Potentially A Signal For The Next Big Crash

by SvenTropics

I’ve been growing in concern over the massive stock buyback bubble we are experiencing over the last few years. This year alone, companies are on track to buy back $800 billion dollars of themselves (a 51% increase from last year and another all time record) (citation: fortune.com/2018/04/20/stock-market-buybacks-nervous/) . Most of these buybacks are centered in the tech sector that has subsequently experienced the most growth with the most gains when they did the most buybacks. Apple alone is buying back $100 Billion dollars this year. One figure alone said that many of the tech companies in the S&P 500 are planning to buy back as much as 10% of their market caps. This normally wouldn’t concern me that much except that there’s this: fred.stlouisfed.org/series/NCBDBIQ027S

It’s a chart of nonfinancial corporate business debt. (The fact that it’s nonfinancial is significant because financial companies are typically quite leveraged, and high debt is just a sign of success) Now, the debt levels wouldn’t concern me either if the money was being used to reinvest in the businesses, but they aren’t. If companies were just using their excess cash to buy back stock and issue dividends, I would see it as just a business decision, but they are literally cannibalizing themselves by taking on massive loads of debt just to pump up their own stock prices. The majority of the new debt that isn’t used for refinancing is used to buy back stocks.

I see a direct parallel to the Mortgage Backed Security market of 2005. In a controlled environment, isolated failures would be absorbed by the larger system with minimal loss. When everyone is too leveraged though, a small failure can have catastrophic consequences. Back in 2004, I had a blog preaching a possible crash in the MBS market, and I was dead on right. The part I was wrong about was that I expected it to happen a LOT sooner than it did. Markets can behave irrationally for a LONG time.

This is how I see this potentially playing out. Interest rates go up a percent or two because a company is too leveraged and because the whole bond market raises its rates (pretty much a sure bet this will happen), one company can’t refinance its debt without showing a loss. So, they reissue a small amount of stock or just accept a reduction in their credit rating. The problem is when all the companies suddenly have to deal with this, the bond market would shift rapidly to higher interest rates to compensate for all the reductions in credit rating and an overall uneasiness about the state of the debt market. This would make the problem worse which would in turn make interest rates even higher. It’s a feedback loop like the MBS crash and subsequent foreclosure crisis. Companies will be left with no choice but to reissue stock to raise capital, and that will crash the stock market resulting in much less money for the same amount of company sold. So, they will have to sell more resulting in bigger valuation reductions. In other words, I see a 25% crash in the stock AND bond market in the imminent future. Once again, I’m probably calling this way too early like I did last time. So, this might not happen for two years, but it will most likely happen.

The biggest companies will probably weather this just fine. They have massive cash reserves and lots of stable income to fall back on. Plus they have tons of tangible assets. The medium sized companies engaging in this behavior will feel the worst of it.

Well here’s a specific example. HCA is the largest hospital company in the world. They are wildly profitable and very successful at what they do. Net income for 2017 and 2016 were $2.2B and $2.9B respectively. During those two years, they bought back $4.8B of their own stock and issued almost $1B in dividends. To finance this, they took on an additional $2.3B of debt keeping themselves highly leveraged and still non investment grade when the company should otherwise have that title. I didn’t cherry pick two years, they have been doing this since 2009 at an ever increasing rate. The amount of money they borrow grows faster than their profit. If any random person was outspending their income and borrowing at increasing rates to increase spending, you would tell them they are headed to bankruptcy. This is no different.

Any thoughts, arguments, discussions welcomed on this please.

 

Disclaimer: Consult your financial professional before making any investment decision.

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