Thursday, November 22, 2007

Tactical Nukes

The fundamental case for a bull market died a long time ago and has not terribly sound in a long, given the combination of high valuations, slowing growth and a significant portion of earnings that were an outright illusion. Strategically speaking, the last time the bull case made any sense was in early 2006. That has not prevented tactical factors from pushing an overvalued market still higher in the interim. The primary tactical focus has been "liquidity" which readers of this blog will recognize as simply a synonym for growing debt.

The UDB threw off a tremendous amount of this "liquidity" as debt expanded rapidly. The serial collapse of mortgage finance, CDOs, MBS, asset-backed CP and other debt markets has reversed the flow as outstanding debt/credit shrinks. But how is this affecting stocks, you might ask? Well, there is the obvious collapse of profits in the building and financial sector as well as similar impending action in the consumer sector. But these are indirect effects and failed to knock down the indexes for long until recently.

There is now a much more direct impact on supply and demand for stocks and the financial pressures are affecting both sides of the equation. On the supply side, many distressed financial firms will be forced to issue new equity to bolster their crumbling capital base. Two major sources of "greater fool" demand for stocks have essentially disappeared - leveraged buyouts and corporate buybacks financed with debt. Lenders are no longer willing to finance such foolishness now that it has been exposed as such. The WSJ has this to say:

Driven by billions of dollars in share buybacks, record-setting buyouts and a wave of mergers, the amount of stock in the market shrank by hundreds of billions of dollars in the past four years.

With the supply of stock down and demand strong, the market rallied. Now, as the economy slows and credit markets buckle, high-profile companies are cutting back on buybacks, and some wish they held on to the cash they gave back to shareholders.

The reversal of the trend exposes a flaw in the buyback strategy -- many companies bought high and are selling low.


Big Buybacks Begin to Haunt Firms

"Liquidity" has been removed. LBOs of any real size are dead. Instead of buying back shares to reduce the supply, corporations are starting to issue more stock and increase supply just as demand is falling. It looks to me as if the even the tactical bull case has been nuked at this point. The strategic case is long-dead. What is the reason to still own stocks today?