Dissecting A Losing Trade

Taking a loss in investing hurts. There is  a mourning period of a few days after I take a loss where a gloom seems to hang over me and I constantly think about what went wrong. Fortunately, losses are also the best way to become a better investor if the proper lessons are taken away.

I took a position in DOLE about two weeks ago upon the announcement of a $200 million share repurchase, which amounted to about a third of the float. I have had very positive experiences with companies that repurchase a large percentage of their shares. I have never seen a company announce a share repurchase for a third of their float.

Aside from the large share repurchase there appeared to be value in the shares of Dole. The market cap was less than a billion dollars and net debt very low. There is as much as $600 million in underutilized real estate that could be sold. Dole is cutting expenses and should be able to produce over $250 million in EBITDA once the cost cuts are in effect. In addition to the seemingly cheap stock and enormous repurchase, an insider owns over 30% of the shares. The upside seemed very compelling.

There were also some aspects of  Dole that I chose to overlook. I prefer to own companies whose businesses are less cyclical and produce steady free cash flow. As a commodity producer in the midst of a restructuring Dole did not meet either of these criteria.

Yesterday, Dole announced a suspension of their share repurchase  two weeks after it was announced. That sort of a  turnaround is unprecedented and could not be expected. However, it was the aspects of the company that I chose to overlook that led to this turnabout.

Was my purchase of Dole an unforced error or a case of  "shit happens"? It is possible to make  a case for both sides, which will probably lead to a few more days of contemplation.

Share Repurchase Fever

After a market rally that has lasted more than a half a year bullish sentiment recently reached the types of extremes seen once every few years. It used to be the case that this type of extreme sentiment would be a reliable indicator for an intermediate term market top. However, that does not seem to be the case this time around. The market pulled back for three days and now seems to be resuming its rally this morning. I believe the reason for this behavior is the historic level of stock repurchases we are seeing. From Bloomberg:
About 79 percent of buyback orders at Goldman Sachs Group Inc.’s corporate trading desk were active yesterday, the most this year, according to a note to clients obtained by Bloomberg News. Companies stepped up purchases as the Standard & Poor’s 500 Index fell as much as 3 percent from an intraday record reached May 22.

The buybacks may have limited losses in American equities after shares in Japan fell the most in two years and stock markets from London to Paris and Frankfurt saw declines of more than 2 percent.

In the current market environment it is crucial to monitor share repurchases.  Here are some things to be on the lookout for:

  • A change in the economic or interest rate backdrop that slows the pace of share repurchases.

  • As prices rise it takes an increasing amount of share repurchases to have the same effect. We could reach a point where share repurchases produce diminishing returns, although we do not seem to be there yet.

  • Insider selling and share issuance begins to outpace the share repurchases and cash M&A.

I used last week's decline to take in many of the shorts I had been scaling into and am now very modestly net long. The reason I did so was that it seems futile to fight these share repurchases, even though I believe the market has gotten ahead of itself.

As Long As The Music Is Playing

Credit Suisse reports that through last week there have been $320 billion in announced share repurchases in 2013. For reference announced repurchases  for the entire year of 2012 were $477 billion and 2012 was a strong year for repurchases. At the current pace there will be well over $800 billion in announced share repurchases in 2013. If indeed corporations repurchase that much stock it would amount to over $3 billion every trading day. I don't believe that corporations will be able to keep up the current pace but even at a somewhat more moderate pace these numbers are astounding.

In the short run a steady buyer of billions of dollars of shares a day cannot be painted any way other than extremely bullish. In the bigger picture this is creating valuations that are unsustainable and will eventually lead to the third reckoning since the new millennium.

Many point to the record cash on the balance sheets of US corporations as justification for the current binge. They ignore the other side of the balance sheet where debt has soared by far more than cash. JPMorgan reports that net debt at corporations ex-autos is at a record of over $1.9 trillion up from under $1.2 trillion at the beginning of 2007.

The S&P 500 is currently trading somewhere between 15 and 16 times forward earnings, well above the historical average. One can also argue that the earnings number is being artificially inflated by low interest costs and an economy artificially propped up by zero rates. However, there is nothing easily identifiable on the horizon that will derail the current share repurchase binge. All this places us squarely in a third game of musical chairs where the music is still playing.

Does Sentiment Still Matter

I have spent far less time discussing market sentiment this year than in previous years. The reason being that I believe that the marginal buyers of stocks have been corporations repurchasing stock and buying other companies for cash. The level of float shrinkage is setting records. Corporations repurchasing shares have no sentiment. They just keep buying steadily on a daily basis.

I still believe that market sentiment matters but in the current environment it matters less than usual. It takes larger extremes in bullish sentiment to knock down the market when there is an underlying bid from corporations. I believe that we are nearing a point where sentiment is extreme enough to matter. The vast majority of the sentiment indicators I track are now urging caution and the market is stretched:

  • Investors Intelligence bears are below 20% while the bulls are at 54%

  • Newsletter writers tracked by Hulbert are recommending the largest long position in stocks since January 2002.

  • Rydex traders are positioned at a bullish extreme

  • Investment advisers tracked by NAAIM stock exposure remains at the upper end of historical allocations.

  • The most speculative of stocks are flying.

  • Margin debt is nearing record levels.

While sentiment has not mattered all year there are now a confluence of indicators in extreme territory. At the same time breadth has been lagging in recent days. If sentiment still matters at all this should be the time when it asserts itself. Normally, I would expect an intermediate term top under these conditions. But with the underlying bid from corporations still present I would not be shocked to only see a shorter term correction.  I am expecting a 3% to 5% pullback at a minimum leading me to take a net short position in the market.