Debt Doesn't Matter... Until It Does

Written By Briton Ryle

Posted September 14, 2016

So, I want to follow up on the article I wrote for Wealth Daily on Monday…

If you think Friday’s sell-off was a bit overdone, OK. If you realize second-quarter earnings were pretty good, that’s OK, too. 

But if you’re thinking about wading in here and picking up some stock on the cheap, before they can bounce back to recent highs, well, that’s not OK. Because the selling has likely only just begun…

Now, it’s absolutely appropriate to start thinking about bargain hunting after there’s been a steep decline for stock prices. Especially if you’re a long-term investor, you should always have some cash set aside so you can act when the opportunity arises. Like after that Brexit vote back in June, when stocks dropped sharply after UK voters opted to leave the European Union. Anybody that waded into that bloodbath and bought was handsomely rewarded by the epic rally that ensued.

However, that was then. The Dow had fallen to 17,140 by the time the buyers turned their tide. That’s 1,000 points lower than it is now, even after Friday’s big drop. The odds are strong that stocks will head lower in the near future.

You probably know by now that stocks rallied sharply on Monday. Yes, it seems like “Buy the Dip” has been the right answer for years. But the thing about trading strategies is: they work until they don’t.

Which brings us to yesterday, Tuesday, when stocks lost all their Monday dead-cat gains. Now we’re right back to where we were after Friday’s nasty close. 

So what’s next? Well, first off, let’s talk trend. One very popular way to measure a trend is with the 50-day moving average. When a stock or index is above the 50-day moving average, the immediate trend is assumed to be bullish — that is, to the upside. When a stock or index is below the 50-day moving average, well, the trend is assumed to be lower. (I’ve written more about how moving averages work here and here.)

So Friday’s decline took the S&P 500 below the 50-day moving average, which was at 2,165. Monday’s rally took the S&P 500 to 2,163, but it failed to move above the 50-day moving average…

spx setpember 2016

The 50-day moving average is the blue line. You’ll notice on this chart that when the S&P 500 crosses the blue line, it usually keeps going. When it fails to break through, it tends to head back from whence it came. A lot of people pay attention to moving averages, so you know that a lot of people saw the failure to break above it Tuesday and are saying “uh-oh.”

Who’s Buying?

I know it’s stating the obvious, but it’s buyers that push stock prices higher. So, who’s buying stocks today?

I’ve told you that the uncertainty about the UK and the future of the EU raised by the Brexit vote pushed a lot if money out of the euro and the British pound and into U.S. assets. That’s helped push stocks higher.

Then there’s stock buybacks by U.S. corporations. They’ve spent better than $1.5 trillion buying their own stock in the last four years. That is steady buying pressure. And the thing is, the companies doing this don’t care about valuation or the economic environment. They buy to help their balance sheet, and they will do it so long as they can sell bonds on the cheap to raise cash. 

corp debt sept 2016

Now, here’s the thing about share buybacks: Earnings are not growing very much for Corporate America. It’s getting more expensive to sell bonds. And companies are already loaded with debt as it is. 

In a low interest rate environment, they say taking on debt is the right thing to do. For you and me, sure, this makes sense. If you’re gonna get a loan to buy a car or buy a house, great. You’ll pay less in interest so the overall purchase is cheaper. But you wouldn’t buy a new car every year just because rates are low. At some point, you’re not going to be able to pay off all the loans. At some point, you might say, “Ya know, I’ve got several new cars, I’m going to stop buying cars.” 

Corporations can’t keep buying stock forever. There will come a point where they are not making enough money and they simply won’t be able to afford it. When corporations do stop buying their own stock, that will remove a significant amount of buying power from the stock market. 

It’s important to understand that we don’t know when companies will stop buying their stock. But we can make some educated observations…

  1. Higher interest rates via a Fed rate hike will make corporate bonds more expensive.

  2. If earnings growth doesn’t improve, a greater percentage of corporate income will go to service debt, and there will be less for dividends.

So, looking at the sell-off that started last Friday, it seems to me that a big reason for the declines is that investors are worried what a rate hike will do to an important source of buying in the stock market. 

The Fed Meets Next Week

It seems like every time the Fed meets, it’s billed as the “Most Important Fed Meeting Ever.” 

Yeah, people love to freak out about the Fed. But the fact is, each meeting does seem to carry a bit more significance than the last one because we all know the Fed has to raise rates at some point. And the really smart money knows that Fed rate hikes will slow corporate spending on share buybacks. And of course, when the corporations stop buying, so will a lot of other investors, and stock prices will go down. 

In my opinion, that’s why stocks have been selling off. I don’t think the Fed will hike rates next week. And that probably means we’ll get a rally. But the threat of higher rates will still be out there, and the angst over when will continue to build. That probably means stock prices will be more volatile going forward. 

Until next time,

Until next time,

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Briton Ryle

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.

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