Experienced investors know we are in an era where central banks are playing
a much larger than normal role in the financial markets. The Fed has openly
talked about money printing and asset prices during their unprecedented three
rounds of quantitative easing (QE). The European Central Bank (ECB) offered
unlimited three year loans to financial institutions to kick the European debt
crisis can down the road in late 2011. The financial engineering has also found
its way onto the balance sheets of U.S. corporations. From Bloomberg:
"As companies are less and less able to deliver earnings growth through
internal efficiencies and top-line growth, and at the same time shareholders
are pushing for increased rewards, they're turning to financial engineering
to push returns," said Alan Shepard, an analyst and money manager at Madison
Investment Advisors Inc., which oversees about $16 billion in Madison,
Wisconsin. "Borrow the money at low rates to finance repurchases and you
can drive earnings-per-share growth."
Similar To 2009
With the Fed and ECB holding interest rates at artificially low levels while
pumping unprecedented amounts of freshly printed money into the global financial
system, it is fair to say pricing has been skewed in almost every asset class.
Rising interest rates could not only spook stock and bond investors, but the
negative effects could spill over to corporate debt loads. From Bloomberg:
Company debt loads in the U.S. are approaching the highest level since
the aftermath of the financial crisis as borrowing to finance mergers and
shareholder payouts exceeds earnings growth. Debt levels have increased
faster than cash flow for six straight quarters, boosting the obligations
of investment-grade companies in the second quarter to 2.09 times earnings
before interest, taxes, depreciation and amortization, according to JPMorgan
Chase & Co. That's up from 2.07 times in the first three months of
2013 and compares with 2.13 in the third quarter of 2009, when it peaked
after the deepest recession since the Great Depression.
Slowing Momentum
High debt levels on corporate balance sheets will most likely not pose any
problems unless they are provoked by a weakening stock market and/or economy.
The stock market may be up to the task. In June, we noted the similarities
in the popular momentum indicator (MACD) to the October 2012 correction. The
updated version of the chart below continues to paint a concerning picture
for stocks.
Steeper Decline Than Expected
Central bankers hope low interest rates will entice buyers to step up to the
30-year mortgage plate. We do not need to be a Nobel prize winning economist
to understand rising interest rates can discourage would-be home buyers. From Reuters:
Contracts to purchase previously owned U.S. homes fell for the second
straight month in July, a sign that rising mortgage rates are taking the
steam out of America's housing market recovery. The National Association
of Realtors said on Wednesday its Pending Homes Sales Index, based on contracts
signed last month, decreased 1.3 percent to 109.5. That was a steeper decline
than most analysts had expected, and could provoke added caution at the
U.S. Federal Reserve over plans to reduce a bond-buying economic stimulus
program.
Investment Implications - Risk Reduction
Our market
model called for the fourth round of risk reduction Tuesday. Our cash
position is now basically on par with our exposure to stocks (SPY). We still
have exposure to technology (QQQ) and small caps (IWM), but they have more
cushions in the form of rising money market balances. If stocks cannot find
their footing, we will consider adding some exposure to gold (GLD), commodities
(DBC), or bonds (AGG). Risk-off assets have not shown enough yet to warrant
purchases, but they are on our radar. If the Fed hints at no taper in September,
we can migrate back to a more fully invested equity allocation. The bulls
have some work to do before we can prudently scamper back toward stocks.