MARKET OBSERVATIONS    

IS CORPORATE AMERICA LOSING ITS APPETITE FOR STOCKS ?

MARKET OBSERVATIONS - 7/11

Buy Back Jack?...An interesting bit of data in the 1Q Fed Flow of Funds Report is that it appears that corporate America was a net issuer of equity in the first quarter of 2000 for the first time in a long time.  In the following table we present an annualized retrospective of net corporate equity issuance over the last 6-plus years.  In fact, one has to go back to late 1993 to find a quarter where corporations were net issuers of equity.

(We have to be honest and mention the fact that a few large corporate transactions skew the numbers in 1998 and 1999, all related to foreign purchases of US corporations.  1998 saw the BP/Amoco and Daimler/Chrysler deals.  In 1999 it was Vodaphone/Airtouch.  Despite these anomalies, corporate new issuance of equity in 1998 and 1999 was still negative by $80 and $180 billion respectively.)

Sure, the first quarter of this year was loaded with tech and Net deals as the NASDAQ skyrocketed to the heavens.  Nonetheless, it appears that there is a marked change in the corporate equity supply demand equation relative to the annual experience of the last six years.  As you know, the Fed Flow of Funds data is released on a notoriously slow basis.  It isn't until mid-to-late June that we can get our hands on the data.  Luckily, our pals at the Leuthold Group have their own proprietary methodology for calculating net corporate supply/demand for equities.  Through the end of May, they calculate that net corporate supply/demand for equities is running near $0 on a year-to-date basis.  Clearly with the implosion in the NASDAQ, many a Net deal has been postponed (some perhaps permanently).  Likewise, in April and May, corporations were given the gift of a "blue light special" in terms of pricing for potential stock buyback activity.  In our book, the April and May net cash acquisition balance merely makes up for the extra special tech issuance calendar earlier in the year.

As you know, one of our primary interests at ContraryInvestor.com is the identification of incremental change.  The ability to identify change at the margin is one of the key tools in the contrarian investment tool kit.  As always, deducing the ultimate effects marginal change requires patience and vigilance in terms of analytical follow through.  In other words, we'll just have to see what happens ahead.  Just why is all of this important?  As you know, corporate America has been a major purchaser of its own stock over the past half decade plus.  This action has been a major prop to prices in this bull market.  Couple this with public inflows to the mutual fund complex and you are talking about hundreds of billion per year in serious demand for equities.  Stock buybacks have been driven, in our minds, by the overwhelming need to manage Street perceptions of quarterly earnings growth and the complete new era management homage to stock price appreciation (stock options interests).

Break The Balance Sheet?...Stock buybacks have been accomplished by an ever increasing amount of corporate debt financing.  We've shown you the following graph a month back in our initial review of the 1Q Flow of Funds data.  Although still quite strong from an historical context, annualized corporate debt growth in the first quarter of this year slowed for the first time in four years.

Clearly along with slowing corporate debt growth, the complexion of corporate net supply/demand for equities changed in the first quarter.  Again, the jury is out as to what lies ahead.  If corporate demand for equities (primarily stock  buybacks) is slowing, that cannot be good for equity prices in general.  As you know, this change is a process, not an event.

Buy High, Sell Low...We have wondered for some time now whether modern corporate America's strong focus on stock option compensation was causing uneconomic choices to be made by executive managements.  In other words, economic misallocation of capital resources.  In his recent book, Andy Smithers argues that stock options are one of the greatest reallocations of corporate resources from shareholders to employees the US has ever seen.  We've been through all of the reasons with you before as to why.  The primary one being the incredible potential for significant shareholder dilution over time.  A second being the lack of incorporation of the present value of stock options expense on the P&L, etc.  One of the major long term repercussions for corporations engaged in debt financed stock buybacks is that corporate balance sheets are being levered into what may be a peaking in economic activity.  As opposed to saving for what is sure to be a rainy day in the economic cycle at some point, corporations are realizing a current benefit (reduced share count) and financing that immediate benefit with a longer term liability.  We have the feeling that the current bond market is way ahead of equity participants in having figured this out.  Why else would yield spreads between Treasuries and corporates already be at levels seen during periods of economic stress in what is currently an economy that is reported to be "on fire".  If corporate bonds reflect trouble now, what happens when corporate cash flows weaken during the next recession?

Lastly, it seems just plain illogical that in a period of equity valuations virtually unprecedented in US history that corporations would be financing anything with debt.  Forget the effect of interest rate levels on cash flow debt repayments.  If investors are willing to purchase stocks at big multiples to book, revenues, earnings, cash flow, etc., shouldn't corporate America have been pumping out additional equity like there is no tomorrow for years now?  Clearly, corporations cannot issue stock to buy back stock, but they can surely issue stock for all capital spending, corporate financing purposes, etc.  In the 1929 period, corporations were issuing tremendous amounts of equity.  It was simply crazy to undertake debt financing when equity was so expensively priced to the average shareholder.  Not so today.  In fact, just the opposite in the aggregate.  Of course there are significant sector differences.  Net companies have had little need for debt...until possibly now, when they currently have virtually zero chance of receiving it.  As you know, our classic example is IBM.  Significant debt funded stock buybacks over the last 3-4 years.  Has it really improved operating results?  Not much.  It has certainly mortgaged the future of balance sheet flexibility.  It has not done much except increase reported earnings per share, the stock price (albeit, temporarily), and the value of stock options to employees.  It has been short term financial engineering,  not long term operational enhancement.              

Whether for interest rate reasons, financial balance sheet leverage reasons, or other reasons that corporate net equity issuance supply/demand characteristics are changing, a net reduction in demand for equities on the part of this key buyer (corporations) deserves attention.  We're not saying that the world is coming to an end for equities tomorrow, just that the historical buying pattern of one of the largest purchasers of common stocks in the last half decade has changed pretty markedly in the first six months of this year.  You can count on us to keep you apprised of corporate behavior in the quarters ahead.

They Came From Foreign Shores, They Came From Distant Lands...In the first quarter of 2000, foreigners continued to be big purchasers of US equities, albeit at an annualized pace reduced from that of last year.  Of course our trade imbalance is putting a lot of dollars in the hands of the foreign community for potential reinvestment in dollar denominated assets, but it was largely European buyers that almost single handedly drove foreign investment in US equities during 1Q.  (In our minds, allocation from Europe is not about the trade imbalance, but rather global perceptions of specific areas of attraction for equity allocation.)  Here's a peek at what global allocation to US equities has looked like over the last six years.   

(Note that approximately $25 billion of the 1Q figure represents the closing of the Pharmacia Upjohn deal.)

The following table is a macro look at geographic demand:

Oddly enough, after being a significant net purchaser last year, Asia has turned to a net seller at the very time our trade deficit with Asia is expanding.  (They are buying our debt, not our equity.  We have the funny feeling that Asians believe they can identify an equity mania having had such recent personal experience.)  It is the European buyer who is carrying the load in terms of purchasing equities in the US.  Interestingly enough, Europe has been slowly liberalizing its rules for pension investing over the past few years with more change surely ahead.  We're sure you saw this weeks Barron's cover article describing the money that is due to mature in the Japanese "postal system" and the potential for liberalized retirement accounts (401(k)'s, etc.) in that country.  Many countries globally  are conceptually moving toward where the US has already been for the past 20-30 years in terms of investment possibilities for the individual.  Again, this deserves serious scrutiny and attention ahead as the forces of supply and demand can dominate individual fundamental security investment considerations for sustained periods of time, as we know all too well in this country.  Who knows, if corporations in this country are beginning to cut back on net equity purchases at the margin, this negative macro effect on equity prices may be more than made up by an influx of foreign private individual capital.  Or maybe not. 

And There's Room For Everyone, Living In The Promised Land...Are foreigners buying at the top?  This has been an old adage on Wall Street for many moons now.  Foreigners have tended to come in heavily right before tops in the US and, likewise, US investors have tended to buy heavily into foreign markets right before significant price peaks.  Having been severely underweight in US equities for a good while, Europeans are clearly making up for lost time.  What may be even more striking than the European allocation to US equities in the last few years are the recent deals done by foreign concerns in the US asset management industry.  In the past month, the following buyouts have been announced:

Unquestionably, the global money management business is consolidating.  In fact, we believe that we haven't seen anything yet.  On the incredibly odd chance that the US slips into a bear market, the consolidation in money management (primarily the mutual fund business) ought to be nothing short of incredible.  What gives us a bit of pause for reflection concerning these current deals is that all are foreigners acquiring US money management assets during a precarious, but not yet lethal, time for the US financial markets and during a period where the dollar has been very strong relative to foreign currencies (making two of the three acquisitions we have shown you quite expensive).  UAM has clearly been a troubled company for some time.  The price is considered to be bargain basement, but it's a fixer.  NVEST went for a 100% premium to its pre-acquisition market valuation.  The collection of money management entities it owns are fair, not great, properties.  Some NVEST entities have lost heavy assets under management in the last few years.  Lastly, Sanford Bernstein went for top dollar in our book.  What do the foreigners know that we don't know?  Why now?  Why do expensive dollar/cash deals?  At the end of what has been one of the greatest ten year runs for stocks in US history, is it really time to shout "all aboard"?  For the sake of the French acquirers listed, let's hope that oui, oui does not turn into wee-wee in the next few years.  (At the publishing wire, UBS is strongly rumored to be acquiring PaineWebber for $12 billion.  It probably happens tomorrow if at all.  Now you know why the brokers have been running lately.  Foreigners buying money management/brokerage firms sure feels like the Japanese real estate extravaganza in the US late last decade.)                  

Next Generation Acquisition Prices...Optical networking technology is unquestionably next generation technology.  Sincerely, we are believers that optical will create myriad new possibilities for the 'Net world as bandwidth blossoms and rich content flourishes.  Despite our conviction regarding the promise of the technology, we have to admit that our eyebrows lifted well above center normal seeing the price JDSU paid for SDLI yesterday.  Prior to the open on JSDU, we're talking about approximately $41 billion.  Of course, the price of admission is being paid in JDSU monopoly money (JDSU stock).  On a pro forma basis, SDLI is expected to generate roughly $450 million in revenue for 2000.  We'll do the math for you.  That's a price tag of 91x's pro forma revenue.  Now that's what we call fiber amplification.  Clearly, this deal even makes John Chambers look like a piker.  At current values, the JDSU/SDLI deal would be the largest ever consummated in tech sector history.

All My Rowdy Friends Are Comin' Over Tonight...(Do ya want to drink?  Do ya want to party?)  Well apparently no one has told the US consumer that an economic slowdown has started because the party in consumer credit has just caught a second wind.  The $11.8 billion increase in May consumer credit was just a tad higher that the almost dead on $7.5 billion prediction by analysts.  In looking at the components, "auto and other" debt spiked up sharply.  The May growth rate in consumer credit was quite close to the seventeen year record breaker recorded in January of this year.  There is simply no question in our minds that consumer spending over the last few years has been fueled not only by the stock market wealth effect, but more importantly by ever increasing amounts of consumer credit taken on by mom and pop America.  What seems quite dangerous is that consumer credit growth is outstripping the rate of growth in wage gains by roughly two to one.

This recent report suggests one of two things to us.  One path of thought is that the economy is far from rolling over and the consumer is gearing up for an increased round of consumption.  The stock market indices have recovered from their recent swoons and the feeling that all is well in the paper wealth department has emboldened US consumers.  The alternative message of the number is that the slowdown in the economy has taken hold and the US consumer is in trouble fast this time around.  The increase in debt is an act of desperately wanting to maintain a bull market lifestyle on the part of consumers.  Regardless of instigation, we simply can't spin this kind of display of increased household leverage as anything positive for either the economy or the stock market.  What simply astounds us in the current environment of hyper upward movement in real estate values (especially along the coasts) is that non-tax advantaged borrowing is soaring.  Doesn't it seem to make a lot more tax sense to borrow from the equity of your home if you need to borrow at all?  Moreover, higher interest rates over the last eighteen months have not stopped the charging beast.  Quite the opposite, its made the beast more ferocious.  

YAHOO?...Hardly.  After much rumored softness in the quarter, Yahoo dutifully "beat the numbers" by the mandatory penny, as reported after hours.  For that little feat, YHOO shares squirted higher by $8+ billion in after hours antics.  At plus or minus $120 in after hours fireworks, YHOO has a current market cap of $65 billion.  It's only about 270x's earnings and 65x's revenues (pro forma '00 numbers, of course).  It's sure a good thing that speculation has already been wrung out of this market with the recent NASDAQ correction so we can all partake of bargain prices in companies like YAHOO (still 50% below it's highs).  One mutual fund manager from a large fund who blew out his entire YHOO position in March and April said he is considering buying back the stock after hearing today's report.  His direct quote was, "It's good to see that they beat the numbers.  Just think what would have happened if they had just come in line (with estimates)."  Whew, that was a close one.  It's sure good to know that deep analytical thinking is behind contemplated mutual fund purchases these days, isn't it?

For a little eye opener on wonderful YHOO, have a look at the following table:

Source:  Bloomberg

Here's a couple of simple observations.  Diluted earnings per share growth from continuing operations seems to be completely non-existent over the period described above.  It's sure a good thing that investors don't seem to mind being wildly diluted by employee stock options.  This type of operating performance is worth $65 billion?  Oddly enough in today's world, it is.  We're just not so sure about tomorrow's, though.  Now can you see why the mutual fund manager we quoted is so eager to buy back the shares?  We have just one word of advice for this individual.  If we were you, we'd absolutely wait for Maria Bartiromo to give the A-OK sign first.  Then you can be sure it's a good investment.

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