We really did think that the equity markets were vulnerable to a sizeable sell-off starting sometime in the late April/early May period. We were wrong as US and European markets have reached new all time or cycle highs. That said, we see evidence building nearly every day of a major top with parallels to both 2007 and 2000. All we can say is that equities remain strenuously overvalued and the reach for yield has created bubble like conditions in developed equity and credit markets. Of course, these markets can continue higher in the short-term, but remaining in the game has the feel of playing financial Russian roulette.
One source of demand for equities that we simply underestimated was in companies buying back their own shares. The chart below courtesy of Zerohedge shows the Dollar amount of buy-backs measured on a quarterly basis with the Q1 total a new record high. Corporate America has seemingly given up on Capex, which would generate long-term growth, in favour of share buy-backs which simply boosts share prices (and executive compensation packages!). We have no problem with companies using what can economically be described as excess cash flow (after reasonable Capex) to buy back their own shares, especially when the share price is depressed. However, buying record amounts of stock at all time highs, and in a number of cases issuing debt to finance this activity, whilst at the same time foregoing Capex which would surely generate long-term growth for the company, smacks of corporate short-termism and managements engaging in another form of smoke and mirrors to boost earnings per share and their own remuneration at the same time. Needless to say, buy-backs are set to exceed 2007 which was the previous peak (before collapsing in 2008 when the equity market fell – talk about trend followers rather than astute use of inside information).
The recent surge in M&A activity is another danger signal, in our opinion. There is reasonable academic evidence to suggest that M&A adds little benefit to shareholders in the long-term and we would make the case that this is another sign of hyper-active corporate management trying to boost performance (and more likely share prices). Rather than spending on Capex to boost long-term growth prospects, by embarking on the M&A path, managements are risking overpaying at current high valuations, most likely “adding value” by destroying jobs, and with no guarantee of long term success. The chart below (with data through early 2009) shows the historical relationship between US M&A activity and the S&P 500. It is clear that M&A activity peaks and troughs at pretty much at the same time as the equity market. Current annualised M&A activity for 2014 is almost as high as it was in 2007!
As well as companies exhibiting hyper-activity on the share buy-back front, the IPO market has been heating up this year as well. However, it is not only the number of IPOs that is of interest, but also the quality. As shown in the chart below, over 80% of recent IPOs have negative or no earnings. This is consistent with the tech boom and bust in 2000 and is a clear sign of speculation in the current market.
Volatility in the equity markets has been crushed as investors reach for yield. To put this in context, the chart below shows a current iteration of volatility over the last dozen or so years, together with the S&P 500. The message is clear here; we really don’t have to make any further comment.
We have written at length in recent weeks/months about the strenuous over-valuation of the market, now we have the “background mood music” that historically accompanies a significant market peak. What we don’t have yet is declining share prices. What is apparent at present are building divergences that are often seen at notable market highs, such as a lack of volume, divergence between price and momentum, and as shown in the chart below, divergence between price and New 52 week highs. When these sorts of divergences are in place, any downside break has the potential to develop into something more serious.
Although we know we sound like a broken record, we absolutely believe that the ingredients for a significant market top are in place. We believe that the next few months have the potential to be quite dangerous for equity investors, but as yet, the main indices refuse to break lower. We have recently scaled back our bearish equity exposure as price was working against us, however, we still believe that the next significant move will be lower. We are therefore looking for a price signal to re-enter our bearish positions.