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According to flow of funds data, the nonfinancial corporate sector spent nearly $1 trillion annualized on dividends and buybacks in Q2, or almost 6% of GDP. That’s just shy of the best level outside of the 2007buyback binge. This has been made possible by flush balance sheets, which held $1.6 trillion in cash and equivalents. Earnings growth and related cash flows have helped build up those cash balances, but businesses have also been tapping credit markets in the current low rate/low spread environment. Corporate bonds outstanding were up more than 7% in the past year; using at least some of the proceeds to payout shareholders or buy back stock. This is not the backdrop we want to see to support higher stock prices as it is clearly unsustainable, particularly if interest rates head higher at some point.
But we also wanted to point out that the news is not all bad going forward. The Global Earnings Revisions Ratio produced by BAML inched higher (from 0.83 to 0.84) in July. The slow improvement in earnings, if it continues, would be good news for the equity markets. The ratio saw a broad improvement across all regions with the US and Japan leading the gains. In terms of the industries driving the improvement, earnings revisions remain highest for Technology Hardware, supporting our continued overweight position in that sector. The ratio also improved for late-cyclical stock groups, specifically the Energy and Basic Materials sectors. However we would want to see if that improvement continues once the 3rd quarter earnings are released.
The bottom line is that we expect increased volatility over the next month and some more weakness in stocks as well. The U.S. market has held up relatively well and is only about 3% below its all-time high as this is written. The risk-reward for stocks in that market is not favourable at this time and bonds are not a good alternative as we see little room for interest rates to drop any further. We continue to have a minimum exposure to stocks for now and have built up cash balances in all of our balanced accounts. We remain net ‘short’ the market in our hedge fund. The economic data out of the U.S. and the third quarter earnings reports will be key to how markets behave in the fourth quarter. For now we remain cautious.