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Investors Still too Bullish

It’s been a wild ride on Wall Street lately. Major averages had hit their highs in late September. But if this sell-off continues, it will be Wall Street’s worst year since the financial crisis and the worst December since the Great Depression! This should have been enough to shake investor confidence. But judging from the data in the chart below, compiled by my friend Kevin Duffy of Bearing Asset Management and using data from Charles Schwab, we see that investors on both the retail and institutional level have a near-record low level of cash. They are anything but scared of this market.

This data was compiled on November 30, 2018, when cash levels registered just 11.2%. That was not up much from the low reading of 10.3% held on September 30th. The retail investors is, relatively speaking, all in.

And, analysts aren’t pulling in their horns either.

According to FactSet: Overall, there are 11,136 ratings on stocks in the S&P 500. Of these ratings from Wall Street analysts, 53.9% are Buy ratings, 40.8% are Hold, and just 5.3% are Sell ratings. Yet, with the mounting weight of evidence in favor of a sharp slowdown in global growth, it has not dissuaded analysts from still having ebullient forecast for earnings growth next year. Analysts are projecting S&P 500 EPS estimates for the Calendar year 2019, according to FactSet, to grow at 8.3% with revenue growth of 5.5%.

The global economy is showing signs of cracking now that QE has gone from $180 billion per month in 2017, to a negative number in 2019. That has sent the Emerging Markets into chaos and help lead European and Japanese economies into contraction.

And now China, which has been responsible for 1/3rd of global growth coming out of the Great Recession, is entering into a recession. Of course, having the government force an increase of debt to the tune of 2,000 percent since the year 2000 guarantees a crash of historic proportions. In fact, the government in Beijing is so concerned about the current debacle that it has banned the gathering of private economic data.

According to the South China Morning Post, China’s central government has ordered authorities in the Guangdong province – China’s main manufacturing hub–to stop producing a regional purchasing managers’ index. This means the province will not release the purchasing managers’ index (PMI) data for both October or November. Instead, all future purchasing managers’ indexes will be produced in-house by the National Bureau of Statistics.

It is evident that Beijing is trying to suppress the dissemination of economic data because its economy is growing at a much slower rate than what the communist party will admit to…that is, if it is growing at all. This is hindering its position in negotiations with the United States in the trade war. And it also reiterates the complete lack of transparency in the Chinese markets and the desire on the part of the Chinese government to keep the world in the dark about the true state of its economy.

Perhaps December’s continued debacle in global markets and economies was enough to begin pushing U.S. investors toward the exit–we will monitor this dynamic closely. However, history shows that it is a multi-month process to move investors’ psyche from euphoria to panic. This dynamic is still in its infancy.

Michael Pento is the President and Founder of Pento Portfolio Strategies, produces the weekly podcast called, “The Mid-week Reality Check” and Author of the book “The Coming Bond Market Collapse.”

Stock Buy-Backs Go Bust

The perfect storm of zero percent interest rates that existed concurrently with a debt-disabled economy lured executives at major corporations into a decade-long stock buyback program. The Fed pumped money into the economy thru its various Quantitative Easing programs to force interest rates near zero percent, with the expectation corporations would borrow money at the lowest rates in history and then invest in their businesses in the form of Property Plant and Equipment (capital goods). This in turn would expand productivity and help foster a low-inflation and strong growth environment.

But many corporate executives found a much more enticing path to take in the form of EPS manipulation. That is, they boosted both their companies share price and, consequently, their own compensation, by simply buying back shares of their own stock.

For the most part, companies have used debt to finance these earnings-boosting share purchases. Stock buybacks have been at a record pace this year.

This is a short-term positive for shareholders because it bids up the stock price in the market; just as it also reduces the shares outstanding. This process boosts the EPS calculation and increases cash flows as fewer dividends are paid to outside shareholders. As an added bonus, it also provides for a nice tax write-off.

Wall Street is easily fooled into thinking valuations are in line using the traditional PE ratio calculation. But this metric becomes hugely distorted by share repurchases that boost that EPS number. Other metrics that are not as easily manipulated, such as the price-to-sales ratio and the total market cap-to-GDP ratio, have been screaming the overvaluation of this market in record capacity.

Traditionally speaking, a company decides to buy back shares when they believe their stock is undervalued. But from 2008-2010–a time when stocks were trading at fire-sale prices, companies bought back very few shares. However, it was only after Wall Street became confident that the Fed’s printing presses were going to stay on for years that share purchases went into overdrive—even though the underlying economic growth was anemic.

The truth is the volume of debt-sponsored share buybacks over the past few years is putting many companies at an extreme level of risk.  According to Bianco Research, 14% of S&P 500 companies must now issue new debt just to pay the interest on existing debt. In other words, these Zombie companies are actually Ponzi schemes that can only continue operations in a near zero-percent interest rate environment; and if the credit markets remain liquid. But, both of those conditions are rapidly moving in the wrong direction.

Share buybacks have a metric known as the Return on Investment or “ROI,” which tracks post-buyback stock prices to measure the effectiveness of corporate repurchases. The fact is that corporate executives have a miserable track record when it comes to their ROI on share repurchase programs.

One such example of this is Chi­potle. According to Fortune Magazine, the company spent heavily on share repurchases in the first quarter of 2016, at the height of their E Coli scare. Subsequently, these shares have crashed, giving the company an ROI of minus 23%.

Then there is General Electric. Between 2015 and 2017, GE repurchased $40 billion of shares at prices between $20 and $32—its share price sits around $6 today. The company has destroyed about $30 billion of shareholders’ money. It lost more on its share repurchase programs during those three years than it made in operations—and by a substantial margin. But GE is just one of several hundred big companies who have thrown good money away on bad share buybacks.

Big Tech icons Apple, Alphabet, Cisco, Microsoft, and Oracle, have bought back $115 billion of stock in the first three quarters of 2018. But now these share prices are headed down. In fact, IBM has lost 20% of its value this year alone. The company bought back $50 billion of its stock between 2011 and 2016 and ended the second quarter with $11.9 billion of cash on hand; but its debt totaled $45.5 billion. In other words, these companies are destroying their balance sheets for a short-term boost in stock prices that has now gone into reverse.

When overleveraged companies are faced with soaring debt service payments, the results are never good. Indeed, as the global economy continues to deteriorate, look for the rate of bankruptcies and unemployment claims to skyrocket.

Corporate America has leveraged itself to the hilt to buy back shares. Once again, with impeccably bad timing. These companies will now have to raise capital to strengthen their balance sheets just as interest rates are rising and the recession of 2019 unfolds.

Then, these same companies who bought back their shares at the highs will soon have to pull those same shares out of retirement and sell them back to the public at much lower prices. Thus, diluting the shares outstanding and lowering EPS counts yet again…Wall Street never learns.

Michael Pento is the President and Founder of Pento Portfolio Strategies, produces the weekly podcast called, “The Mid-week Reality Check” and Author of the book “The Coming Bond Market Collapse.”