An Early Winter for Corporate America

Stocks have started out the month of October in a sluggish fashion, with the S&P 500 off about -2% so far this month.

The market has been weighed down largely by weak corporate earnings reports.  Through the end of last week, 61% of the 127 companies in the S&P have missed revenue expectations, although more than half have beaten earnings estimates.


The gloomy mood of the market has not been helped by the downbeat commentary from corporate chiefs, who have generally reported that the economy has clearly slowed from earlier in the year.

It seems to me that some of the slowdown is not totally unexpected.  If I were head of a major corporation, I would be slow to initiate any new projects without a clearer picture of what government policies will be in 2013, especially with regards to taxes.

Then there is the whole issue of the fiscal cliff.  If Congress does not act before the end of the year, a whole host of draconian federal budget cuts kick in, and our fragile economy could be delivered a major blow.

So most of corporate America is hunkered down, building cash and delaying projects.  General Electric, for example, did a $5 billion bond issue earlier this week for the express purpose of building cash reserves in case Congress does not act before year end.  Corporations are borrowing, but then tucking the proceeds into cash reserves.

The cash build is startling.  Here's what CNBC said this morning:

Corporations are stowing away cash at record rates, reluctant to invest in their businesses or hire new workers as uncertainty clouds the future.

Amid a lackluster earning season that has featured many companies missing sales expectations, cash balances have swelled 14 percent and are on track toward $1.5 trillion for the Standard & Poor's 500, according to JPMorgan. Both levels would be historic highs.

http://www.cnbc.com/id/49519419

Meanwhile, the public remains skittish about stocks.  Ned Davis Research (NDR) noted this morning that the public pulled $10.6 billion out of domestic equity mutual funds last weeks, the largest outflow since August 2011.

NDR goes on to say that a last week's poll from the American Association of Individual Investors showed just 28.7% bulls, while 44.6% are bearish.

Historically lots of cash on the sidelines, and bearish sentiment building,  would set up the market for a pretty powerful rally.

Will this time be different?

Should I Worry About The Corporate Bond Market?

In 2008, well before the stock market collapsed in the aftermath of the Lehman Brothers bankruptcy, the corporate debt markets were signalling trouble ahead.

Corporate spreads (i.e., the yield premium of corporate bonds relative to U.S. Treasury obligations) started to widen in early 2008 as bond buyers nervously asked for more yield concessions in order to take on new positions, and continued to gap higher right into the Lehman failure.

Ultimately the credit markets froze in October 2008, and a full-fledged credit crisis ensued. It was not until March 2009, after aggressive intervention by the Federal Reserve and the U.S. Treasury, that some sort of relative calm returned to the capital markets.

So it was with some concern that I read an article in this morning's Financial Times titled "Investors demand big yield premiums on corporate bonds".  Here's an excerpt:

Investors are demanding significant yield premiums to buy new corporate debt being sold in the U.S. as compensation for the rise in market volatility stemming from the worsening of the debt crisis in Europe.

Bankers estimate that for investment-grade bonds, investors are asking for yields that are on average 20-25 basis points higher than where existing bonds by the same issuer are trading in secondary markets.

That is the highest so-called new issue concession since the start of the year.

http://www.ft.com/intl/cms/s/0/545b558c-b94f-11e1-b4d6-00144feabdc0.html#axzz1yFvs4Ikh

The piece goes on to note that new corporate bond issuance is running at just $28 billion this month, compared to a monthly average of $88 billion, according to Dealogic.

After reading this article, I walked down the hall to talk to my friend Barbara Cummings about what's going on in the bond market.

Barbara runs the bond area here at Boston Private Bank, and is particularly knowledgeable about corporate bonds.

Barbara told me that while things are not great in the credit markets - everyone is nervous about Europe - we are not yet in conditions similar to 2008.

Apparently there are a couple of factors influencing the debt markets today.

First, investors are reluctant to give up their existing bond holdings for new issues because of today's lower rates.  They would rather hold onto an older issue with, say, a 3% coupon, rather than swap into a new issue with a coupon of 2% or less, regardless of yield-to-maturity.

And, second, current bids for older corporate bonds in the secondary market also weak.  This is the result not only of investment concerns, but also because new stricter capital requirements make banks less eager to tie up capital in low margin fixed income business.  Thus bond swaps - selling older issues for new ones - are less easily accomplished.

So I asked Barbara:

"Should I worry?"

"Oh,"Barbara replied with a smile, "you can worry about lots of things - you always do - but I wouldn't read too much into the current corporate bond markets."

Corporate Treasurers Continue to Stockpile Cash

Around the world, corporations are awash in cash.

There is an estimated $1.9 trillion stashed in US corporate coffers, yet the dividend payout ratio for the S&P 500 is a meager 26%.

Numerous companies are sitting on cash stockpiles that are far in excess of any possible corporate use; Apple, for example, will have nearly $80 billion in cash by the middle of next year, yet does not pay a dividend.

So why are corporations continuing to raise cash at record rates?

Nearly $20 billion in new corporate debt issues came to market yesterday, and underwriters are looking to sell an additional $10 billion or more in this holiday-shortened week. Only one company - Amgen - has announced that it will be doing a stock buyback with the proceeds of its $6 billion offering. The rest apparently are just going to hold onto the cash.

According to CNBC:

If the corporate issuance this week surpasses $30 billion, it would be for the fourth time this year. The last was in May, when the week of May 20, issuance reached $35.97 billion. There have been 11 weeks of $30 billion plus issuance since April, 2008.

http://www.cnbc.com/id/45194318

Corporate treasurers are justifiably nervous about the state of the credit markets. They remember all too well the credit crunch of 2008, when borrowing window slammed shut for all but the highest rated borrowers. Better to stash cash in Treasury bills - even at 0% interest rates - than to not be able to fund normal business operations.

And it's not likely that we will see a resurgence in M&A activity, even though it might make sense. Citing a survey from Fidelity International, here's an excerpt from another article on CNBC yesterday:

Companies' cautious outlook has also led firms to avoid growth through acquisitions, the survey said, adding however that conditions were right for a resurgence of M&A activity given strong balance sheets, low interest rates and attractive valuations.

Fidelity analysts said roughly 84 percent of companies they covered had either dismissed M&A entirely to drive growth or were only considering it on a small scale.

"That's because they are generally paralyzed with fear about what's going on in the world, and they don't really want to do anything with the cash," {one Fidelity analyst}said.

"They are worried that they may have to survive a six-month period where global liquidity freezes again."

http://www.cnbc.com/id/45200565

With interest rates so low, huge positions in cash are not especially helpful to shareholders, but it appears that caution is outweighing investment considerations for the time being.