Weekly Economic Update 04-28-2017

More Hedge Fund Managers Warn that Markets are Overvalued
Almost every day another hedge fund manager is trying to warn investors that this market may be getting too high, just like it did before the last two corrections. Considering the typical hedge fund manager directs billions of dollars’ worth of client funds, it’s probably a good idea to take heed. Here are a few things some of them have said recently:

  • The value of the stock market relative to the economy should be terrifying.
  • Stocks are trading at unsustainable levels.
  • Next correction could see prices plunge 20 to 40%.
  • The S&P 500 is trading at 22 times earnings, the highest multiple in almost a decade.
  • Corporate insiders have been heavy sellers of company shares, which is an indication that valuations have become excessive.
  • Higher interest rates mean fewer companies will be able to borrow money to buy back shares and pay dividends – I’ve mentioned this was a big driver of stocks recently!
  • Investors buying equities as volatility touches near historic lows (Wednesday) will be forced to sell when stocks fall when volatility spikes.

Debt is Killing Retailers
If I asked the average person why retailers are closing stores, they’d probably say it’s because of online retailers such as Amazon, who make shopping quick and easy. And while online retailers are partial to blame, the notion that Americans no longer want to go shopping is far from the truth. The main reason people are buying online today, convenience aside, is that the Internet makes it easier to find the lowest price. Given the fact that incomes have not kept up with inflation, saving money has become important. But that’s not why retailers are suddenly closing stores. It’s debt.

If you’ve never heard of a private equity firm, they are firms that pool investor money and use it to generate a return. They charge a fee for their service and seek to return profits back to the investors. While private equity firms are not new, in recent years they have amassed large amounts of capital to invest. So much capital that they began buying out poorly managed companies with the idea to turn them around to sell them for a profit.

The story sounds good up until this point until you realize they weren’t concerned about turning any of the companies they bought around. Following the last recession, money was cheap and easy to get, and banks were all too willing to lend. So these private equity firms would strip these companies of their assets and then pile on the debt, debt which was used to return investors’ money. How well the company did after that didn’t matter.

And for a while, many of these retails survived, but suddenly they are finding themselves drowning in debt as sales decrease. So much debt that it is easier to close than it is to try to stay alive. If you look at most of the retailers that are closing stores right now you’ll find that they are heavily leveraged in debt.

And it’s not just retailers that were victims of Private Equity firms. Just this week iHeartRadio announced that it may not survive another year due to the 20 billion dollars of debt they are stuck with. The scary thing is that investors have been snapping up this high yield (or junk) bond debt that is full of companies like iHeartRadio. One can only guess what will happen when defaults start to hit the high yield space as these companies fail to make loan payments. I promise you it won’t be pretty.

Just think, some experts believe that more than 8,600 retail stores will close this year, which is more than closed during the depths of the 2008 recession. And if you think that’s bad, after they got done pillaging the retail sector, private equity firms did the same thing to technology companies.

GDP Tanks
For those of you that follow my weekly updates, finding out that GDP growth in the first quarter came in at 0.7% should be no surprise. This isn’t a good number. GPD growth below zero, especially this late in the business cycle, signals we are in a recession. This number directly challenges the notion that the economy is growing and puts into question what the stock market is doing near all times highs. I assure you, one of these two is an anomaly that will get corrected in the months to come.

Not to worry, the anomaly is in the GDP data because the consumer is going to start spending big time in the next three months, or so said the first article released about 10 minutes later. We’ve had some low GDP numbers this cycle, but the issue is coming back to growth. Can the economy grow? Setting numbers aside, let’s look at the macro view:

  • Late stages of the business and credit cycle.
  • GDP growth has been trending down since Q3 2014.
  • Wage growth has been flat and is contracting.
  • Bank lending to corporations and consumers is rapidly contracting.
  • Inflation is rising in rents, medical and energy.
  • Money supply is contracting.
  • 40% of Americans spend half their take home pay servicing debt.

Just looking at that alone suggests that it is unlikely the economy is going to come roaring back anytime soon unless the consumer can increase their income or reduce their debt costs.

Corporate Stock Buybacks are Ending
In this week’s video portion of the update I’m going to discuss why the stock market has been driven the past few years by corporate buybacks (in addition to the Fed). Over the past three years’ corporations have been borrowing money to fund stock buybacks and to pay dividends. Now that interest rates are higher, corporations are massively scaling this back which will have implications for investors. You’ll learn why corporations do this and what it means for stocks going forward.