Why the Fed's profit bubble will soon pop
I'm just going to say it: The market is in a bubble. It's not just stocks or housing this time. It's a broad swath of assets, starting with government bonds, corporate credit and stocks.
This is no ordinary business cycle. And this is no ordinary bull market. The Federal Reserve and the other major central banks have embarked on the greatest deluge of cheap money in human history.
The Chinese have gorged themselves on credit, expanding their banking assets over the last few years on a scale roughly equal to the current size of the U.S. banking system. The Europeans have convinced folks to lend money to Greece again, which still carries a near 30 percent unemployment rate and just elected a bunch of anti-euro zealots. The Japanese continue their kabuki dance on the edge of sovereign insolvency.
And here at home, the Fed is doing all it can to inflate stock prices -- and worsening the gap between rich and poor in the process. But some evidence shows the game has entered its final phase.
Focusing on what's happening in the U.S., the mechanism works like this: The Fed, which has taken the monetary base from $850 billion before the financial crisis to nearly $4 trillion now, has pushed down interest rates so low that it's encouraging a flow of capital from government bonds to corporate bonds which, in turn, is flowing into stocks via corporate share repurchases.
While the economic recovery has been meek, corporate profits are roaring. At first, this was driven by a rebound in revenues, mainly from emerging markets like China, which were unleashing a torrent of credit-fueled growth. Then came the deep cost cuts, the layoffs and the stagnant wages.
Lately, as revenue growth has slowed amid signs the global economy is stalling out (the -1 percent first-quarter GDP result suggests something is amiss) corporate earnings per share have been padded by a steady reduction of the number of shares outstanding. If you can't grow the top number of the earnings-per-share calculation, then you can hit your target by reducing the denominator. And that's exactly what companies have done, using either cash from operations and/or raising ultra-cheap money from the credit markets.
Just look at what happened with Hewlett-Packard (HPQ) last week. The giant tech company reported weaker-than-expected profits and weak forward guidance, and it announced it would cut up to an additional 16,000 employees to bring the total headcount bloodbath in the months to come to 50,000 souls. Capital spending is dropping.
But shares surged the next day. Why? Because HP also announced a near 50 percent increase in its stock buyback allocation.
IBM (IBM) has been another poster child of this dynamic. In the most recent quarter, Big Blue purchased more than $8 billion of its own stock up from $3 billion in the third quarter of 2013. To fund all this, it has issued more than $32 billion worth of debt since 2012.
For a while, free cash flow protected Big Blue's balance sheet. Not anymore: IBM's net debt has increased from less than $20 billion in 2012 to more than $34 billion now. As a result, the company's debt-to-equity ratio -- a metric of balance-sheet strength -- has ballooned to its highest on record, threatening its credit rating.
So, the Fed's false profit bubble is coming to an end because its drivers are no longer sustainable. A slowdown in the real economy is pinching profits, which in turn impedes CEOs' ability to manage the increased debt loads used to fund share buybacks.
If interest rates keep rising, the problem will get worse. If inflation kicks up, the problem will get worse. If profits decline, the problem will get worse. If credit ratings are cut, the problem will get worse. If investors eventually see through the curtain, the problem will get worse.
Some of this is already happening. Capital Economics notes that the S&P 500 Buyback Index, which measures the performance of the 100 stocks in the index with the highest buyback ratios, has nearly doubled since the beginning of 2008 compared to a 30 percent gain for the overall S&P 500. Yet so far this year, the relationship has reversed: The Buyback Index is lagging the overall market.
There's more. The ratio of domestic nonfinancial corporate profits to gross value added has surged to the highest level in 63 years, according to data released Thursday by the Bureau of Economic Analysis. This has been a product of slack wage growth, low corporate taxation, the impact of globalization and ultra-low borrowing costs. While taxation is probably not going to change anytime soon, the other three factors are turning to the downside.
Wage pressure is building as the labor market tightens. Global trade is slowing amid regional territorial disputes, a burgeoning currency war and China's credit overhang. And borrowing costs are vulnerable as the Fed ends its long-term bond-buying stimulus later this year and hikes its short-term interest rates sometime in 2015.
As the fuel for the debt/profit dynamic described above runs dry, earnings-per-share growth -- the so-called mother's milk of the stock market -- will stagnate and turn lower. The Fed's carefully constructed but ultimately unsustainable asset price bubble will fall apart.
That's the bad news.
The silver lining is that while corporate profits and the stock market will fall from record levels, middle-class wages will finally drift higher amid competition for qualified workers. And maybe, just maybe, the gap between rich and poor will start to heal, the percentage of Americans on food stamps will normalize and we can build the foundations of a more lasting economic recovery.
