With the sale of Twitter to Elon Musk last week, a syndicate of banks had previously offered to loan Mr. Musk $13 billion to help pay for the $44 billion deal. The intentions of the banks were to turn around and sell the debt to the investing public as bonds underwritten by the banks who participated in the loan.
It will be some time before the banks issue Twitter bonds. As of this writing, the pricing action in the market for non-investment grade debt such as Twitter is non-existent. Investment banks are holding on to the paper that they could sell to the public at this time only at a loss. Speculation currently puts the loans at 90-95 percent of face value. This would mean that the banks would lose $650 million to $1.3 billion by selling Twitter bonds to the public.
The problem with the sale of Twitter debt has come on the heels of similar situations with Citrix Systems (an internet security firm) and Neilson PLC, the audience rating company. In each case the investment bankers could be on the hook for $500 million in debt losses each if the banks went ahead and issued bonds after each firm went private. The funds were needed to purchase the public stock.
Having debt held by banks to not be sold to third parties is ominous for two reasons. First, it restricts banks from doing more deals should the debt not be off-loaded to others. Second, if the regulators sense that the debt is not worth face value, the reduction in value would be a hit to the bank’s capital position. This is currently the case of Credit Suisse, a Swiss bank that took several losses from financing hedge funds. They are selling off divisions and trying to attract capital from the middle east in a bid to stay in regulators’ good graces.
Debt buyers are reluctant to assume the obligations of former growth companies. This would suggest the return to a stock market where growth names rule the market is wishful thinking. The performance of Meta Platforms (nee Facebook) falling 20 percent in a day last week would suggest some degree of panic is beginning to set in among its long-term holders. Add to this list the names of Amazon, Netflix, and Alphabet (nee Google), all down 35-50 percent or more from their highs set last year, and one begins to detect a pattern.
The common thread of all these stocks is the belief that their above-market growth rate would go on forever. That never pans out. Eventually a company’s rate of growth begins to approach that of the economy in which it operates. Other impediments to growth beyond size are rising interest rates and an economic downturn. While people buy growth stocks on the assumption that they will be above the economic cycle, at some point a company becomes so large that it is impossible to avoid the economy’s pull.
Can a growth stock that led the stock market cycle lead again? Not likely. Studies have shown that there is a less than on in five chance the leaders of one market advance will lead the next upturn. The reason for this is simple. A new company or concept is not constrained by relationships to real world factors like interest rates or the limits of its growth. Once those factors are established, more sober analysis can be conducted.
A good case study of this is the auto industry. At one point Tesla was valued at more than all the domestic car companies combined. This valuation came in spite of making only a small fraction of the number of cars. With GM, Ford and others now producing electric vehicles, Tesla looks more like a car company and less like a hot concept.
How long does it take for another hot concept to introduce itself? Sometimes it can take a while. After the market declines in 1973-74, it took until 1982 for the large stocks to start notching gains. Until then they basically treaded water for eight years while stocks of smaller companies went up by a factor of four. Like today, higher interest rates and inflation were factors. Also, smaller stocks represented better value in 1973, after a market driven up by the “Nifty Fifty” large company mindset from 1962-72. Everything old is new again as a concept. It may not be as an investment.
The Economy
As economic contractions go, this has been the mildest so far on record. Consumers have spent their way through it with aplomb, keeping employment demand elevated in the process.
Layoffs so far seem to be concentrated in the technology sector. Lesser skilled jobs still have a ratio of two openings for every candidate. While the housing slowdown should change this, so far this has been a white-collar recession.
Of greater concern is the paucity of capital spending. Aside from the government’s efforts at expanding the semiconductor and renewable energy industries, companies are not making the investments needed to add jobs and expand the economy. Part of this is due to the lack of workers, which is in turn a function of the restrictions made by the government’s immigration policies. Unless this is addressed, the idea of firms retuning offshore production to the US will be a pipe dream.
Inflation
Inflation is scheduled to become more manageable as comparisons are made to the same month of the prior year.
Inflation continues to be a world-wide phenomenon. Prices have increased in most countries due to economic disruptions caused by the lock down policy in China as well as the Russian war with Ukraine. Transportation is beginning to normalize which will be deflationary.
Interest Rates
With the deceleration in the rate of inflation, interest rates should moderate their advance. The issue is whether inflation will moderate enough to permit interest rates to be reduced. At this point a reduction in interest rates does not seem to be in the cards.
A lack of interest rate reversal would be a blow to Modern Monetary Theory (MMT), which believes that so much capital exists in the form of retirement accounts and the like that interest rates will be negative (that is, below inflation) for the foreseeable future. MMT did not account for the Federal Reserve’s bond buying program or its subsequent reversal.
In order to keep inflation in check, interest rates have to be above the inflation rate. For this reason, it is not forecast that interest rates will decline any time in the near future.
The Stock Market
Stocks have scored a large rally in October. This rally would have been even more impressive save for the collapse in technology in the same time frame.
While some people are predicting a market rally after the mid-term elections, it is not expected to be the basis of another sustained market advance. The pressure of higher interest rates and tighter lending standards may provoke another financial crisis which the market is not now anticipating.
The best stock market strategy is to keep aware of earnings forecasts and buy what is out of favor. Do not chase rallies that do not have foundations. Be ready to sell when appropriate.
Warren M. Barnett, CFA
October 31, 2022
Statements made within the Perspective are those of the author and should not be considered as individual investment advice. For personal investment advice, please contact the firm at 423-756-0125 or [email protected] to set up a meeting with one of our investment advisors.
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