The relationship between low rates and inflated stock prices is dangerous, and that danger is likely impacting your money.
As market veterans who’ve seen this movie before, we’d like to make this point stick with another source of entertaining fiction – Netflix.
The company’s taken on a frankly disturbing amount of debt, something that even a market darling FAANG stock isn’t safe from.
First, the Backdrop
The pulse of the bond market (and hence the current stock market bubble) rests on low interest rates and borrowing costs, driven by those compressed yields on the 10-year U.S. Treasury.
As you know by now, yields on that benchmark Treasury Bond recently hit the basement of history:
When the cost of borrowing hits a bargain basement like this, companies naturally borrow.
In fact, they borrow and borrow and borrow more, almost tripling the levels of corporate debt seen on the eve of the Great Financial Crisis of 2008.
Is such borrowing a bad thing?
If that borrowed corporate money is used for new capacity outlays (CapEx) and overall corporate building from within, it can actually be a good thing, especially if a company has the revenue to pay back the well-used debt in an orderly way.
If, however, fathead executives use that borrowed money to buy back their own shares and hence fatten their share-price-measured salaries, that’s not only bad, but it’s also sickening. A true horror film.
With that said, guess where the borrowing has gone in corporate America. You guessed it – corporate stock buybacks.
And I’m talking about massive, historically unprecedented levels.
In effect, the primary buyer of U.S. corporate stocks has been the corporations themselves, not retail investors or other institutions – i.e. natural demand.
This, by the way, is just further proof of a market totally rigged to fail.
In fact, between 2017 and 2019, over 20% of the market cap for the U.S. stock market has been driven by companies drinking their own Kool-Aid – i.e. buying their own stock.
What’s even scarier is that while S&P companies have been going into debt to pay their executives with stock buybacks that distort/inflate their EPS (earnings per share) data, the major institutional buyers have been selling those same stocks to the tune of 7% of the market cap of our equity markets.
Meanwhile, bond buyers (suckers) are slurping up the low-yielding IOUs of these self-serving companies for almost no yield in the foreground of a Fed that has all but murdered natural yield in the broader markets. Just look at the yields on the 10-year U.S. Treasury above.
But it gets worse…
For in addition to drinking their own Kool-Aid to stay alive, the vast majority of these buyback-driven companies are otherwise broke and surviving exclusively off debt. They are like the zombies we’ve seen streaming on hit shows like “The Walking Dead.”
As of today, nearly 75% of the $3.2 trillion gain in market cap is driven by BBB rated securities – i.e. the D- students (and zombies) of the bond market, which means a lot of these corporate bonds will be downgraded to junk status when the inevitable recession becomes official and the debt cycle ends.
Stated otherwise, corporate bonds today are what subprime mortgages were in the melt-up to the 2008 disaster: ticking time bombs.
What About Your Favorites?
Some of you may be thinking that your favorite stocks are safe, well-capitalized, and debt savvy. Perhaps you’re thinking those infamous big tech FAANG stocks are the A+ students?
Think again. Here’s a peek behind the curtain of one stock in particular to make this sad reality sink in…
Specifically, I’m talking about Netflix, otherwise known by many of us math geeks as “Debtflix.”
Netflix, of course, streams some pretty cool content. I’m a subscriber, but I’m not a stockholder. And here’s why.
The hard fact is that Netflix subscribers like me are not triggering enough revenue for the company at the levels necessary to cover marketing and other expenses essential to making the company even remotely close to profitable.
To cover this widening gap, Netflix is taking on debt. Lots and lots of it.
In terms of free cash flow (FCF), Netflix is burning through cash at record speed. Other bad boys in the FCF burn race to the bottom include Uber, Snapchat, Lyft, and Tesla. Together, they’ve posted an astounding $24 billion in negative cash flows since their respective launches.
But Netflix is outpacing even these class clowns, posting negative cash flows of $1.7 billion in 2016, $4.8 billion in both 2017 and 2018, and another $1.2 billion for the first half of 2019.
And at the same time, Netflix has been burning through cash, it has been stacking up a mountain of debt to cover the shortfalls. And guess who’s been watching those default risks rising… Netflix stockholders, of course.
Since 2016, it has added $8 billion in debt, once again outpacing the broken balance sheets of Uber, Tesla, and its other broken peers above. Total debt for “Debtflix” now stands at nearly $13 billion, widening the gap even more.
And that is where Netflix stands today – a classic metaphor of a “safe name” losing money, taking on debt, and yet promising some magical bright new day of rising revenues despite strong evidence to the contrary and a recession around the corner.
But hey, why worry? With the Fed slamming rates to the floor, can’t companies like Netflix just borrow forever to keep stock prices elevated on IOUs, revenue promises, and low-rate debt that never goes higher?
If you believe that, then go long Netflix.
If, however, you understand that low rates compressed to historical lows can and will eventually spring forward into balance sheet-killing rising rates, I’d suggest you think differently.
At the current and compressed rates, S&P companies spend about $20 per share to service their debt. But if interest rates climb by just 2% (and they eventually will), the cost per share to service that same debt climbs to over $50 per share, which means companies will need to dip into their fake earnings just to cover interest expenses on their debt.
Needless to say, that’s when earnings fall like rocks and hence stock prices, too. And that, by the way, is when I’ll be telling you to short names like Netflix, not buy them, because over-indebted stocks like these always fall much faster than they rise.
In the meantime, stay informed, stay patient, stay safe… and stay tuned for Monday’s What’s Happening Now. We’re going to show you three startling charts on what’s happening outside our borders that’s heading our way, sooner rather than later, that could put our country (hence our markets) in jeopardy… and therefore all that money that you’ve worked so hard to preserve.
No more hints, but you’re definitely going to want to see this one before Q3 2019 ends (in just two weeks’ time) so you have time to prepare. It’ll be in your inbox Monday.
5 responses to “What Low Rates Do to Your Favorite Stocks”
September 13 2019