So here we are yet again. Second quarter results are coming in and we’re about to enter one of the (normally) most boring parts of the trading year.
Everyone in the big investment firms above the rank of analyst/ junior desk jockey is packing for a month in the Hamptons or the Poconos, depending on their pay grade.
Portfolios are turned over to the algos, or left with the instructions to not make any changes unless things get really ugly and the senior manager is incommunicado on his yacht.
Now is the perfect time to take a look at the bigger picture, and what is in store for the second half of the year.
Instead of the rose-tinted view of buy-side analyst consensus for where the indices will end as the year turns over, I have a more dire, and far more important prediction to make.
Through the end of this year, and probably all of 2016, markets are going to continue to shrink, with implications and risks that will affect investors across the board.
Ill Omens
Something off has been happening this year, and it is visible through the S&P 500 earnings results for the first and second quarters.
In the first three months of the year, 71% of S&P 500 companies beat earnings per share (EPS) estimates. Yet only 45% reported revenues above consensus forecasts. The total revenue decline came in at -2.9%.
For the second quarter results we’ve seen to date, 71% of the companies beat EPS estimates, yet only 51% reported revenues above estimates, well below the 61% estimated so far.
Total profits are expected to come in at -2.9%, with sales posting their worst decline in nearly six years, according to Thompson Reuters estimates.
So companies are delivering on a per-share basis roughly in line with past results, but their top lines are shrinking, along with the amount of cash generated from business.
On the surface, this doesn’t make sense for how the market works. Traditionally, stock markets are vehicles for companies to sell themselves to the public to raise cash to make more money.
Even the strongest dividend-paying companies dedicate a portion of their cash flow and profits to their owners while retaining enough to expand and grow in normal times.
That is kind of only happening on a per-share basis. Companies are, and have been for some time, actually making less and less every quarter.
So what gives? We’re in early stages of a cycle that reverses the market’s role and cannibalizes future gains.
Wall St. ATM
What we’re talking about here is a concept some are calling “de-equitization.” Equity is being removed from the market.
Think of it this way: Companies do things that either add or subtract equity from the public market. This virtually always involves a cash transaction.
Share buybacks, which I have discussed often and, most recently, last week, as well as cash mergers and acquisitions are two prime examples of taking money out of the system by removing shares from the market.
IPOs and secondary share offerings are the opposite. They add shares and equity to the public markets.
Right now, there is a lack of IPOs and secondary offerings, while buybacks are out of control and cash M&As are going strong.
The result is fewer shares circulating out there for investors to buy. On its own, this isn’t inherently bad, but the scale and length of time involved is frightening.
In 2013 and 2014, a good $1 trillion went into buybacks. $550 billion was pulled out of the public markets via buybacks, while just $85 billion in new money was added.
This year looks even worse. Just under $600 billion in buybacks is expected this year, and the latest figures I’ve seen from BofA Merrill Lynch show a $100 billion net outflow of investor money.
We’re looking at a shrinky dink market. It’ll look the same and have all the same proportions and colors. However, by the time the process is done, you’ll own something smaller than you bought.
However, the float, or publicly traded portion of a company, is getting much smaller for many companies, especially the big ones that make up the Dow and S&P 500.
To sum it up in one sentence, prices are being driven up because there are fewer shares, and the companies look healthy because they’re manufacturing their own EPS figures.
The Implications
I really don’t like this phenomenon at all. I want the shares I buy today to be worth more because the company is making more and worth more in the future. Not because the portion of the company I own is slightly greater or because of financial maneuvers that encourage more bidders than sellers.
Don’t get me wrong here. I’ll take a profit from a greater fool. I just don’t want to depend on trades based purely on herd mentality and sentiment.
Put the extraction of money from public markets, EPS-boosted share prices, and the outflows together, and you have a very disturbing divergence that is effectively hidden:
Buybacks and great EPS values are masking the outflows, the shrinking top lines of companies, and the shrinking profit margins that illustrate how companies have weakened over the last several years.
As long as shares of companies keep rising, people will continue to chase gains. When the reality of the situation emerges and an inevitable correction occurs, we’ll see the market as it really is.
We saw this in October 2014, and we’ll see it again. If it happened now, we’d see the divergence in the chart above disappear, potentially bringing the S&P 500 back down to ~1800.
There is a silver lining, though. By recognizing this divergence, the effect of buybacks, and the implications of a shrinking equity market, we have the luxury of planning ahead.
Trailing stop-losses are a good first step for core positions. The second step is to plan on what to invest in when the dust settles.
