As we have reported on numerous prior occasions, the biggest marginal buyer of stocks in both 2014 [5]and 2015 [6](and forecast to remain in 2016 [7]), are corporations themselves, using debt-funded buybacks [8]to push their stocks to record highs, allowing the smart money to sell in record amounts.
[9]
But what happens when companies are so levered that they can't possibly afford to issue any more debt, virtually all of which has been used to repurchase stocks, as we have shown before [8]...
[10]
... especially in a time when yields on Investment Grade bonds are rising courtesy of the first Fed rate hike in nearly a decade, and when cash flows are sliding faster with every passing year?
For another version of the answer we have provided many times before, we go to MacroStrategy's Julien Garran, who informs us that as credit & returns deteriorate, an increasing number of stocks are crossing the "Rubicon." By Rubicon he means the "cut-off point where corporates can no longer justify gearing up to do buybacks. In 2013, 60% of my sample could justify buybacks. Since then, US corporates have raised debt by US$1.1trn and bought back US$1.1trn of stock. But now, with debt levels & costs up, and returns down, only 35% make the grade." That, in his view is also the key to the narrowing breadth in the market. His conclusion: breadth is now set to narrow to the point where the whole market turns down in 2016.
Some more details on Crossing the Rubicon:
Why does breadth decline? In my view, corporates’ ability to gear-up and buy-back stock is critical to the story.
From the start of 2014, US corporates covered their entire capex budgets from internal funds. They then raised US$1.1trn of debt to do US$1.1trn of corporate buybacks (Data from the Fed’s Z1 report & Factset).
The combination of rising debt, deteriorating returns and a rising cost of debt means that, increasingly, corporate’s debt levels threaten their credit ratings, or their marginal cost of debt deteriorates relative to their cashflow yields. Both threaten their ability to gear up to buy back stock. And both threaten the value of their equity.
As more companies cross the Rubicon out of the buyback zone, the bid for their equity shrivels. The key to trading the topping process is to sell the sectors which will see their margin cost of debt rise above the free cashflow from new business. Clearly the extractive industries, the utilities, and several industrial and retail companies have already crossed the line. I think that the leveraged buyout firms in the US are likely the next to go, as their cost of funding continues to blow out.
To show the process, I have taken 50 S&P companies from 10 sectors (excluding financials). I've put them in a matrix with net debt/EBITDA on the horizontal axis and the free cashflow yield less the cost of debt on the vertical axis. The zone to the left and above the red line show the prime opportunities for gearing up for buybacks. That’s because free cashflow yields are well above the current marginal cost of debt, and net debt to EBITDA is contained. The zone to the right & below the red line shows stocks that will struggle to gear up for buybacks – either because their cost of debt is up to or above their free-cashflow yields, or because the net debt to EBITDA is too high.
For the 2013 financial year, 60% of stocks in my sample were in good shape to gear-up for buybacks.
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By the end of 2015, just 35% of the sample were in good shape to do buybacks.
I estimate that the liquidity shortfall will expand further in 2016, to US$750bn. Against that backdrop, I expect more pressure on credit, returns & growth, more corporates will cross the Rubicon. And as that continues I expect that buyback activity will fade further, and the net bid for equities will likely evaporate.
[12]
The conclusion:
My recommendations are; Short US indices, long the US$, long gold & gold equities & short the leveraged buyout sector in the US.
So is 2016 the year it all falls apart? Stay tuned for the follow up comments from Garran because if he is right, the answer is a resounding yes.
