Back In The Saddle

My apologies for missing in action last week, but I was battling a pretty nasty cold that kept me from doing most anything, especially writing something coherent.  Thankfully, though, the financial markets did little more than trade within their well-defined ranges once again.  Perhaps, then, it was a good thing for me to be away from the computer since writing about stagnant market would have been quite challenging.  But enough with my issues, let's talk about the markets....

While the S&P 500 did have an impressive move higher, we came into the week about 20 points away from the key resistance level of 1,131.  And continuing the general optimism that has permeated the marketplace over the past couple of weeks, the equity markets finished higher on the day with the S&P 500 closing up 12.35 (1.11%) at 1,121.90.  With this close, the S&P 500 has now finished higher in 10 of the past 12 trading days and is likely getting a bit overbought.  To be sure, today's move above the widely-followed 200-day moving average is a bullish sign.  But since the equity markets' top in April, traders have not been able to hold prices above this average for more than seven sessions before pushing values below once again.  This is not to say that prices can't continue to rise from here, but it does suggest that the rally could be vulnerable to a precipitous move lower at any time.  As such, I would suggest treading lightly in this environment.  Also, be aware that today's equity price action on the S&P 500 has left a price gap on the daily chart that likely will be filled during tomorrow's session.  For this reason, I wouldn't be surprised to see the futures lower in the morning as traders look to take advantage of potential technical selling.  But as with most days, the story will be told in the last 30 minutes of the session, not at the open.

Unlike equities, fixed income traders didn't find any data that foreshadowed improving domestic economic performance and, therefore, bid up debt securities rather robustly.  Treasury bonds saw yields fall across the curve with the benchmark 10-year note yield falling 4.88 basis points to 2.7462%.  To an extent, today's move was a reaction to last week's significant selling pressure that forced yields up nearly 20 basis points.  Furthermore, Friday's price action actually left a small gap on the daily chart of the 10-year yield and, therefore, provided a technically based incentive for traders to add positions on the day.  With this gap now filled, though, the question becomes whether or not the recent backup in yields represents a longer-term change in trend or a temporary phenomenon.  Considering that equity prices are nearing technical resistance and today's divergent price performance between equity and debt, the probability that the short term trend is weakening continues to rise.  As such, I would consider adding Treasury-based positions opportunistically over the next few days.

As followers of this blog are aware, I regularly post links to many of the articles, blog posts, and thought pieces that I find interesting during the day.  My hope, of course, is that by sharing these articles with you I will bring to light perspectives and insights that will widen the collective understanding of the markets and the factors that shape them.  And while I normally leave it up to you to peruse these items at your leisure, I thought that I might highlight a post from the Financial Times Alphaville blog today that, I believe, says a lot about the economic environment we are in.  Here's the post:


Debt/Equity Arbitrage Is Back:


Remember de-equitisation? It was very popular before the Great Recession.
If not here’s a little refresher, via Bloomberg.

Microsoft Corp. is planning to sell debt this year to pay for dividends and share repurchases because too much of its cash is held overseas, according to a person familiar with the matter. The company would try to raise as much as it can without jeopardizing its debt rating, the highest possible, said the person, who declined to be named because the plans are confidential and not completed. Microsoft could raise at least $5 billion without putting the rating at risk, said Jason Brady, a managing director at Thornburg Investment Management.

Chief Executive Officer Steve Ballmer is under pressure to return some of the company’s $36.8 billion in cash and short term investments to investors in the form of dividends or share buybacks. Much of that is held overseas, requiring Microsoft to pay taxes on money brought home.

That’s right, Microsoft is going to issue debt to buyback stock. And why not when debt is this cheap — the average yield on investment-grade debt is currently around 3.96 per cent according to Bloomberg — and free cash-flow yields are in excess of corporate bond yields.
UK companies who could follow Microsoft’s lead include Anglo American, British American Tobacco, AstraZeneca and GlaxoSmithKline. All of these so called mega-caps have free cashflows yields in excess of their cost of debt, low gearing and therefore are in a position to buyback stock.
Debt/equity arbitrage is back.

For those of you who read through this post and began to fall asleep, let me summarize:  Microsoft, in response to shareholder calls for them to return some or all of the cash currently on the company's balance sheet to shareholders, is considering paying out this cash as a special dividend (and repurchasing shares) to shareholders.  But rather than reduce the firm's available capital, they are considering paying for this dividend with the issuance of additional debt securities!  That's right, the firm is considering taking on debt rather than simply paying out their cash.  This says a few things to me:  1) The cost of corporate debt is WAY too low.  As I've posted a few times on this blog, the prices of corporate debt and equity have diverged markedly over the past few months, with debt coming away as the big winner.  While I suggested that this could be a leading indicator of higher share prices, the fact that yields are low enough that a plan like this is even under consideration suggests that debt may over bid.  The fact that this action is not likely to move the company's yields meaningfully is all the more strange as the solvency of the firm would be impaired.  2)  In light of the uncertain economic environment, Microsoft is suggesting that there are fewer and fewer quality investment opportunities available them and, as a result, returning cash to shareholders is a more efficient use of capital.  This is a huge departure from the firm's previous stance on maintaining such a large cash hoard.  3)  Dividends, as an indication of financial health, may be less viable in this environment.  Many look to firms that pay and grow dividends as refuges for their capital since they are largely perceived as financial stable.  Only a firm that has a solid business model and strict capital management practices, the story goes, would be willing and able to pay such dividends.  But as this piece suggests, firms could be enticed into creative financing schemes that could weaken the company's long-term financial position.  To be sure, this report bears watching.

Looking to tomorrow, I suspect equity markets will take a break from the recent rally and put in some technical repairs.  But as I've been saying for what seems like an eternity, I won't get too bullish or too bearish on this market until volume begins to pick up and we get some sort of conviction outside the recent ranges.  Patience, at least for now, will likely prove a virtue.  And with my personal portfolio largely sitting in cash at present, this is all the more difficult.  Sooner or later, though, the markets will show their hand.  Until tomorrow.....