Another day, another quick reversion from near-all-time-highs to near-zero returns for the year.
“Business as usual” is a weak saying to trot out to describe it, though it is tempting. After all, the market is coasting along a straight, if bumpy, path.
The thing is, a market running on momentum and sentiment doesn’t work. It is a fire that lacks fuel, bleeding heat until it is reduced to a base of hot coals.
Or a tree with a rotting heart, cut off from its roots and inexorably withering away.
The broader market lacks the means to sustain itself, and it is starting to show more signs of it every day.
All About ROI
Stocks are like anything else you buy. You expect a return on investment.
I wouldn’t suggest living life calculating everything in dollars and cents, but on a basic level it is true.
The happy hour beer(s) for the benefits of stress reduction. The car that constantly depreciates. The astronaut ice cream in the over-priced museum gift store to placate your kids.
It all has a purpose, and if it doesn’t satisfy our expectations, we sell it if we can or never buy it again.
The same goes for stocks. You buy equities — particularly company shares — because you’re willing to bet that the company will deliver an ROI.
Even if you didn’t buy the shares from the company, that is what you’re doing. Buying from someone else in the market is, in essence, a way of buying out the person who originally paid the company for this future ROI.
What sets stocks apart from everything else is how your stock market ROI is contingent on another.
In other words, your personal ROI for investing in a company depends on the company’s ability to generate its own ROI.
Plus you’re not buying at book value. The Shiller PE ratio for the S&P 500 is over 26, and the forward PE ratio is over 16.
Your break even points are 26 and 16 times, respectively, what the companies are worth.
Weaker and Weaker
So far, for second quarter 2015 results, S&P 500 companies aren’t looking too hot. Revenue is weakening, and overall earnings are off -2.2% year-over-year.
The number of companies hitting 52-week lows in the index is up to 42 and counting, a solid 10%.
All of these have worsened since the first quarter, hinting at a deepening trend.
Yet EPS figures are looking good. 74% of companies have beaten estimates on that metric. So what gives? Are these mixed signals?
Unfortunately, no. It is a symptom of worsening ROI for companies.
While the top lines (revenue) of companies contract, buybacks increase the amount of earnings on a per share basis as shares are removed from the market.
That, in turn, means that companies are investing in themselves at a terrible time.
They are doing it right near all-time highs in the market, with year-to-year declines in earnings.
Even with all the money plowing into a shrinking market, there is only enough momentum to tread water.
To spare you the burden of reading another thousand words, this is the kind of divergence it creates:
Prices have been bid up so high with the expectation of a strong ROI for investors that a wide gulf has been created between expectations and reality.
Keep in mind this is based on the forward EPS. These estimates are only now starting to adjust to the deepening trends we’re seeing today.
This divergence will correct, either through forward EPS catching up, or by prices coming down. Considering the situation, the latter seems far more likely.
Remember how a lot of these companies are investing record amounts of money (an estimated $1.6 trillion from 2013 through the end of 2015), fueled by debt, into their own company near all-time highs?
That money, in the face of a correction (like in the energy sector) or shrinking earnings, adds an extra layer of consequences for investors.
Here are the 10 worst performing companies that bought their own shares. All faced corrections or bad earnings, leading to negative ROIs from their investments:
That money is gone, and the companies are still going to be paying interest on a lot of it.
That interest is low now, but it won’t be in the future if they have to keep rolling it into new debt. With weak earnings, thats practically a given.
The money for those buybacks came off of balance sheets, and erased investor ROIs and wealth. For many of these investors, it will be a permanent loss.
Light on the Other Side
In spite of all the negatives in this situation, do not underestimate the positives you can create by seeing it coming.
Yes, we’re going to be exposed to any and all corrections that happen in the market. Yes, we will see losses on paper as a result.
However, the right asset allocation can limit your exposure to equities that will see share prices compounded by misguided, or even reckless, behavior from management.
It will also set you up to recover faster than other investors, and boost your returns from your investments in the long run.
In the face of anything that can go against you, the best thing you can do is to prepare now. When a correction comes along, you’ll come out the other side stronger than ever.
