Y2K Redux
2019 was a great year to be in the stock market with the S&P500 returning 30.43%. It went from being a very good year to a great year thanks to the Federal Reserve injecting $500 billion into the banking system because they were afraid that current troubles in the banking system would spill over into the financial markets. Much like Y2K, or the transition from 1999-2000 when technology experts fretted over global computer problems, the money injected made its way into the stock market.
In the present case, the banking issues stemmed from illiquid money markets that drove prices charged between banks much higher, threatening to create havoc in securities markets that rely on money markets for funding. Typically, this happens when banks fear that hidden losses exist at other banks resulting in higher prices for those banks to borrow money. The Federal Reserve, not wanting an environment like 2008, injected half a trillion dollars into the banking system. Much of this money found its way into the stock market, just like in the year 2000.
In both years, the stock market spiked from October through December. This begs the question of whether we’re facing a sell-off similar to what happened in March 2000? The answer will depend on whether the Fed keeps the liquidity in the banking system or attempts to reduce it over the course of 2020.
The Fed
Like good investors, the Fed learns from its mistakes. It employs scores of PhD’s and analysts to study the impact of the central banks actions on markets. One thing they don’t want is a stock market crash, so presumably, they won’t withdraw money from the banking system rapidly like they did in 2000.
As I’ve pointed out many times before, the government through the Fed and the Treasury Department has been intervening in the markets for years. Over time, this has become more pronounced such that I’m not sure the markets could survive without intervention. In retrospect, it appears that our national leaders got spooked in 2008 and have decided to prevent another episode at all costs – the costs in this case being “free markets”.
Corporate Earnings
They have been aided by corporations buying back their own stock. It’s simple supply and demand. As companies buyback their own shares of stock, the earnings that companies produce are divided over fewer shares. This is significant because total corporate earnings have been falling since 2014 such that total pre-tax earnings in the US are less than produced in 2012.
I’ve included two charts below. The first shows the S&P500 index and earnings per share. The blue line is earnings per share. Both have been trending higher since 2010 with earnings per share topping out in 2018.
The second chart shows total corporate earnings in the US – both private and public corporations. This chart isn’t impacted by stock buybacks and reflects the total value of corporate earnings in the US as measured by the Bureau of Economic Analysis. The blue line is corporate earnings and the red line is the S&P500 index. You’ll note that total corporate earnings in the US are lower today than in 2012.
Unlike the first chart where the S&P500 index largely followed earnings per share, the second chart shows that the S&P500 has largely separated itself from earnings. Historically, this is unprecedented which is why relying on quantitative stock market disciplines is no longer favorable for asset returns since “quant funds” rely on past data and correlations between stock market variables. You can see from the chart below that money has been leaving “quant funds” since 2016.
US Economy
Based on total corporate earnings, you can see why I’ve been calling the US economy “stagnant” for the past ten years. Pundits will point to the growth of the S&P500 earnings per share but they leave out the impact of stock buybacks on the computations – an extraordinary omission given current circumstances.
Corporate earnings have been declining since 2014 and even the S&P500 earnings per share measure have been declining for the past year. This is indicative of an economy that is weakening on the margin, not a recession. I’m not sure we can experience a recession over the next couple of years with so much intervention by the Federal Reserve and the US Treasury.
Based on what we learned in previous economic cycles, it’s possible that we’d be in a recession today because the stock market would have fallen along with total US corporate earnings which would have made economic decision makers a lot more careful than they are today. Stock buybacks would have stopped while companies with too much debt would have been forced by the market to sell more stock to investors.
But the stock market didn’t fall; instead it rose 30.43% last year. Economic decision makers such as chief financial officers of large corporations are quietly reducing risk but nobody is panicking. Measures of industrial activity in the US are weakening while freight carried by railroads is down 5% over the past year. The great British economist, John Maynard Keynes, would have commented that it’s been the taming of the market’s “animal spirits” that has made the difference!
Growth
Our economy may not go into recession but I don’t believe we’ll experience any real growth for one simple reason – nobody is investing. That may sound crazy coming from someone who invests in the stock market for a living but it’s true. Corporations are using their spare cash as well as the proceeds from borrowing in the bond market to “invest in their own stock”. That’s quite a bit different than investing in new products and operations.
Below is a chart of the contribution to GDP growth from fixed investment. Fixed investment involves the purchase of assets like trucks/computers/machinery or building new warehouses/ plants/offices, etc. Since the tax bill of 2017, real investment has declined in favor of stock buybacks.
The result of these decisions is more stagnation at best and decline at worst. The reason is that this measure by the Bureau of Economic Analysis doesn’t include past fixed investments that have been shut down or written off. Anyone who lives in an old industrial town such as Buffalo, New York can attest to what happens when businesses move overseas.
A good way to describe the US is an economy that does more harvesting than planting. This situation is only possible in a time when the Federal Reserve has added obscene amounts of money to the banking system such that asset inflation has ensued. It’s a great strategy for making today a wonderful experience but it’s not so great for the future.
Corporate Debt
In past economic cycles, corporations sold debt in order to invest in some new technology with the hope of generating future strong returns for shareholders. Even when those investments didn’t work out, there were physical assets that could be sold to pay back at least part of the debt. But that isn’t the case with the present cycle.
Corporations, both private and public, have been selling debt in order to buy back shares and reduce equity on their balance sheets to spread dwindling earnings over fewer shares. Equity is ownership in an enterprise; it represents “skin in the game”. Owners of equity only get paid dividends when enterprises produce a surplus of earnings.
In effect, corporations are “buying high” as without investing in new operations and products, the probability of producing strong earnings in the future drops. The chart below shows the S&P500 priced by “sales per share”. You may note that the stock market is trading at levels last experienced during the “dot com” insanity when companies with scarcely any sales were trading at extraordinary valuations. A chart like the one below is only possible when companies are being managed to produce cash, not growth and that cash is being used to buy back stock to propel shares higher in the short run.
Debt is a fixed obligation and it needs to be paid back regardless of whether companies make money or not. The amount of corporate debt has ballooned over the past decade even as corporate earnings have declined. And unlike past cycles, corporations don’t have the assets to sell to increase cash when necessary. The chart below gives us a sense of just how bad it has gotten.
In my opinion, the reason that corporate earnings are slowly declining is that nobody is investing in the future. This makes the rapid accumulation of debt in our financial system even more insidious. The buyers of this debt have done very well in the markets but before much longer, I expect things to reverse. The combination of excess debt and declining earnings is an unprofitable match.
The GeoVest Approach
This is why we are looking for shares to own of companies with real sales growth. We prefer companies that are taking advantage of changing trends and demographics that are able to pay their bills and have money left over for new investment and shareholder enrichment.
There are a number of similarities between 2020 and 2000 that are keeping us wary but today’s investment environment is profoundly different than 20 years ago. There are more risks today than in 2000 but the government’s involvement in the markets tempers much of that risk in the short run. We’re managing with one eye on the short run and one eye on the long run.
We generated another strong year for our clients because we continue to modify our approach to investing to incorporate the changing circumstances of the economic and political cycle while maintaining the discipline that is the trademark of our investment process. Thank you and it is our continued privilege to serve you.
Philip M. Byrne, CFA
Chief Investment Officer
