by Brian Pretti CFA, Contrary Investor. August 29, 2008
Bull markets are always a lot of fun. No question about it. But amidst all the high fiving and backslapping, especially among the Wall Street community, few stop to count the cards, if you will, during these periods and fully realize just how many support mechanisms to equity prices show up at the party to help levitate prices. In every bull market, there are many legs to the proverbial bull market stool. Yet in bear markets, I also believe too, few stop to think about how many of these legs to the greater price support stool are summarily pulled away, one leg at a time. After all, asset prices any point in time are essentially determined by the “weight” and direction of money. This applies to everything from equities to real estate. Human beings make similar emotional decisions, really regardless of asset class. I want to spend just a few minutes quickly covering a number of the “legs” to the equity market stool of the moment that have been and are being pulled out from under the market as we speak. No big mysteries. No magic thoughts that aren’t in plain sight anyway. Just a quick review of some of the components that essentially help drive that weight and movement of money equation.
CORPORATE EQUITY BUYBACKS
For now, we only have numbers through the first quarter of this year. It will be a few weeks until 2Q numbers hit the tape. Right to the point, first quarter 2008 data show us that corporate equity retirement is falling relative to the magnitude of buybacks over the last few years. (Negative equity issuance numbers represent equity retired for the period.) Please be aware that in the chart below, the 2008 number is annualized. Is what we see below yet another equity price support that is fading along with the dual influence of slowing corporate earnings growth and heightened inflationary pressures causing valuations to contract? You bet. For now, this reduction in equity retirement is being driven by a multiplicity of factors. First, the private equity industry is relatively dead in the water, related directly to funding issues, hence their ability to acquire public equity has been diminished greatly. But this is nothing new as the continued constriction in funding available to the private equity industry has been going on since last summer. The second driver is a slowdown in direct equity buybacks by corporations themselves, completely outside of M&A related equity retirement. Clearly a slowing in earnings is restricting free cash flow availability to firms. Free cash flow that could easily be used to retire equity. Secondly, a general tightening in the credit environment means that corporations must allocate their credit available with a bit sharper set of eyes. Both capital and credit availability have become quite the precious corporate assets at the moment. As you know, plenty of equity retirement over the last few years was indeed driven by debt financed buybacks. This is slowing. Stool leg number one is being seen partially pulled away below.
As we've told you in the past, and as is clear in the historical experience you see in the chart above, during periods of macro economic slowing/recession, corporations back off on equity buyback activity in a big way. Clear as a bell in the early 1980's, the early 1990's, and the early part of the current decade. Outside of these periods, corporate equity retirement activity has been strong, a very meaningful support to equity prices in aggregate. How meaningful? You can see the incredible nominal dollar repurchase activity of the 2005-2007 period. A period, by the way, that coincides perfectly with the height of the prior credit mania.
One last FYI chart before leaving this portion of the discussion behind. Again, another update. This is the very long-term history of US corporate equity retirement and corporate debt issuance. There is absolutely no question, and is public information especially decade to date, that a lot of corporate equity retirement has been debt financed. Whether it's at the corporate level singularly or through the private equity industry, leverage has gone a long way toward supporting equity retirement. In a credit contraction environment, experience here will be an about face.
There you have it. We believe we are looking at an important support to the equity markets at the current time that is falling by the wayside in cyclical fashion. Not that this is unexpected by any means as these cycle patterns of equity retirement have been repeated across the decades. And, of course, the cyclical irony is that by these very actions, corporations tend to buy back their own stocks at high prices, but are never around to support their stocks during equity/economic downturns. In a rational world, shouldn't it be exactly the other way around? Of course, but who said the action of the financial markets or the corporations that make up those financial markets are rational? As a final comment, as you look across historical experience, some of the best times to have purchased equities from a fundamental valuation standpoint have been when corporations are taking a holiday from buyback activity and private equity deals are close to nonexistent. Contrarianism in action? You bet. We're not there yet, but it looks like we're finally on our way in the current market. Stay tuned as the personal buying opportunities lie ahead.
In many ways, the cyclical ups and downs of margin debt reflect human emotion. Just as the application in the wonderful world of residential real estate also exhibited this same quality. Our little way of saying that leverage has been important to stock prices. To be honest, it has been a very important indicator really since last summer in terms of corroborating, and in large part foreshadowing, macro equity market trajectory. Moreover, an additional reason this issue is critical to review now revolves around the larger theme of deleveraging I have been hammering home really this entire year in our discussions. Yes, we are watching deleveraging in the US financial system as we speak. This is a process that has really just begun this year. Deleveraging at the household level will be a lingering phenomenon to come. Same deal for the corporate and financial sector. Importantly for the financial markets, leverage has likewise been a support mechanism to stock prices in aggregate that is also in the midst of important change as we speak. Time for a review.
Last November, I was questioning whether we were again seeing a very important peak in margin debt balances stateside. The comment at the time was that very meaningful spikes in nominal dollar margin debt have historically coincided with meaningful peaks in the equity averages themselves. Sure enough, it appears as though we have yet another example of this truism looking back over both margin debt and equity market action of the past year. For now, this very important correlation continues. And in the current cycle, the decline in margin debt is now part of a greater deleveraging theme playing out in the broader US financial markets and real economy.
Very quickly, although this is now behind us in the current cycle, equity markets have tended to peak in the past when both the year over year rate of change in margin debt AND nominal margin debt balances peak. In March of 2000, we experienced a peak in both the year over year rate of change in margin debt growth and nominal dollar margin debt outstanding itself. Right on the money in terms of the important message of this powerful indicator. Last summer, the year over year rate of change in margin debt outstanding peaked in June, while nominal dollar margin debt made a very small higher high in July. Close enough to again reinforce the importance of monitoring margin balances on an ongoing basis.
Point blank, at least in the current cycle playing out, accelerating margin debt is no longer a support to equity prices. It can now join the diminishing power of corporate stock buybacks as being two important support mechanisms to equity prices that are clearly diminishing in impact simultaneously as we speak. For an equity market that can use all the help it can get at the moment, this is not good, but in the larger picture it is both predictable and all part of the market cycles and patterns of human decision-making that play out over time.
In addition to the very important and now receding macro stock price supports that are expanding margin debt and expanding corporate equity buybacks, outright buying of equities by the public is now and has been a very important leg to the total stool for decades now. Without dragging you through another chart, the fact is that the US public has been selling their US centric equity funds for close to a year and one half now on a net basis. Public inflows to foreign centric equity funds continued very strong throughout 2007 and into the first quarter of 2008, but since that time even the foreign equity funds have been under liquidation. No mystery as these markets are getting hit. Unlike the late 1990’s when the public simply could not get enough in the land of equities, they seem to have lost their taste as of now. As I’ve mentioned on a number of occasions, I believe we face a generational issue in the equity markets over the decade, and perhaps decades ahead. We face a baby boom generation that has spent close to the last three decades in net financial asset accumulation mode. It has been a one way street in terms of funding IRAs, profit sharing plans, 401(k)s, and tangentially corporations funding defined benefit plans for these same boomers. You already know the punch line. Many of these invested vehicles will come under distribution as we move forward. And perhaps to a greater extent than many believe if indeed financial market returns are as subdued as they have been over the last decade. Let’s face it, anyone sitting in an S&P index fund over the last decade would have been better off in a brain dead money fund. And now with residential real estate values facing the reconciliation we all knew was “out there,” the pressure on the boomers has to be enormous in terms of maintaining a sense of financial well being. Concern levels have to be quite high for many in terms of facing the “will I have enough money to last the rest of my life?” question. For now, public support of domestic and foreign equities isn’t receding; it has become non-existent in terms of new buying.
As an adjunct, it’s not just the public that is having “second thoughts” in this cyclical downturn in equities. As of the latest reading, cash in the equity mutual fund complex rests at a 3 ½ year high. You already know equity fund managers of today are loathe to have existing cash. It’s a statement when we see them pull a bit of an about face.
There you have it, short and sweet. Yes, the financial markets face huge macro economic and credit cycle question marks of the moment. Without sounding melodramatic, I believe we are facing a generational cycle of reconciliation. But amidst all of the volatility and news barrage of the day, a number of very important legs of the equity market stool are slowly but surely being gnawed away. I promise you, all of these supports will return…well AFTER the markets have clearly and definably put in a bottom.
© 2008 Brian Pretti