This Man Has No Shame

Written By Briton Ryle

Posted April 20, 2015

Chinese stocks rally like crazy… then crash.

Oil stocks crash… then rally.

Europe has been the number one investment idea for many gurus so far this year, even though Greece is on the verge of default and the EU economy is persistently flat.

The fear-mongers will tell you the U.S. dollar will crash… but the charts clearly show it is the strongest currency in the world.

Oil is the single most important commodity in the world, but one look at an oil chart would make you think we’re all driving electric cars.

The S&P 500 is trading within a stone’s throw of all-time highs. And yet the companies themselves are earning less than they did a year ago.

How’s this possible? And does it mean stocks are headed sharply lower?

Here are some thoughts on the strange and conflicted headline stories…

  • It’s still early in earnings season, but companies are beating lowered expectations by the typical amount — around 70%. The one caveat here concerns revenue growth and earnings-per-share growth. Revenue isn’t really growing, as you can see from the chart below. In fact, S&P 500 revenue is just about where it was in early 2008, before the financial crisis. But earnings per share is hitting records. Why? Stock buybacks…

S%26P revenue

S&P 500 companies have spent ~$4 trillion on share buybacks in the last few years. When a company buys back shares, it is lowering the number of shares outstanding. That, in turn, makes earnings per share (EPS) rise because you’re dividing the total earnings by a smaller number.      

There is nothing wrong with this in and of itself. It becomes a problem when revenue isn’t growing (and, as the chart shows, revenues are not growing). Because in a very general sense, we could say that earnings are about a company’s efficiency, and revenue is about the overall business climate. So regardless of how efficient a company is, if the general business climate (economy) is weak, stocks are less attractive.  

The problem can be made worse if companies are taking on debt to buy back shares, which is what’s happening now. Sure, with rates so low, it does make sense to take on debt — if there are higher revenues and earnings ahead. But if revenue falls, then a larger percentage of revenue has to go pay debt, leaving less for EPS…    

I can’t tell you for sure this is what U.S. investors are worried about right now. And in fact, I do think we’ll see higher revenues and a better business climate ahead as more people get jobs and wages (eventually) rise. With all of that said, I do think the next recession we get will look worse for stocks, because they will have to devote a larger share of revenue to pay debt.

  • The U.S. dollar has been on a huge run higher. Yes, the U.S. economy is the best in the world. And the Fed is close to hiking interest rates. Both of these things have helped the dollar get stronger against other currencies. But there’s another reason the dollar has been strong…

Consider that foreign companies and countries hold $9 trillion worth of dollar-denominated debt (bonds and loans).

France and Sweden have borrowed a combined $100 billion in U.S. dollars. Russia’s Gazprom, Spain’s Telefonica SA, and the world’s largest steelmaker, ArcelorMittal, have each raised about $12 billion in U.S. dollars.

These entities have to continue to buy dollars to repay the debt.

Bloomberg reports that foreign central banks are increasing their dollar holdings: The dollar’s share of global foreign reserves shrank to a record 60% in 2011 from 73% 10 years ago, though it’s since climbed back to 63%.

  • China is a problem. The government there is actively creating investment bubbles to keep its economy moving. First it was factories. In the early part of this century, China built an incredible number of steel factories, cement plants, coal power plants, etc. China now makes more steel, cement, solar panels, clothing, plastics — you name it. China makes so much stuff that it routinely dumps its excess on the global market at below-market prices. This “dumping” is helping to create deflation in the global economy.

Then China started on its domestic real estate market, lowering lending standards to encourage home ownership and creating huge ghost cities. China needs a real domestic economy, where consumers buy stuff and support the economy. One way to do that is to create a wealth effect, where people’s assets increase in value. Unfortunately, China is resorting to monetary policy and debt to do this. In other words, it is creating asset bubbles.

Sound familiar? It should, because the U.S. Federal Reserve is doing the same thing — trying to increase consumption by using low interest rates to push asset prices higher. It’s not likely to end well for China… or the U.S.

  • We’ve already gotten a taste of a burst asset bubble in oil. Low interest rates allowed U.S. oil companies to take on $500 billion in debt and loans over the last four years. Investors liked the oil bond yields because Treasuries weren’t paying squat. And they loved the oil story — high prices, plenty of domestic supply, energy independence…

Well, Saudi Arabia poked a hole in that idea. U.S. oil companies have now lost $200 billion in market capitalization. That’s nearly half of the debt they took on.

Oh, and U.S. oil economies are now taking on more debt than ever…

oil debt bloom

Obviously, these companies have to get cash from somewhere. They’re not going to get it from oil sales, with prices at eight-year lows. Interestingly, though, plenty of investors are happy to buy more oil bonds. You know what they say: fool me once, shame on you…

If oil prices don’t recover, these investors will have no one to blame but themselves.

As an aside: The oil stock price crash has been ugly. And we could see a similar sell off for “regular” stocks when the share buybacks stop. Because that’s when investors will have to confront the reality that revenues aren’t growing.

  • Now, getting back to China. China’s stock market has been on a tear. Why? I don’t know — economic growth has been slowing. I suspect it is just another Chinese asset bubble. I’ve written before that you should avoid Chinese stocks… with one caveat: Chinese solar. Canadian Solar (NASDAQ: CSIQ) and Trina Solar (NYSE: TSL) are both good stocks to own.
  • Remember Jon Corzine? Former Goldman Sachs co-CEO, governor of New Jersey, and CEO at MF Global who stole $1.6 billion out of customer accounts to pay margin calls on Greek bonds he “invested” in? Yeah, he didn’t go to jail. Nothing like being connected, right? But now the Wall Street Journal reports he’s trying to launch a hedge fund. The man has no shame whatsoever.

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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