War—what is it good for? With apologies to Edwin Starr, the war of words between the U.S. and North Korea was responsible for a losing week for stocks around the globe as investors sought havens amid the trash talk between those nations’ leaders.
The U.S. equity markets fared relatively well in the escalating verbal battle between President Donald Trump and North Korea’s Kim Jong Un, with the Standard & Poor’s 500 index shedding 1.4%, the Nasdaq Composite losing 1.5%, and the Dow Jones industrials slipping 1.1%. Asian bourses, not surprisingly, bore the brunt of the battering. Seoul’s Kospi, which had seemed impervious to the rising threat from the north’s missile launches, dropped 3.2%, with other markets in the region suffering slightly narrower losses. Europe also fell, with declines averaging about 2.7% for the various bourses.
Safe-harbor assets benefited. Bonds rallied, with the 10-year U.S. Treasury yield falling to 2.19%, a one-month low. Gold surged 2.3% on the week. It’s up 12% this year, bettering the S&P’s 9% gain. The barbarous relic also won the endorsement of Ray Dalio, the billionaire head of Bridgewater Associates, the big hedge fund management outfit.
But even before the equity markets shuddered and volatility vaulted on Thursday in reaction to the rhetoric between Pyongyang and Washington (actually Bedminster, N.J., at Trump’s golf resort, where he is spending a 17-day working vacation), stocks seemed precariously perched near their highs.
Indeed, there was an unusual chorus of warnings of rising risks from prominent investors, including DoubleLine’s Jeffrey Gundlach, Omega Advisors’ Leon Cooperman, and Oaktree’s Howard Marks. None of them could be called a Cassandra by any stretch, and they all shared similar observations to the effect that caution is in order, given stretched valuations and apparent complacency on the part of many investors. All they lacked was the proverbial bell to ring.
Doug Ramsey, chief investment officer at the Leuthold Group, had thought it was time to take a few equity chips off the table in late July. While signs of a major top in the 8½-year bull market weren’t apparent, there were indications that a minor setback was looming. “Sentiment was a bit overcooked,” he says. And when the geopolitical headlines turned ugly, the markets weren’t prepared.
There were other worrying signs, Ramsey related in a phone conversation. Giving a big tip of the hat to Savita Subramanian, Bank of America Merrill Lynch’s equity and quantitative strategist, he noted that shares haven’t been reacting positively when earnings beat expectations during the current reporting season—something that hasn’t happened since 2000.
Another big minus is smaller stocks’ poor relative performance, Ramsey said. The “Trump bump” following the election propelled small-caps sharply higher, owing to their greater anticipated benefit from tax reductions and simplification, deregulation, and the lifting of the burden of health-care expenditures mandated by the Affordable Care Act. Because none of those Trump initiatives has come to fruition, the Trump bump has been reversed. “Or maybe they just got tired of winning,” Ramsey added sardonically.
The Russell 2000, the small-cap benchmark index, has declined 10% or more in 31 of the 38 years of its existence. Through Thursday, the “drawdown” from its high on July 25 was 5.2%, so this dip is totally ordinary. It is, after all, the stormy season for stocks anyway. August and September are the worst months for the market, as discussed on Aug. 3 in my online column (“Will Stocks Take a Big Hit in August?”).
And, for reasons possibly mystical, years ending in 7 have been particularly treacherous during this period.
In Leuthold’s Green Book (as the firm’s widely read monthly publication for clients is popularly called), Ramsey reproduces charts of stock prices for years ending in 7, going all the way back to 1887, and darned if they all don’t have some sort of swoon around this time of year.
In recent times, the mother of all of these autumnal tumbles was October 1987, when the Dow plunged 22% in a single session. In 1997, the first phase of the Asian currency crisis rippled around the globe. And 10 years ago last week, in August 2007, fissures from the financial crisis, caused by the housing bubble and bust, began to appear. Now it’s 2017, and threats of war loom.
This sort of calendar-based pattern borders on astrology. But Ramsey notes that years ending in 7 follow an election year, either a presidential or midterm vote, although the third year of a presidential term typically is positive.
Looking at the past three years ending in 7, there was a definite monetary or financial event to account for a fall. In 1987, the Federal Reserve was raising short-term interest rates, and long Treasury yields hit 10%, which sent stocks tumbling. In 1997, there was the aforementioned Asian crisis. And the 2007 tumble was preceded by Fed tightening that resulted in a flat yield curve, a reliable indication of restrictive liquidity.
The Fed currently is on a course to reduce accommodation, having raised the federal-funds target four times in increments of 25 basis points (one-quarter of a percentage point) since December 2015, when it was just above zero. In addition, the central bank, under Chair Janet Yellen, is expected to begin to shrink its balance sheet after next month’s Federal Open Market Committee meeting.
The Fed doesn’t look like the culprit this time. The FOMC’s so-called dot plot of year-end fed-funds projections calls for one more 25-basis-point hike from the current target of 1% to 1.25%, as do many Fed watchers’ forecasts. But the fed-funds futures market demurs, giving only a 25.5% probability for such a move, according to Bloomberg data. The latest July readings, reported last week, show inflation continuing to fall short of the central bank’s 2% annual target, worsening the odds for a rate boost.
If there is a market rout in this year of the unlucky 7, let us hope it is a conventional one, caused by the usual economic and monetary suspects, rather than a military conflagration.
WHEN THE DUCKS QUACK, feed them, goes an old Wall Street adage. What the gaggle of institutional investors are squawking for these days are securities that pay something more than the paltry interest on government debt—even if the extra increment of yield is relatively small, given the extra risk. And the main beneficiaries are equity investors.
Major corporations are taking advantage of this seemingly unquenchable desire for income by issuing bonds by the carload to finance acquisitions. Last week, British American Tobacco (ticker: BATS.UK) brought to market the year’s second-biggest corporate bond offering, totaling $17.25 billion, to help fund its $49 billion acquisition of Reynolds American. That was topped by the $22.5 billion deal from AT&T T -0.2356637863315004% AT&T Inc. U.S.: NYSE USD38.1 -0.09 -0.2356637863315004% /Date(1502485409617-0500)/ Volume (Delayed 15m) : 12938431 AFTER HOURS USD38.16 0.06 0.15748031496062992% Volume (Delayed 15m) : 340551 P/E Ratio 17.971698113207548 Market Cap 234486591567.993 Dividend Yield 5.1443569553805775% Rev. per Employee 604228 More quote details and news » (T), discussed here a couple of weeks ago, to fund that company’s $85 billion takeover of Time Warner TWX -0.039238767902687856% Time Warner Inc. U.S.: NYSE USD101.9 -0.04 -0.039238767902687856% /Date(1502485372925-0500)/ Volume (Delayed 15m) : 2317506 AFTER HOURS USD101.95 0.05 0.04906771344455348% Volume (Delayed 15m) : 8712 P/E Ratio 18.97579143389199 Market Cap 79289038427.2486 Dividend Yield 1.5799803729146222% Rev. per Employee 1204920 More quote details and news » (TWX).
Later in the week, BAT followed up with offerings in Europe totaling 3.1 billion euros ($3.666 billion) and 450 million British pounds ($585 million). Investors around the globe evidently were undeterred by news last month that the U.S. Food and Drug Administration plans to reduce nicotine levels in cigarettes and that the United Kingdom Serious Fraud Office had opened a formal investigation into alleged bribes by BAT of officials in Africa. The bonds did get investment-grade ratings, if just barely: BBB+ from Standard & Poor’s and Baa2 from Moody’s.
But perhaps the best example of the seller’s market in bonds was Tesla’s TSLA 0.694991558806978% Tesla Inc. U.S.: Nasdaq USD357.87 2.47 0.694991558806978% /Date(1502485200178-0500)/ Volume (Delayed 15m) : 4317121 AFTER HOURS USD358 0.13 0.036326040182189066% Volume (Delayed 15m) : 48662 P/E Ratio N/A Market Cap 59311636438.678 Dividend Yield N/A Rev. per Employee 566241 More quote details and news » (TSLA) $1.8 billion offering of eight-year notes, upsized from $1.5 billion originally, which yielded only 5.30%. That’s a relatively small increment of 3.2 percentage points over comparable Treasuries, despite the notes’ junk ratings of B- by S&P and B3 by Moody’s.
Yet even at that low interest cost, it doesn’t make sense for Tesla to issue debt, according to Aswath Damodaran, finance professor at New York University’s Stern School of Business. The electric-car maker would have done far better to have used its soaring stock to fund its cash needs to support rapid growth. The deductibility of interest costs isn’t of any use to Elon Musk’s outfit, as it continues to lose money and already has close to $4.3 billion in tax-loss carryforwards, he writes on his Musing on Markets blog.
Tesla apparently is averse to dilution of its common stock, and so opted to issue debt instead, he continues. But that’s a risk. “Adding a contractual commitment to make interest payments, on top of all of the other capital needs that the company has, strikes me as imprudent,” he observes. Damodaran calculates Tesla’s debt at $10.3 billion, including lease obligations, before the latest borrowing.
The company would have been far better served to issue convertible debt, as it did in 2014. As this column has observed, Tesla then was making the most of the irrational exuberance for its shares. In effect, Musk was able to sell high-priced (that is, low-yielding) debt with high-priced options to purchase the company’s high-priced shares. At Friday’s closing price of $357.87, those options would be close to being in the money.
Tesla was able to take advantage of a strong high-yield bond market by netting a borrowing cost more consistent with a double-B credit, says Cliff Noreen, deputy chief investment officer at MassMutual. But given that buyers of Tesla’s new bonds get only a small spread over Treasuries, it strikes him as less of a good deal for them. As NYU’s Damodaran concludes, Tesla bond investors get none of the upside for their risk. Shareholders owe them a debt of gratitude.
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