18/3/20: What's Scarier? Corporate Finance or COVID?

Larger corporates in the U.S. are seeking public supports in the face of COVID19 pandemic, from airlines to banks, and the demand for public resources is likely to rise over time as the disease takes its toll on the economy.

Yet, one of the key problems faced by companies today is down to the long running strategies of creating financial supports for share prices that companies pursued over the good part of the last decade, including shares buybacks and payouts of dividends. These strategies have been demanded by the activist investors across numerous campaigns and by shareholders, and have been incentivized by the pay structures for the companies executives.

Artificial supports for share price valuations are financially dangerous in the long run, even though they generate higher shareholder value in the short run. The danger comes from:

1. Shares buybacks using companies cash to effectively inflate share prices, reduce free float of shares and lower the number of shareholders in the company, thereby reducing future space for issuance of new shares;
2. Shares buybacks have often been accompanied by companies borrowing at ultra-low interest rates to purchase own firm equity, reducing equity capital and increasing debt exposures;
3. Shares buybacks generate future expectations of more buybacks, even during the times of financial weaknesses;
4. Shares buybacks also reduce future firms' capacity to borrow by either increasing debt to equity ratio, increasing overall debt loads carried by the firm or both;
5. Payouts of dividends also use cash reserves the company can hold to offset any future risks to its financial wellbeing and to invest in organic growth and R&D;
6. Payouts of dividends create future expectations of higher dividends from investors, reducing firm's capacity to deploy its cash elsewhere;
7. Payouts of dividends increase cum dividend prise to earnings ratios, reducing the overall capacity of the firm to raise capital cheaply in the future.

These are just some of the factors that overall imply that shares buybacks and payouts of extraordinary (or financial unsustainable) dividends can be a dangerous approach to managing corporate finances. 

So here is the evidence on just how deeply destabilizing the scale of shares buybacks and dividends payouts has been within the S&P 500 sector:

In Q3 2019, shares buybacks and dividends yielded USD1,246.73 billion on a four-quarters trailing basis, fourth highest quarter on record. Overall market yield contributions from buybacks (3.12%) was higher than that from dividends (1.81%), with combined yield of 5.05%. In simple terms, any company operating today will have to allocate 5.05 percent of its return to simply match shares buybacks and dividend payouts yields. This is a very high fence to jump.

Put differently, what the above data shows is that just one, single quarter - Q3 2019 - has managed to absorb more resources in shares repurchases and dividend payouts than what the corporate America is currently asking in financial supports from Washington. 

What's scarier? Corporate finance or corona virus?.. 

14/6/19: Rising Concentration Risk in S&P500 Earnings and Revenues

S&P 500 companies earnings and revenues are heading for another round of de-diversification (increasing concentration of earnings and revenues toward the U.S. markets), per Factset latest data:

10/1/19: QE or QT? Look at the markets for signals

With U.S. Fed entering the stage where the markets expectations for a pause in monetary tightening is running against the Fed statements on the matter, and the ambiguity of the Fed's forward guidance runs against the contradictory claims from the individual Fed policymakers, the real signals as to the Fed's actual decisions factors can be found in the historical data.

Here is the history of the monetary easing by the Fed, the ECB, the Bank of England and the BOJ since the start of the Global Financial Crisis in two charts:

Chart 1: looking at the timeline of various QE programs against the Fed's balancesheet and the St. Louis Fed Financial Stress Index:

There is a strong correlation between adverse changes in the financial stress index and the subsequent launches of new QE programs, globally.

Chart 2: looking at the timeline for QE programs and the evolution of S&P 500 index:

Once again, financial markets conditions strongly determine monetary authorities' responses.

Which brings us to the latest episode of increases in the financial stress, since the end of 3Q 2018 and the questions as to whether the Fed is nearing the point of inflection on its Quantitative Tightening  (QT) policy.

24/10/2014: One Ugly with some Ugly Spice... EURO STOXX EPS

It's Friday... ECB is coming up with the banks tests on Sunday... And before then, if you want 'ugly', here's 'ugly':

The above chart plots Earnings per Share, in euro, for S&P500 and for EURO STOXX. It comes via @johnauthers

Now, despite this, you wouldn't believe it, but roughly 68% of European companies reporting earnings this quarterly cycle to-date have been outperforming analysts expectations.

And for some real 'ugly' spice on top of this pizza, the sub-trend decline in the EPS for European stocks has set on roughly H2 2011... something we shall remember when we re-read all the European 'recovery' tripe from 2011 and 2012 and a good part of 2013.

23/1/2012: Extreme Events

Going through 2 charts and mapping the big themes of the ongoing crises, one has to be in awe of the volatility. Here are the maps of extreme (3-Sigma-plus) events with 'directionality' reflected:

Lovely, aren't they? But the trick in the above is: we are not at the decay stage of volatility on the sovereigns re-pricing stage. This, to me, suggests that once the sovereign crisis re-pricing draws to conclusion (whenever that might happen - isa different story), there will be the need for finding that 'new normal' (reversion-to-the-trend target) for the markets valuations overall. And that is the whole new game, dependent less on the previous equilibrium that should have followed the Great Bursting period, but more on the future risks and trends in post-debt economies. Which, itself, really depends on whether any given market can sustain growth without endless supports (implicit and explicit) from the Government borrowings.

Just thought I'd throw few thoughts out there...

Economics 31/01/2010: S&P, Gold and forward view on risk

Couple articles worth reading:

1) China bubble - here. In my view - the analyst is spot on - there is a massive bubble in Chinese economy. So large, when it goes, the entire global growth will be derailed. We are, in effect, now treading to closely to the 1932-1934 period of the Great Depression, when the markets forgot fear for a sustained Bear rally before rediscovering that risk mispriced is a disaster waiting to happen.

2) Gold - here. Great chart on 89% loss line.
A very promising direction on gold, of course, which is in line with (1) above.

Prepare for some fun. Take a look at VIX:
All supports are out at this stage and risk appetite is falling since the beginning of the year. Bonds rallying, S&P is taking on water. The only way from here for the likes of Gold is up, for DJA and S&P - down. Back to that 89% rule line in (2) above.

Daily Economics 27/04/09: Brian Lenihan/NAMA and US opening

GM debt-for-shares swap as an illustrative example for Irish banks?
General Motors is offering an interesting insight into senior debt recovery rates in the US. The company has offered to swap some $27bn worth of new equity in exchange for old debt at 225 common shares per $1,000 in debt - effectively implying a recovery rate of 45% (at flat current price per share of $2.03) on its senior debt. Now, factoring in the dilution effect of the new shares, this implies a discount rate of ca 65-70% on the existent debt.

The lesson for NAMA: although Irish banks are not in bankruptcy, like GM, much of the stressed property-linked assets are virtually there already. If NAMA were to buy these at a discount of 15-30% - the numbers rumored out there in the NAMA-proximate worlds of Irish finance, such a discount would imply that the Irish state believes our property development and investment loans to be some 220-430% more secure than the senior debt of one of the largest corporations backed by the US Federal Government cash.

Being realistic was never a strong point of this Government, I guess.


Brian Lenihan on NAMA: per Reuters report on Brian Lenihan's statement to the RTE yesterday, in addition to repeatedly referring to 'pounds' as Irish currency, our Minister for Finance has managed to state that 'if we nationalise BofI and AIB outright, our entire banking system will be 100% nationalised' (I am using an audio recording transcription here, so the quotes are not exact, but preserve the core of his arguments). Hmmm... one would have thought that the Minister who extended banks guarantee to 6 banks (not just AIB and BofI) and who should be aware of the significant presence of non-Irish banks in this economy would be more careful in phrasing his statements.

'I believe it would be very difficult for Ireland to attract funds from abroad, much more challenging, were we to do that.' Now, in effect, as BL points out (hat tip to him), this amounts to an admission that our state is now at or near the limit of its borrowing capacity. Of course, achieving a miserly 110% cover in 9-year bond last week (a bond of very small volume, one must add: see here) suggests just that, but... an admission from the Minister is an all together new dimension to the state borrowing saga.

on the matter. Now, Funny, of course, the Minister should take the same stance as his adviser, Alan AhearneNAMA would require borrowing ca Euro56-60bn to finance a bond-debt swap, with additional Euro4-8bn in post-NAMA recapitalization. A nationalization outright would involve borrowing just Euro2bn to cover existent equity and Euro5bn to shore up some of the capital losses due to transfer of equity and writedowns on the loans books totalling 50% (while driving Capital ratios down to 8% statutory requirement). If we face tight borrowing markets, surely the logic suggest we should try borrowing Euro8bn rather than Euro68bn?

Ah, logic, as well as economics and finance, and fiscal policy and management of public expenditure, are apparently not the strongest skills in DofF - either at the top or at the bottom... So what is then?


Ireland's corporate insolvencies as predicted back in March, here, (actually, I made a more detailed prediction of the rates of insolvencies increases in 2009 in the December 18 issue of Business&Finance magazine pages 42-43, available here, and that forecast itself was building on the defaults model I created when forecasting corporate defaults back in the spring 2008: here scroll to page 10), Irish companies are facing a dramatic rise in insolvencies in 2009 and the rate of bankruptcies is rising. Table below - courtesy of FGS says it all - Q1 2009 number of insolvencies was 170% above that for the same period of 2008.

Back in December 2008, my forecast was for the average rise of 247% in 2009 across the main sectors of this economy. We are now well on the way to meet this prediction.

Table below summarises two of my previous forecasts, with the later one still holding nicely, in my view... and yes, for those of you aware of it - the first forecast is, judging by the table color, from an even earlier publication (June 2008).

US news front has worsened substantially last week and the stocks snapped their weekly gains accordingly.

Friday’s figures showed demand for durable goods falling 0.8% in March in a seventh monthly decline since July 2008. New orders posted declines in virtually all sectors. Shipments were down 1.7%. On what appeared to some to be a more positive note, inventories fell 1.1% and capital spending by businesses rose 1.5% posting a second consecutive increase, albeit on an abysmally depressing fall-off in January. Both, in my view, are not signs of strength, but of the moderation in the rate of industrial production slowdown. Inventories declines are hardly significant, given rapid and drastic cuts in capacity over the previous months.

The rate of banks closures accelerated. American Southern Bank of Kennesaw, Georgia, was shut down with assets of about $112.3mln and deposits of $104.3mln. Then, Michigan Heritage Bank of Farmington Hills, went bust with total assets of $184.6mln and deposits of $151.7mln. Calabasas, Ca.-based First Bank of Beverly Hills bit the dust with $1.5bn in assets and $1bn in deposits. This time around, no institution stepped up to pick assume the homeless deposits. All within one day – Friday. But before the end of the week, FDIC closed Ketchum, Idaho-based First Bank of Idaho with $374mln in deposits. The grand total of failed US regional banks now stands at 29 since January 1 and 54 since the beginning of this recession. Not many green shoots (other than weeds) out there, amongst the smaller financials.

Now on to more fundamental stuff. I’ve done some numbers crunching and guess what: since 1981, for 27 years S&P500 has outstripped growth rates in the US and global economy in nominal terms. Over the last 27 years annual average growth in nominal GDP in the US stood at 5.8% (2.96% in real terms). Globally, it was 6.2% or 1.37% in real terms. Now, over the same period of time (December 1981-December 2008) S&P 500 moved from 122.55 to 683.38 – a gain of 6.53% pa on average. But this is excluding dividend yield. Thus, should S&P 500 return to some sort of a fundamentals-justified trend, index levels that are justified as sustainable by economic growth standards are in the range between 560-620. In the current range, the implied dividend yield should be around 1.6% pa over the 27-year horizon. In other words, if you think there is something in this economy to drive S&P500 beyond current levels, you better think of a GDP growth rate of 6.2% and a dividend yield of 1.6% in 2009… Otherwise, we are in the over-sold territory.

Then, of course, the US GDP fell 6.3 annualized rate in Q4 2008 and the consensus expectation is for a 5.1% decline in Q1 2009 – adding together to the worst contraction recorded in two consecutive quarters in over 50 years. We shall see this Wednesday when the figures are released.

The data will also give us the trend in inventories and consumer spending contributions to GDP growth. The latter is what many are pinning their hopes on to see the ‘greenish’ shoots of not the recovery yet, but of a stabilization in the rate of decline. Later during the week we will get weekly jobless claims, April consumer confidence and manufacturing sentiment. Of course, the US consumers got some $200bn worth of stimulus in tax refunds and cost-of-living indexation in Q1 2009. (Clearly, not the case in Ireland, where Government advisers, like Alan Ahearne think it’s a bad idea to help consumers by lowering their taxes – see here).

But offsetting the expected consumer spending stabilization will be capital investment. Although there was some increase in capital spending relating to durable goods in March (see above), capital investment is likely to take another hit in Q1 2009 overall, as January and February saw significant cuts in productive capacity by the US firms. Ditto the residential investment: UBS estimated last week that housing investments contracted 38% in Q1.

My bottom line: given that
• inventories did not contribute much to the decline in GDP growth through Q4 2008, and are now likely to show serious deterioration;
• consumer spending is unlikely to post significant upsides despite personal disposable income increases;
• housing and business investment continue to contract; and
• exports are falling precipitously, while most of imports demand contractions have already taken place,
we can expect a 4.9-5.2% fall off in Q1 2009 GDP.

Good luck hunting when the markets open today.

Renewing appetite for risk?

“I have some good news, at least for the intermediate term: Investors are slowly regaining their appetite for risk”, wrote Marketwatch’s Mark Hulbert in his today’s column (here)
“This represents a big shift from the situation that prevailed last fall, when investors became so repulsed by any kind of risk that the yields on safe-haven investments like Treasury bills actually went negative.”

But now, says Hulbert, with January effect in full swing, things are looking up – investors are looking for risk once again.

“Of the several straws in the wind that point to at least a partial return of a risk appetite, one of the more compelling is the recent relative strength of risky small-cap stocks over the more conservative large caps. So far this year through Tuesday night, for example, large-cap stocks (as measured by the Standard & Poor's 500 index (SPX: S&P 500 Index) have fallen 3.5%. Small-cap stocks, as measured by the Value Line Arithmetic Index (92040310), have declined by just 1.1%.”

Now, I am not convinced by Hulbert’s main argument.

January effect is a tax-minimization event, driven by heavier sales of shares with lowest capital gains potential to maximize losses in December (blue chips down) and re-balancing portfolio toward higher capital gains potential (small cap) in the new year. In normal years, movements correlate positively with risk, i.e. small cap – higher expected return, higher risk, blue chip - smaller expected returns, lower risk. But is that the case this time around? In other words, the markets might be going into smaller cap because the larger cap is actually relatively riskier (controlling for current valuations), not because they are seeking higher risk-return strategies.

Chart below illustrates Mark Hulbert’s point – at its right-hand margin. Indeed, the short-term performance by the two indices does suggest that the markets are placing more faith in the small-caps. But it shows that this was true for much of the 2008 with exception of the late autumn. In other words, if current divergence vis-à-vis S&P is a sign of new appetite for risk, what did the market have appetite for in July 2008 when small caps went up and S&P stayed relatively flat? Why did the price of risk implicit in the difference in two indices has fallen in April-June and July-early August? Were these the ‘turning’ points in underlying appetite for risk or just traditional bear rallies?
An alternative explanation for the ‘January effect’-like pattern observed is that investors' risk perception might have shifted. Consider the following scenario: You are in a market with four broad asset classes:

• large-cap,
  
• small-cap,
  
• corporate bonds and
  
• Treasuries.

You believe that too much risk-taking has taken place in the second half of December by pursuing a bear rally in S&P500 stocks and the Treasuries. If you move into relative safety, you will move into the two remaining assets. You will have an incentive to prefer the small caps if you believe that they have taken the heaviest beating to date (which they did – see peak to trough moves around September-mid November) and you invoke another powerful anomaly of the ‘Winner’s Curse”. The real question then becomes is what does the analysis of relative position changes in corporate debt and small cap shares tell us. The large cap stocks are irrelevant here.

Hence, what appears to be a renewed appetite for risk can be interpreted as a hedging strategy against rising risk levels and falling expected returns in the so-called traditionally ‘safer’ asset classes.

What Hulbert is right about is that one should not overplay the story too much. Instead, the return of the January effect pattern (or something else resembling it) might mean “that the stock market will gradually resume its normal function of assessing different securities' relative risks and returns, a function it couldn't fulfill when it was indiscriminately punishing virtually everything other than Treasuries.”

Yes, but… even if Hulbert is correct, the return to rationality in the markets will be bound to:
• trigger fresh downgrades in many companies and indices as corporate returns deteriorate throughout H1 2009, as the bath water gets muddier with longer recession; and
• this rationality will remain extremely fragile and prone to collapse every time the elephant in the room – the US Government – moves about.

Hulbert omits the latter issue, but it is non-trivial to his topic. We are in the changing political cycle – and with it – a prospect of a new stimulus that is bound to prop up smaller business. If, as is the case, Uncle Sam’s rescue packages for many blue chips were already priced into these companies valuations in late December, Obama's first 100-day sweetheart package for Congress is yet to be fully priced into stocks valuations. It might be that the ‘January effect’ is simply the reflection of this delay in recognizing that the next Uncle Sam's move will a stimulus for smaller companies?..