GE, Debt and Dividends
A few weeks ago General Electric (GE) announced that they were cutting their dividend in half in order to preserve cash flow. The last two times GE cuts it dividend were 1929 and 2008. That says something about the state of the economy. The stock market is by no means a reflection of the “real” economy anymore. It’s a reflection of how “financialized” the world has become and how distorted incentives currently are. The markets used to be a map that reflected reality. Now we’re just in the game of manipulating the map while neglecting the real world.
GE – 5 years
Being an industrial conglomerate, GE probably reflects economic activity better than any other company. They do industrial manufacturing, healthcare, energy, transportation, etc. But they got caught up in the game of trying to boost their stock price and lost focus on the long-term. A lot of companies fell into this trap of being lured by low interest rates to take on debt to buyback stock and boost their dividend. The problem is that this debt needs to be serviced (interest payments) and eventually repaid. I’ve discussed this many times before as it ultimately means less money in the long run for owners of the equity. GE is an example of the potential fallout we’re likely to see with a lot of companies that have misused debt over the last 5+ years. These are the powder kegs sitting in the corner of the room. As Warren Buffett says: “Only when the tide goes out do you discover who’s been swimming naked.” This refers to the tide of easy liquidity conditions that keeps credit and asset markets afloat. When the economy and business inevitably slow, the stock of companies with excess leverage get pummeled twice as hard.
The key point to understand is that debt is leverage. The more debt an entity has, the more risk there is.
Equity = Assets – Liabilities
So when you increase debt but don’t use the proceeds in a productive manner, you put stress on the equity making the stock more “risky.” This isn’t an issue unless (until) the business can’t continue to grow. If Free Cash Flow is limited and you aren’t able to grow the business, it’s game over. There’s no money to pay back the debt. This is akin to using credit cards to live beyond your means. You can keep the game going until you can no longer make the payments and the debt begins to build exponentially.
I recently listened to an interview with Tobias Carlisle and he described this perfectly by using the analogy of an iceberg. Everyone focuses on the 10% you can see above water (the equity/stock) but it’s the 90% below water (the debt) that will sink a ship (the company).
Current Market Environment
We’re approaching the extended deadline of reaching the federal government debt ceiling on December 8th. I’m sure it will inevitably be lifted again at the last hour but the drama leading up to it is not the real risk for the stock market. The real issue will follow once the limit is raised and the Treasury issues its next round of funding, reducing excess reserves at the Fed and draining liquidity from the markets via bank balance sheets. From a timing perspective this should hit in early January but I’m already starting to see weakness in the markets.
High Yield credit is already weakening and breadth of participation is slowly dropping. The major indices continue to be carried by the largest of the mega cap stocks so weakness isn’t showing up there yet but it can be seen internally. This means the next pullback is close and should occur at some point over the next 2 months. The magnitude of which is impossible to predict but financial conditions remain easy so I don’t expect it to be anything major. We’ll likely see US dollar strength leading to international and emerging market weakness (which is probably a good opportunity to add to EM), and the typical pullback in high yield credit and stocks.
S&P 500 (black) vs High Yield bonds (blue) – 6 months
The wildcard to all of this is China. With Xi solidifying his next term, I’m expecting a forced crackdown on the excessive lending. Just like everyone else, China juiced economic activity this year leading up to their election and now that we’re past it, the excesses need to be slowed and unwound. This could exacerbate weakness in stocks and EM in particular.
I also still expect inflation readings to come in higher than expected over the next 6 months or so, so we’ll likely see pressure on bonds and yield sensitive assets as well. This leaves little to “hide out” in, but that’s the problem with inflating all asset prices… by the way, have you noticed that the Fed has been on a CYA campaign over the last week? In addition to the same message in a couple of speeches, here’s a line from the Fed minutes:
“In light of elevated asset valuations and low financial market volatility, several participants expressed concerns about a potential buildup of financial imbalances,” the minutes said. “They worried that a sharp reversal in asset prices could have damaging effects on the economy.”
Ah yes… now that Janet Yellen is on her way out they have no problem mentioning that their policies of lifting asset prices with the hope that it will “trickle down” to the real economy have not succeeding as they hoped, leaving us in the precarious position of a weak economy, elevated valuations and financial imbalances (see GE above).
To explain, here’s a line from an op-ed Ben Bernanke wrote in 2010:
“Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.” (emphasis added)
Sorry Ben, outside of lower mortgage rates, most of that didn’t happen. What it did do was distort the price of money, encourage more leverage and financial engineering, impose financial repression on savers/retirees and increase wealth inequality. Bravo, job well done. You mean if you give companies money at next to nothing, executives will buyback stock to boost their stock option values instead of investing/hiring? Huh, that’s weird… If you want a healthy economy, just stop meddling. Free markets will naturally balance themselves and the best investment opportunities will be funded. The end.
-Nick