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The 'Put' That's Really Driving US Equities Is Not Ben Bernanke's


Last Friday investors witnessed a key event illustrating the current bull market dynamic.

I wrote the article below on the evening of July 22. Not much has changed in the week since, except that new bond issuance grew even hotter, with more than $35 billion of bonds sold in the last five days, and we discovered Apple (NASDAQ:AAPL) has already executed on about half of its $50 billion buyback plan. Not much, that is, until Friday morning, when a transaction took place that encapsulates the driving forces behind equities for the last four years. With that tease out there, I'll save the best for last and offer you the following thoughts and anecdotes, which, even if a week old, are just as relevant this morning.

From an articled written on July 22, 2013:

As I left the office behind for some family time in the old country (Italy), the corporate credit market was on fire, with credit default swaps of large US financials down 5-8%, PIIGS sovereign CDS down double-digit bps (Portugal who?), and a new issue bond calendar jam-packed with offerings, especially if you consider we are right in the midst of the dog days of summer. Now on the plane and reading through today's Bloomberg Leveraged Finance newsletter, I realize I've actually missed some of the really juicy parts of what's happening in bond land. Take a gander at these headlines:
  • "New Jersey Division of Investments may add as much as $500 million next year to its $3.5 billion in HY investments."
  • Continental Resources (NYSE:CLR) looking to refinance 8.25% notes of 2019; if all goes the same as its other recent refis, it should be able to slash its rate in half.
  • "MPH Intermediate Holding Company scheduled to sell $750 million in PIK toggle notes (read: I'll pay you interest on my debt with more debt). Proceeds together with a $100 million add-on to term loan were earmarked to fund a distribution to shareholders of the parent company." (The deal was completed mid last week.)
  • "Harbor Freight Tools set the rate on a $1 billion covenant-light term loan to refinance debt and support a dividend."
  • And the much watched HY Bond Funds, which have little to do with the real health of corporate bonds but are nonetheless the obsessive focus of many fixed income "worriers," had the biggest inflow weeks since February of 2012.
I didn't have the chance to scroll through the news on structured products such as CDOs and CLOs, but when I do I fully expect to find more of those monsters created and sold to yield-starved buyers.

What for equities then? Over the weekend (July 20-21), I noticed a slew of tweets comparing the current stock market environment to the 2007 pre-crash euphoria. I tweeted back that if you look at what was happening in the 2007 bond market pre- and post-Bear Sterns, you'd see that everything from HY spreads to bond issuance was heading in the wrong direction. Today, the environment is almost diametrically opposite.

I share the view that earnings, for the most part, are stinking up the joint, and despite a fair amount of optimism in the media, I'd rather wait to see the signs of a real US recovery before believing we are in something more than a liquidity high. But for better or worse (almost certainly the latter...eventually), reality doesn't quite matter to the current dynamic of equities. The only thing that matters is the ability of companies to fund their buybacks, dividends, and distributions to shareholders.

Tomorrow night (July 23) we may well get the quintessential example of the above when Apple reports its earnings. I have no idea if they will be good or bad, though I have very little reason for optimism. What I do know is that at some price below where it trades right now there is an immovable $50 billion debt-funded stock bid, and when that is turned on, no amount of fundamental or technical analysis, forecasting, and opining will matter: When that buyback kicks in, the stock will go only in one direction -- up.

If you are muttering to yourself that this game will end horribly, horribly bad, I am with you 100%. I was telling myself the same thing in 2005 and 2006 when I was relentlessly shorting the homebuilders, and banks that no longer exist. As it turns out I was 100% correct, and what I have to show for it is a P/L statement worthy only to be burnt. The day to go all in on the short side and sell every rip will undoubtedly come, but not as long as the AAPLs of the world continue to be fed money to engineer their stocks higher.

Little did I know at the time I wrote the above, that come Friday morning, the AAPL buyback would be upstaged by what is perhaps the crown jewel (to date at least) of the current bull market dynamic: the recapitalization plan by Activision Blizzard (NASDAQ:ATVI). Here are the salient terms of the transaction as summarized by StreetAccount:
Activision Blizzard has reached an agreement under which it will acquire from Vivendi (EPA:VIV) approximately 429M Company shares and certain tax attributes, in exchange for approximately $5.83B in cash.... ATVI expects that its new outstanding share count and capital structure (which will include approximately $1.4B of net debt) will result in expected pro forma 2013 EPS accretion of between 18-29% on a GAAP basis and 23-33% on a non-GAAP basis.

The highlighted portion above is key because, prior to this transaction, ATVI carried $4.3 billion of net cash on its balance sheet. That means that this deal, the jump in ATVI's stock, the accretion to earnings, and everything else that inures to the benefit of shareholders (and, let's not forget, ATVI's insiders), hinges on, and is made possible by the ability of ATVI to borrow billions of dollars in the bond market. No bond sales = no deal = no EPS accretion = a stock price that continues to languish as it has for almost five years. Introduce debt in the equation and without any changes to the fundamentals of the company or the industry, the stock price is 15% higher overnight.

This is what the current bull market is all about. Day to day the market may go up or down some, and macro factors can scare it into sharp corrections every once in a while, but in the end, stocks and the market will move based on companies buying back their own stocks, and those proceeds being reinvested in other stocks. Based on companies' balance sheets and the amounts they are able to borrow, that's the real "put" under the market, one that doesn't appear to be going away any time soon.

Twitter: @FZucchi
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Position in AAPL.
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