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Why Corporate America Can’t Prop Up Stocks Much Longer

by Doug Casey, Casey Research:

Corporate America is bracing for tough times…

Since you’re reading an investment newsletter, you likely own stocks. And if you’re like most investors, you keep up with how the companies you own are performing. You might even listen to quarterly “earnings calls,” which are when CEOs present results and give their outlook on the business.

Most of the time, CEOs act as cheerleaders on these calls. If business is bad, they’ll say business is good. If business is good, they’ll say it’s great. And CEOs are notoriously optimistic about the economy. After all, thousands of investors and analysts listen to these calls. CEOs know their stock can crash if they’re pessimistic about the business or economy.

Because many CEOs will say anything to make their stock go up, we don’t put much stock in their words. We pay much more attention to their actions. And right now, large U.S. companies are acting like very tough economic times are ahead.

• Business investment fell 2.2% last quarter…

This metric measures how much companies spend on property, plant, and equipment. It was the third straight quarter that business investment fell. That hasn’t happened since the 2008-2009 financial crisis.

We wouldn’t see this if the economy was headed in the right direction. Companies would be building more factories. They’d be buying more machinery. They’d be spending more money on research and development.

Instead, companies have cut back on investments. This tell us they don’t see many good opportunities. That’s a bad sign for the economy, yet stocks keep rallying. The S&P 500, Dow, and NASDAQ have all recently hit new record highs.

At this point, you’re probably wondering what’s keeping stocks afloat if it’s not the economy.

• Companies have spent about $2.5 trillion on “share buybacks” since the financial crisis…

A buyback is when a company buys its own stock from shareholders. This can lift a company’s stock price.

According to investment bank Goldman Sachs (GS), buybacks have been the biggest driver of U.S. stock performance since the financial crisis.

Buybacks also reduce the number of shares that trade on the market. This boosts a company’s earnings per share. But buybacks don’t make a company more profitable. They only make profits look bigger “on paper.”

Companies have been buying up their own stock for two reasons: 1) They don’t see many growth opportunities. And 2) it’s incredibly cheap to borrow money.

• The Federal Reserve has held its key interest rate near zero since 2008…

The Fed cut rates to encourage households and businesses to borrow and spend more money. Mainstream economists thought this would “stimulate” the economy.

It didn’t work. The U.S. economy has grown at an annualized rate of just 2.1% since 2009. This makes the current “recovery” the slowest by far since World War II.

The Fed did get folks to borrow huge sums of money. U.S. corporations have borrowed more than $10 billion in the bond market since 2007. Last year, they issued a record $1.5 trillion in bonds.

Buybacks are a big reason companies borrowed so much. MarketWatch reported last week:

[C]ompanies have been taking on piles of debt to finance buybacks, leading the total debt on the S&P 500 to grow 56% during the past five years.

According to Yahoo! Finance, companies in the S&P 500 funded 22% of last year’s buybacks with debt. This year, debt paid for 39% of share buybacks.

• Corporate debt is now dangerously high…

According to Barron’s, corporate debt now equals 45.3% of gross domestic product (GDP). The only time this key ratio has ever been higher was in 2009, when it hit 45.4%.

If the economy was doing well, this wouldn’t be such a big problem. Companies would be making enough money to pay their debts.

But right now, Corporate America is struggling to make money. Profits for companies in the S&P 500 are on track to fall for the fifth straight quarter. That hasn’t happened since the 2008-2009 financial crisis.

There’s no telling when this earnings drought will end either. According to research firm FactSet, analysts expect third-quarter corporate profits to fall 1.7%. The third quarter ends on September 30.

Keep in mind, the U.S. economy is technically in a “recovery” right now. Imagine what will happen to corporate profits during the next recession.

The more profits fall, the less money companies will have to prop up their shares with buybacks.

• Companies have already started to cut back on buybacks…

According to Business Insider, buybacks fell 18% last quarter. This sharp decline in buyback activity followed a near record-breaking first quarter, in which companies in the S&P 500 spent an incredible $166 billion on buybacks. That’s the second most ever, and the most in one quarter since 2007.

We don’t know exactly why companies are suddenly spending less on buybacks.

Maybe it’s because corporate profits are drying up. Maybe companies are starting to realize they have too much debt. Or maybe it’s because stocks are expensive.

According to the popular CAPE ratio, stocks in the S&P 500 are 62% more expensive than their historic average. Since 1881, U.S. stocks have only been more expensive three times: before the Great Depression, during the dot-com bubble, and leading up to the 2008-2009 financial crisis.

Like any investment, buybacks only make sense when stocks are a good deal. With stocks as expensive as they are today, buybacks are a terrible use of money.

Read More @ CaseyResearch.com

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