“The great era of equity rallies driven by monetary ease is coming to an end,” I wrote in this space April 19, when the S&P 500 closed at 2,946. The free-fall in US equity prices that followed the Federal Reserve’s expected quarter-point cut in the overnight rate took major indices to within tickling distance of the April 19 close.
The market sold off sharply after Federal Reserve Chairman Jerome Powell told a press conference that Wednesday’s cut isn’t the beginning of a long easing cycle, something he couldn’t have said, whether he believed it or not. Central banks have to keep at least a few of their cards hidden.
The Fed did exactly what the market expected it to do, and the Fed chairman said exactly what he was supposed to today. The market received no new information of any kind. Instead, it reevaluated what it already knew, the way one might wake in the morning with a hangover and reevaluate what one sees on the other pillow.
The companies of the S&P 500 have borrowed cheap money to pay out dividends to shareholders and buy stock back to an extent not seen before the Great Financial Crisis of 2008. The average S&P 500 company returned money to shareholders through dividends and buybacks equal to 75% of its earnings before interest and taxes. Apple, which sailed through the post-Fed market swoon with gains of about 2.5%, paid out 125% of earnings. Its estimated net income is expected to fall this year, but it has so much cash to give back to shareholders that investors continue to buy the stock (I wouldn’t).
Among the worst-performing issues Wednesday afternoon after the Fed announcement were popular consumer staples, which fell nearly 2% while the broad market lost less than 1%. High dividend payers like Coors, Colgate Palmolive, and Philip Morris were down by more than 3%. Coca-Cola was down by about 2%. Stable, defensive, dividend-rich consumer stocks rose as interested rates fell. Coke’s price-earnings ratio soared to 25, compared to just 15 times earnings back in 2015 and 20 times a year ago. The trouble is that the soft-drink giant paid dividends during the past year in excess of 100% of earnings. That troubles investors, and should.
I wrote on July 24 that the explosion of leverage to support distributions to shareholders was a “storm warning” for the stock market. Goldman Sachs’ David Kostin observed in a note to clients July 26: “From an investor perspective, lower interest rates have lifted P/E multiples from 14x to 17x, which contributed nearly 95% of S&P 500’s 20% YTD climb. From a corporate perspective, lower interest rates increase the ability of firms to invest for growth and return cash to shareholders. Share repurchases are pacing for a 26% year over year rise, but payout ratios are elevated, cash balances have declined, and leverage has risen to a new all-time high.” Remarkably, Kostin urged investors to buy companies that have levered aggressively: “Stocks with weak balance sheets have outperformed as expectations for Fed easing have risen and should benefit from a modest acceleration in the pace of US economic growth.”
That has been the way to invest during the past eight months, as the Federal Reserve shifted from mildly restrictive to accommodative. But Herb Stein’s law applies: “If something can’t go on forever, it won’t.” Corporate profits before tax and depreciation adjustments have been falling for the past seven years, according to the Commerce Department’s National Income and Product Accounts (which tabulate profits from corporate tax returns). Corporate accountants have learned to make more soup with less chicken, and investors have lapped it up in the absence of nutritious alternatives in the bond market. Today’s response to the Fed is a warning that levering up mediocre earnings can’t support stock prices forever.