Uber’s $91bn IPO marks the top for today’s debt-fuelled stock markets

Uber’s IPO next month is set to effectively “ring the bell” at the top of the post-2008 equity bull market on Wall Street.  True, it is now expecting to be valued at a “bargain” $91bn, rather than the $120bn originally forecast. But as the Financial Times has noted:

“Founded in 2009, it has never made a profit in the past decade. Last year it recorded $3.3bn of losses on revenues of $11bn.”

And Friday’s updated prospectus confirmed that it lost up to $1.1bn in Q1 on revenue of $3.1bn. In more normal times, Uber would have been allowed to go bankrupt long ago,

So why have investors been so keen to continue to throw money at the business?  The answer lies in the chart above, which shows how debt has come to dominate the US economy.  It shows the cumulative growth in US GDP since 1966 (using Bureau of Economic Analysis data), versus the cumulative growth in US public debt (using Federal Reserve of St Louis data):

  • From 1966 – 1979, each dollar of debt was very productive, creating $4.70 of GDP
  • From 1980 – 1999, each dollar was still moderately efficient, creating $1.20 of GDP
  • Since 2000, however, and the start of the Federal Reserve’s subprime and quantitative easing stimulus programmes, each dollar of debt has destroyed value, creating just $0.38c of GDP

After all, if one ignores all the hype, Uber is just a very ordinary business doing very ordinary things.  Most people, after all, could probably run a serially loss-making taxi and food delivery service, as long as someone else agreed to keep funding it.

Yes, like the other “unicorns”, it has a very customer-friendly app to help customers to use its service. But in terms of its business model:

  • When one takes a ride with Uber, the driver often also drives for Lyft and for the local taxi firm, and her car is often also the same car
  • This means that in reality, Uber’s main competitive advantage is its ability to subsidise the ride or the food bought via Uber Eats

DEBT HAS CHANGED FINANCIAL MARKET BEHAVIOUR

This addiction to debt on such a scale, and for such a long period, has changed financial market behaviour.

Nobody now needs to do the hard graft of evaluating industry dynamics, business models and management capability.  Instead, they just need to focus on buying into a “hot sector” with a “story stock”, and then sit back to enjoy the ride. The chart above from Prof Jay Ritter confirms the paradigm shift that has taken place:

  • It highlights how 80% of all IPOs last year were loss-making, compared to around 20% before 2000
  • The only parallel is with the late 1990s, when dot.com companies persuaded credulous investors that website visits were a leading indicator for profit

Like other so-called “unicorns with $1bn+ valuations, today’s debt-fuelled markets have allowed Uber to raise money for years in the private markets. So why has Uber now chosen to IPO, and to accept a valuation at least 25% below its original target?.

CORPORATE DEBT IS INCREASINGLY FUNDING STOCK BUYBACKS TO SUPPORT SHARE PRICES

The above 2 charts from the Wall Street Journal start to suggest the background to its decision:

  • They show the ratio of US corporate debt to GDP has now reached an all-time high at 48%.  The quality of this debt has also reduced, with the majority now just BBB-rated and with record levels of leverage
  • BBB ratings are just above junk, and most major investment managers are not allowed to hold junk-rated bonds in their portfolio. So they would have to sell, quickly, if this debt was downgraded

The problem is that much of the corporate debt raised in recent years has gone to fund share buybacks rather than investment for the future. President Trump’s tax cuts meant buybacks hit a record $806bn last year, versus the previous record of $589bn in 2007.  According to Federal Reserve data, investors sold a net $1.1bn of shares over the past 5 years – yet stock markets powered ahead as buybacks totalled $2.95bn.  As Goldman Sachs notes:

“Repurchases have consistently been the largest source of US equity demand. Since 2010, corporate demand for shares has far exceeded demand from all other investor categories combined.”

THE FED’S RECENT PANIC OVER INTEREST RATES HIGHLIGHTS THE STOCK MARKET RISK

Against this background, it is not hard to see why the US Federal Reserve panicked in January as 10-year interest rates rose beyond 3%.  For years, the Fed has believed, as its then Chairman Ben Bernanke argued in November 2010 that:

“Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”

Rising interest rates are likely to puncture the debt bubble that their stimulus policy has created – by reducing corporate earnings and increasing borrowing costs for buybacks.

Uber’s IPO suggests that the “smart money” behind Uber’s IPO – and that of the other “unicorns” now rushing to market – has decided to cash out whilst it still can, despite the valuation being cut. They must have worried that in more normal markets, they would never be able to float a serially loss-making company at a hoped-for $91bn valuation.

If they really believed Uber was finally about to turn the corner and become profitable at last, why would they accept a valuation some 25% below their original target of less than  a month ago?  The rest of us might want to worry about what they know, that we don’t.

Stock markets risk Wile E. Coyote fall despite Powell’s rush to support the S&P 500

How can companies and investors avoid losing money as the global economy goes into a China-led recession?  That’s the key question as we enter 2019.  We have reached a fork in the road:

The central banks’ aim was set out in November 2010 by US Federal Reserve Chairman, Ben Bernanke:

“Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”

And the current Chairman, Jay Powell, rushed to calm investors on Friday by confirming this policy:

“We will be prepared to adjust policy quickly and flexibly and use all of our tools to support the economy should that be appropriate.”

His words confirm he equates “the economy” with the stock market, as the chart shows:

  • The Fed no longer sees its core mandate on jobs and prices as defining its role
  • Instead it has become focused on making sure the S&P 500 moves steadily upwards
  • Every time the S&P 500t flirts with breaking the lower “tramline”, the Fed rushes to its rescue

Like Wile E Coyote in the Road Runner cartoons, the Fed has used more and more absurdly complex strategies to try and keep the market going upwards.  But now it is very close to finding itself over the cliff edge.

CORPORATE DEBT IS THE KEY RISK FOR 2019

The Fed should have realised long ago that markets cannot keep climbing forever.  Instead, by printing $4tn of free cash, it has temporarily destroyed their key role of price discovery.  As a result:

  • Investors now have no idea if are paying too much for their purchases
  • Companies don’t know if their new investments will actually make money

We are heading almost inevitably to another  ‘Minsky Moment’ as I described in September 2008,:

“Earnings from the new investments prove too low to pay the interest due on the debt. Confidence in the ‘new paradigm’ disappears and, with it, market liquidity. Investors find themselves unable to sell the under-performing asset, and suddenly realise they have over-paid. In turn, this prompts a rush for the exits. Prices then begin to drop quite sharply, as ‘distress sales’ take place.

This time, however, the risk is in corporate debt, not US subprime lending.  As the charts above show:

  • The ratio of US corporate debt to GDP has reached an eye-watering 46%, higher than ever before
  • Lending standards have collapsed with most investment debt in the lowest “Triple B” grade

Investors’ obviously loved Powell’s confirmation on Friday that he is determined to cover their backs. But they may start to remember over the weekend that the cause of Thursday’s collapse was Apple’s problems in China – about which, the Fed can actually do very little.

And whilst Apple won’t go bankrupt any time soon, weaker companies in its supply chain certainly face this risk – as do other companies dependent on sales in China.  And as their sales volumes and profits start to fall, investors similarly risk finding that large numbers of companies with “Triple B” ratings have suddenly been re-rated as “Junk”:

  • Bianco Research suggest that 14% of companies in the S&P 1500 are zombies, with their earnings unable to cover interest expenses
  • The Bank of International Settlements has already warned that Western central banks stimulus lending means that  >10% of US/EU firms currently “rely on rolling over loans as their interest bill exceeds their EBIT. They are most likely to fail as liquidity starts to dry up”.

CHINA’S CORPORATE DEBT IS THE EPICENTRE OF THE RISK

As the chart shows, China’s corporate debt is now the highest in the world.  Yet it hardly existed before 2008, when China’s leadership panicked and began the largest stimulus programme in history.

The “good news” is that China’s new leadership recognise the problem, as I discussed in November 2017,  China’s central bank governor warns of ‘Minsky Moment’ risk.  The “bad news” – for the Fed’s desire to support the stock market, and for companies dependent on Chinese demand – is that they are determined to tackle the risk, having warned:

“China’s financial sector is and will be in a period with high risks that are easily triggered. Under pressure from multiple factors at home and abroad, the risks are multiple, broad, hidden, complex, sudden, contagious, and hazardous. The structural unbalance is salient; law-breaking and disorders are rampant; latent risks are accumulating; [and the financial system’s] vulnerability is obviously increasing.”

Companies and investors need to take great care in 2019.  China’s downturn means that markets are starting to rediscover their role of price discovery, despite the Fed’s efforts to keep waving its magic wand:

  • Companies with too much debt will go bankrupt, leading to the Minsky Moment
  • The domino effect of price wars and lower volumes will quickly hit other supply chains
  • Time spent today in understanding this risk will prove time very well spent later this year

Once the tramline is broken, the Fed and the S&P 500 will find themselves in Wile E Coyote’s position in the famous Road Runner cartoons – with nowhere to go, but down.