarded given time.

In closing, I really hope you had a chance to view the U.S., Women’s Soccer World Cup Final?!!!?  How wonderful was that?  Wow…  Congratulations to them!
 


Thank you so much for your trust and your business.  I have a great job and you make it possible.

Yours,

 
Jack Parsons CTFA, AEP
President & Chief Investment Officer
Vickery Creek Capital Management, LLC