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Buy Back Rant

Brouwer & JanachowskiMay 13, 2016

Stocks drifted. They are up on the year. Up 12% from the lows. But flat for nearly 18 months. There hasn't been many places to make money unless you're willing to trade High Yield, distressed or some gold. We’re not. But we feel fine about the outlook. Here are some reasons:

  1. Earnings: the season is winding down with 90% of companies reporting. First, we knew that earnings were weak. It’s mostly energy, financials and tech (blame the dollar). Around 70% of companies beat earnings. But that's not what interests us. The more important number is the 45% who beat on sales. Management can engineer earnings. It's tougher with sales. We have seen some modest margin expansion and management mostly recommitted to share buy backs. 380 companies in the S&P 500 buy back their shares.

And here we break for why share buy backs are a dumb way to return shareholder cash. For the pro camp, the argument is shrink the share pool, earnings accrue to fewer shares, shares go up, cap gains are good. For the ‘”er, I don't think so” camp:

  1. the share buy back yield (3.2%) is greater than the dividend yield (2.1%) but
  2. cash is cash and a very strong signal; buybacks remove you three times from cash (company has to buy them, market has to react and you have to sell) and are a weak signal. Think direct speech vs semaphore on the horizon.
  3. companies spend 150% of their reported earnings on dividends and buy backs compared to 72% a few years ago.
  4. the market seems to agree. Here's the chart:

Blog 2 51316-2 $SPHYDA,$SPX,SPYB - Performance Workbench copy

Anyway, we’ll be back on this one. It’s kind of an obsession.

  1. U.S. Treasuries: there is some seasonality to Treasuries, but we were surprised by just how robust the Ten-Year auction was this week. Dealers only got 14% of the issue compared to 31% a few months ago. The indirects, which are a good initiation of real (i.e. not transactional) demand, got 72% of the issue compared to 65%. The yield came in at 1.71%. This is what the drop in Treasuries looks like over the last six months (a period, ahem, which nearly all pundits thought rates would rise):

2Blog 2 51316 - 1Print SharpCharts from copy

What's going on? We think the following:

  1. The economy is fairly weak. The GDP “now” numbers, here and here, are still below most forecasts.
  2. Treasury supply is declining. Net issuance may decline as much as $100bn this year. Public finances, at least from the U.S. Government, are showing higher receipts than a year ago.
  3. The demand for Treasuries as the ultimate safe asset and yield play over Japanese and German government bonds remains very strong. In the last two months, private sector foreign buyers added $155bn in Treasuries to their $6.2tr pile. Brexit fears only add to the trade.
  4. The Bank of Japan said that they would ease more if needed. Japan then promptly reported its highest current account surplus in nine years, helped by a massive 37% decrease in fuel imports. So they will probably ease.
  5. And to cap it all, risk off sentiment is high after earnings and some dreadful performance by prominent hedge funds. Gotta run. Gotta cover.

Bottom Line: as we have said, we’re comfortable with this consolidation phase. The more bad news the market absorbs now the better. Our high quality bonds, Small Cap and Emerging Markets thesis. Look for some risk events in the next few weeks.



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The problem with limited data sets (we’ll come back to this)

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--Christian Thwaites, Brouwer & Janachowski, LLC


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