Following the recent broad market selloff which has taken all US stock indices into the red for 2015 [7]and in some cases, red for the past 52 weeks, the real question traders should be asking themselves now that the power and potentcy of central bank intervention is increasingly questioned (see Deutsche Bank's note this morning [8]stating that "The Fragility Of This Artificially Manipulated Financial System Was Finally Exposed") is whether stocks are now fundamentally cheap or at least, "fairly" valued. The answer, as SocGen's Andy Lapthorne points out, is a resounding no.
The SocGen strategist notes that heading into the August global market crash, catalyzed by both China's devaluation and the FOMC Minutes (the S&P was just shy of 2100 last week), "corporate debt levels in the US in particular were rising at an alarming rate whilst cash flow growth was all but absent in most markets, save for M&A deals and currency translation effects. As such, median valuation levels, particularly those based on EV/EBITDA, were at extremes and equity market positioning, as we noted at the beginning of August (see link [9]), was already behaving in a bear-market fashion. The equity markets have finally given up and are now falling and fast!"
So here is the first part of the problem: it is no secret to anyone that the biggest contributor to soaring stock prices in the past year were stock buybacks, funded almost exclusively not with (declining) cash flows, but with new debt. So, "as equity values decline, implied leverage will be on the rise and this risk should be at the forefront of investor concerns" Lapthorne warns. He adds that as a result, balance sheet problems "will inevitably emerge given the size of the price declines so far and the uptick in volatility will make it increasingly difficult for companies to continue to raise debt to the extent they have done in recent years. Share buybacks, especially those fuelled by debt are likely to screech to a halt and investors eyes are likely to shift to the elevated levels of net debt to EBITDA, particularly in the US."
Indicatively, following today's rout, some 80% of the corporations that have engaged in stock buybacks in the past year are underwater on their purchases: perhaps they should have "invested" all that money in capex and growth instead...
But we digress. Because the second problem for investors, as Lapthorne notes, is "where to hide."
Higher quality stock valuations were already at relative extremes, despite not actually being in a recession. Quality income stocks (those high quality companies with a 4% dividend yield or higher) are notable for their rarity and despite recent share price declines, the median EV/EBITDA ratio for MSCI World is still at extremes.
And here is the take home message: despite the equity rout, and the tumbling equity valuations, EV/EBITDA for the MSCI World ex financials is just about 10 turns, the direct result of the collapsing cash flows over the past several years. Because one can fabricate and manipulate non-GAAP earnings all one wants, but when it comes to cash flows, there is just one number.
[10]
