Make Sure You Have a Chair When the Music Stops

A very interesting read in the Bloomberg article below. Clearly this market is being driven by a different mechanism than those of the past and investors need to have a plan when corporate buybacks begin to slow.

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Buybacks at $46 Billion a Month Dwarf Everything in U.S. Market

The biggest source of fresh cash in American equities isn’t speculators or exchange-traded funds -- it’s companies buying their own stock, by a 6-to-1 margin.

Chief executive officers, who just announced the biggest round of monthly repurchases ever, executed about $550 billion of buybacks last year, according to data compiled by S&P Dow Jones Indices. That compares with a net $85 billion of deposits by customers of mutual and exchange-traded funds, the biggest gap since 2012, data compiled by Bloomberg and Investment Company Institute show.

If you sell a share of stock in the U.S. market, there’s a fair chance the buyer is the company that issued it -- and it’s buyers who’ve been on the right side of the trade since 2009. Buybacks are helping prop up a bull market that is entering its seventh year just as investors bail out and head back to bonds.

“Buybacks have come up in every meeting with clients and always have, because of the observation that the largest buyers of stocks have been companies themselves,” Dan Greenhaus, chief strategist at BTIG LLC in New York, said by phone. “For the last few years, that’s been the right call.”

Repurchases by U.S. companies averaged $46.1 billion a month in 2014, compared with $7.1 billion in ETF and fund inflows. Investors have pulled more than $10 billion out of equity funds in January and February and sent $38 billion to bonds -- even as companies announced $132.7 billion more in buybacks. February’s total of $104.3 billion was the highest on record, according to TrimTabs Investment Research.

Buyback Index

Companies with the most buybacks are beating the market. The S&P 500 is up 1.6 percent on the year after falling from a record on Monday to 2,092.21 as of 11 a.m. in New York. The S&P 500 Buyback Index, which contains the 100 companies with the highest repurchase ratio, has climbed 4 percent this year.

“It’s amazing that people are still sitting on the sideline getting zero-something percent returns,” Howard Silverblatt, senior index analyst at S&P Dow Jones Indices, said in a phone interview. “Usually when you get where everyone says we’re in a bull market you see big money coming out of lifeboats and chasing yield, yet we haven’t seen the mass money come in.”

The reluctance of investors to pile into equities has left corporate America the larger source of cash throughout the bull market. Buybacks exceeded inflows by $468 billion last year when the S&P 500 climbed 11 percent and $318 billion more in 2013, when the gauge had its biggest advance since 1997.

Companies in the S&P 500 have spent more than $2 trillion on their own stock since 2009, underpinning an equity rally in which the index has more than tripled. They were on pace to spend a sum equal to 95 percent of their earnings on repurchases and dividends in 2014, data compiled in October showed.

Buyback Incentives

Not everyone is convinced buybacks are good. They’re used to boost per-share earnings in a way that enhances the pay of chief executives, according to William Lazonick, a professor of economics at the University of Massachusetts Lowell.

“Companies use a phony ideology saying if you maximize your shareholder value you somehow increase the efficiency of the economy,” Lazonick said in a phone interview. “But the only justification for doing it that holds water is that executives get a lot of their income from buybacks.”

Home Depot Inc., Comcast Corp. and TJX Cos. were among 123 companies that disclosed repurchases in February. The increased buybacks came as plunging oil and a strengthening dollar threaten to stall five years of earnings expansions.

Profits from S&P 500 members will decline at least 3.2 percent this quarter and next, according to analysts’ estimates compiled by Bloomberg. For the full year, growth will be 2.3 percent, down from 5 percent in 2014.

Profit Contractions

Buybacks will boost per-share earnings, with the potential of helping avoid the first back-to-back profit contractions since 2009, according to Yardeni Research Inc.

“In the last earnings season, the strength of the dollar clearly had a negative impact on earnings guidance by a lot of companies,” Dan Miller, who helps oversee $23 billion as director of equities at GW&K Investment Management, said by phone. “In some cases, the announcement of buybacks was perhaps meant to soften the blow a little bit. It shows the management is committed to their own stock.”

Switching Positions

Corporations and investors have switched positions as the bigger buyer of stocks. Inflows from equity funds exceeded corporate buybacks every year in the late 1990s, contributing a total of $640 billion over the three years through 2000. That compared with $418 billion from share repurchases.

Companies have since taken the lead, with buybacks setting a record $589 billion in 2007. Last year, corporations beat all other groups as the biggest source of fresh cash to the stock market, according to a January report by Goldman Sachs Group Inc., which tracks money flows from pension funds, foreign investors and ETFs.

The S&P 500 will increase about 7 percent to 2,238 by the end of 2015, according to the average of 21 equity strategists surveyed by Bloomberg. The Nasdaq Composite Index closed above 5,000 for the first time in 15 years on Monday and is within 2 percent of a record.

S&P 500 companies hold $1.75 trillion in cash and marketable securities, data compiled by Bloomberg show.

“These companies do this because they can,” Richard Sichel, chief investment officer at Philadelphia Trust Co., which oversees $2 billion, said in a phone interview. “So many have tremendous amounts of cash historically and the investment rates on short-term cash are not too attractive. It’s good for the company and good for stockholders.”

March's Charts on the Move Video

With the market reaching its expected target out of the divergent low "W" bottom, active investors should be sharpening their pencil and refining their plan for a consolidation or worst case test of February's lows.  Consolidations eventually lead to strong moves.  My latest video, view-able at the link below, outlines which way i think we go.  Let me know what you think.

https://youtu.be/DzpnGy5KyuM

Politics and the Economy

While the markets take a breather and consolidate I thought it be fun (or not) to step away for a quick look at politics (a subject I try to avoid). The WSJ asked economist’s their view on the potential impact the individual presidential candidates would likely have on the economy.  Like all predictions, I put zero faith in the results but find the discussion interesting and fodder for some fun. 

Q: Why did God create economists?      A: In order to make weather forecasters look good.

Three econometricians went out hunting, and came across a large deer. The first econometrician fired, but missed, by a meter to the left. The second econometrician fired, but also missed, by a meter to the right. The third econometrician didn't fire, but shouted in triumph, "We got it! We got it!"

A physicist, a chemist and an economist are stranded on an island, with nothing to eat. A can of soup washes ashore. The physicist says, "Lets smash the can open with a rock." The chemist says, "Let’s build a fire and heat the can first." The economist says, "Let’s assume that we have a can-opener.”

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More than three-fourths of forecasters in a new Wall Street Journal survey say the presidential election has introduced more uncertainty than is typical from a change at the White House.

Their current economic forecasts aren't all rosy: On average they see about a 20% risk of recession in the next year, down slightly from 21% in the previous survey. They forecast the economy will be too fragile for the Federal Reserve to raise rates before June. They predict the economy will add fewer jobs this year than in 2014 and 2015.

More than four-fifths of economists rate the possible election of either Mr. Sanders or Mr. Trump as an outcome that may force them to lower their economic forecasts. About half the survey’s respondents rate them as “significant” risks. Regardless of who wins, it is unlikely the new president would be able to change policy quickly enough to affect 2017.

As with most things, the economists polled could not reach consensus, unlike their past recession predictions where they accurately forecasted 29 of the last 3.

Bad News: People Are Saving More

With the market at what I consider to be a crossroads, I have dozens of setups I could show that are both bullish and bearish opportunities. But they can’t both be right, so at times like these I prefer to sit on my hands and wait for the market to show its hand before committing precious investment capital.  As such, I thought the latest from one of my favorite technicians, Tom McLellan would keep readers occupied until we have clarity on market direction. Readers should recognize Tom's name as I have used his teaching many times in the past so he requires no introduction. He always has an interesting take on topics and this one is no different. It’s a good read on savings rate and stock prices. Enjoy!

Bad News: People Are Saving More

Savers are masochists.  They deny themselves immediate gratification for the hope of future reward.  And more interestingly, they do this behavior more when the rewards are taken away.

Anyone who ever took Psychology 101 learned about what lab rats will do if you take away the food pellets.  They stop pressing the lever, and they lose interest.  But savers do not behave that way.  The Fed has taken away the incentive for Americans to be savers, through its Zero Interest Rate Policy, or ZIRP.  In response, people are saving more.  Go figure. 

During the 1960s and 1970s, when inflation was running ahead of interest rates, Americans displayed a rising rate of savings as a percentage of personal income.  They did this even though they were not adequately rewarded for that savings behavior.  Their savings lost value via inflation faster than it was made up for with interest income, which Congress naturally taxed and thus made the reward value even lower.  But they kept on doing it more and more anyway.

When money market funds were created in the mid-1970s, Americans were suddenly confronted with the opportunity to earn a more appropriate reward for deferring their compensation, and for instead saving their money.  But curiously, Americans did not do as B.F. Skinner would have suggested they would do.  They did not increase their savings behavior in response to the greater reward for doing so.  Instead, they started a long downward trend in the savings rate, saving less and less of their income even though they could earn more in real terms for doing so.  And that downward trend in the savings rate just happened to coincide with a secular bull market for stock prices.  

But since 2005 we are seeing the monthly savings rate data show an upward trend.  This change in behavior makes complete sense.  Baby Boomers are facing imminent retirement, and thus they are mounting a last-minute campaign to save up enough to live off of without eating cat food, or turning to their formerly helicoptered children for support.  At the same time, the “Millennials” or “Echo-Boomers” are just now moving out of their parents’ basements, and have not yet become a major economic force.  So the Echo-Boomers are not yet making up in consumption for what their parents are saving.  

In one way, it makes sense for individuals to save more even though they are rewarded less for doing so.  They know that they need to have a big enough pile to live off of, irrespective of how much interest they make off of that pile.  The loss of interest income (reward) acts as a perverse incentive to engage in that saving behavior even more.  It is as if a rat somehow knows that the food pellets are not going to be there in the future, and so rather than eating them, he “squirrels” them away in a safe place to eat later.  Hey, who says I cannot have mixed rodent metaphors?

One problem is that episodes of this behavior of people saving more tend to be associated with negative growth rate periods for stock prices.  That’s a bummer for stock market bulls.  So what you should do as a prudent bullish rat is to save your own food pellets while simultaneously encouraging your neighbors to eat all of theirs, and thus make the stock market indices rise.  Good luck with that plan. 

Inflection Point Dead Ahead

In a post at the end of Feb I wrote about the “W” pattern that formed in the SP500. I didn’t mention it at the time but the right leg of the W bottom reflected a sentiment reading of 14, extreme fear. After that sharp 15% decline, as you would expect, no one wanted anything to do with stocks. But we know investor’s sentiment is a contrary indicator and when there is blood in the streets (extremely fearful sentiment), those usually mark the best times to invest. And this time was no different. We have rallied hard to close last week at 2044 just 16 clicks away from my “W” pattern target of 2060.

While we haven’t yet gotten there, the higher we go from here the greater the amount of overhead resistance we will need to chew through which should slow the ascent. As such, I expect sometime this week we start to see a period of consolidation. As with all consolidations it’s where we go after that matters. The market is (soon to be) at an inflection point. Out of consolidation we either punch through overhead resistance and resume the longer term bull market by making new highs or we will be able to look back and see this recent move higher was just a bear market rally and we head lower, a lot lower.  

As with all inflection points, good analysts will be able to make both a bull and bear case.  This time is no different. While I won’t go through the arguments to be made on both sides I do want to leave you with where we closed last week’s reading on the fear/greed index since it is an excellent gauge of market sentiment.

While not at a dangerously high level (85-90) there is no doubt this index is extended and reflecting the wild swing in market emotions. It’s time like these I think back on a very prescient saying from Uncle Warren (Buffet) who said “be greedy when others are fearful and fearful when others are greedy”.