Why Things Could Soon Get Ugly For Stock Investors

bear marketMy Comments: Another voice predicting woe and gloom. I’ve tried to protect myself and my clients but there are no guarantees.

By Scott Barlow on Wednesday, Dec. 09, 2015

We’re about to find out what happens when a market rally built on a foundation of cheap borrowing rates is faced with the end of a credit cycle. It might not be pretty for equity investors.

The U.S. Federal Reserve’s slashing of interest rates from 5.25 per cent to 0.25 per cent during the financial crisis boosted stock prices in three ways. First, corporate chief financial officers were able to lower interest expenses by refinancing debt at lower rates. Second, companies borrowed funds at low rates to buy back stock, which increased earnings per share by reducing the number of shares outstanding (even if actual profits didn’t grow). Third, low yields motivated bond investors to buy equities, which drove valuation levels and stock prices higher.

There are now signs that the global credit cycle is rolling over – from expansion to contraction – and this threatens to severely undermine equity performance. The happy process whereby low interest rates led to corporate borrowing, share buybacks, higher valuations and higher stock prices may be about to work in reverse.

The shale oil producer industry has been the poster child for the cheap credit era. Shale producers financed new production capacity at very low borrowing rates but the cycle went too far. The trend resulted in an oil glut that drove crude prices lower by more than 50 per cent and, at this point, many debt-laden producers are struggling to make interest payment on their loans. Similar financial distress is now evident throughout the mining industry.

Financial strain, and even bond defaults, are not huge surprises to investors at this point. More alarmingly, there are indications that the pain is spreading beyond the commodity complex. Deutsche Bank research, as cited by the Financial Times, writes “From its starting point in energy a year ago, [the percentage of companies in ‘deep financial distress’] has now reached other commodity-sensitive areas such as transportation, materials, capital goods, and commercial services. But it did not stop here and is also visible in places like retail, gaming, media, consumer staples, and technology – all areas that were widely expected to be insulated from low oil prices, if not even benefiting from them.”

An increasing number of companies are now shut out of corporate bond markets, either because they can’t afford to pay the rising interest rates – the average yield on U.S. high yield bonds has exploded to more than 16 per cent above Treasury bonds – or because investors are no longer interested in buying their debt. Standard & Poor’s has counted at least 100 defaults globally already in 2015 and UBS has estimated more than $700-billion in corporate debt is at risk of further default over the next couple of years.

To make matters worse, corporate access to capital is being curtailed at the same time aggregate S&P 500 earnings is declining. Trailing 12-month earnings per share for the S&P 500 is currently $111.9, 1.1 per cent lower than $113 in December of 2014. This is being termed an “earnings recession.” Energy is the biggest problem – down 55 per cent from a year ago – but materials, industrials and financials are also seeing negative year-over-year earnings growth.

The Fed has never raised interest rates during an earnings recession but it looks very much like this is going to happen on Dec. 16. Markets, understandably, are already becoming twitchy and volatile.

Declining profits and rising interest rates are not a good recipe for investors. Stocks are expensive, struggling for revenue and earnings growth, while the Fed is about to raise rates and crimp the refinancing and buyback activity that helped the market rally.

The first quarter of 2016 is likely to see sluggish, minefield-laden markets. Investors will have to be nimble to avoid asset price downdrafts and look harder for profit growth.