The Tired Rally That Refuses To Die

We’ve talked a lot about the likelihood of a US recession over the past couple of days (see here and here) - probably not exactly what everyone wanted to hear over the holiday weekend. It’s not so much that we want to come across as doomsayers. Rather, the point is to assess the extent to which asset prices - particularly equities - may be out of step with economic reality.

Now first of all, there’s an argument to be made that stock prices haven’t reflected economic fundamentals for some time now and this is all just one prolonged central bank sugar high. That’s probably accurate at least to some degree and you don’t have to believe in secret bulge bracket prop desks and/or E-mini-hungry, Citadel-affiliated NY Fed plunge protection teams to buy that explanation. In fact, all you need to believe in is the power of the buyback.

It’s a pretty simple dynamic. Low rates herd investors down the quality ladder (or up the risk ladder, depending on how you want to conceptualize it) from government debt, to investment grade corporate bonds, to high yield corporate bonds, and then eventually, to stocks. It’s the whole “search for yield” dynamic. The demand for corporate credit is apparent from issuance trends.

(Chart: Wells Fargo)

As you can see, it’s been up, up, and away for IG supply since the crisis.

It’s also important to understand the extent to which this is self-fulfilling. That is, investors want yield, so they rotate from government bonds to corporate credit, which drives up issuance and drives down yields. As borrowing costs fall, corporates are enticed to issue even more debt or to refinance existing obligations. And can you guess what they do with the proceeds from debt sales? That’s right: repurchase stock:

(Chart: Wells Fargo)

As Wells Fargo notes, cash spent on dividends and buybacks now exceeds 50% of corporate cash usage for the first time since the crisis. Buybacks do two things: they keep a bid under stocks and they help the bottom line by reducing shares outstanding (incidentally, they’re pretty good at inflating management’s equity-linked compensation as well). Want to know just how much buybacks matter? Consider the following graphic from Goldman:

(Table: Goldman)

Net demand for equities is actually negative if you exclude the buyback bid.

So the natural question (and one that we’ve asked here on a number of occasions), is this: what happens when the cost of capital rises and the buyback bid dries up? Further, where are the EPS beats going to come from if not from financial engineering (i.e. leveraging the balance sheet to repurchase shares)? You’re certainly not going to be able to grow the bottom line with revenue growth like this:

(Chart: Wells Fargo)

With all of the above in mind, let’s take a look at where analysts think this market is headed because, as Bloomberg wrote on Tuesday, this “punch drunk” market “doesn’t give up”:

“The 5.3 percent selloff of June 24 and 27 is now a blip on a chart after $1 trillion in market value was erased and restored over eight days.”

“The volatility never swayed Wall Street equity strategists, who let stand forecasts for shares to reach records in 2016. While U.K. secession joins a lengthening list of ills for investors that include falling profits, soaring valuations and the presidential race, events of the last two weeks show just how hard it is to land a blow on equities when economic growth is too fast to signal a recession, and too slow to steel the Federal Reserve.”

“‘The only reason you see weakness in the market on an event is if it has the potential to bring a recession, and there is no data to support that,’” Tony Dwyer, co-head of U.S. equity Research at Canaccord Genuity Inc. in New York, said by phone. “‘We’ve got the same outlook as we did going into it and that’s why I’m bullish.’”

Ok Tony, fair enough.

The 12-month outlook is even rosier. Here’s FactSet:

“Industry analysts in aggregate predict the S&P 500 will see a 10.0% increase in price over the next 12 months. This percentage is based on the difference between the bottom-up target price and the closing price for the index at the end of June.”

(Chart: FactSet)

Meanwhile, SocGen isn’t optimistic about the longer-term picture:

“We keep an UW on US equities after the rebound of the beginning of the year, as they look more tired than ever. Although we do not expect recession in the coming quarters, the current expansion cycle has been very long already, and recession will eventually arrive. Looking at past cycles, we calculate that on average, the end of the bull market happens 10 months before the top of the business cycle. SG Economics expects the US to start slowing down significantly in H2 2018 and enter recession in 2019, putting the top of the equity market cycle around mid-2017.”

(Table: SocGen)

Of course all of this is just food for thought, but you should bear in mind that the Street tends to be too optimistic on average (boys will be boys or, more accurately, bulls will be bulls). On that note, we’ll close with one last excerpt from FactSet:

“Over the previous year (July 2015 to June 2016), the average difference between the bottom-up target price estimate at the end of the month one year ago and the final price for the index at the end of the same month one-year later has been +9.7%. In other words, industry analysts on average have overestimated the final price of the index by 9.7% at the end of each month during the previous year.”

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