The weighted average Return on Investment for the S&P 500 is slightly over 11%, and the cost of medium-term BBB borrowing (the average rating for the S&P 500) stands at just over 3%, thanks to the Fed’s quantitative easing program. In sectors where cash flows are annuity-like, e.g., consumers and utilities, it makes sense for companies to issue record amounts of bonds and buy back their own shares. That helps explain why earnings can continue to grow, at least modestly, even though revenues appear to have fallen by nearly 1% during the first quarter.
Here’s a simple example. Suppose you and a partner jointly invested $100,000 in a business that earns $10,000 a year. You each have $50,000 in capital, and take out $5,000, for a return of 10% a year. If Ben Bernanke will lend you money at 3% to buy out your partner, you will now make $10,000 on your capital of $5,000, minus the interest expense (3% of $50,000, or $1,500). You earn $8,500 net on a $50,000 investment, or a 17% rate of return.
You would do that trade all day if you could. Thanks to the Fed, large U.S. companies can, and do. The cost of BBB-rated bonds (the average credit rating of the S&P 500) is at an all-time low of 3%. And the average return on investment for the S&P 500 is around 11%. The actual numbers are not much different from the example I just gave.
There’s a catch, of course. If you take on debt to buy income from a business, you could get into trouble if business profits drop. That’s why companies play this leverage game in sectors that have reliable income streams, for example consumer staples. Below, we see the performance of the Consumer Staples ETF (XLP) against the Industrials (XLI) and Technology ETF’s. Stable sectors with annuity-like cash flows — consumer, utilities, and health care — soared during the first quarter, while riskier sectors languished.
There’s another catch. It’s so easy to make money by levering up corporate balance sheets that there’s no incentive to invest in new plant and equipment. Bernanke’s cheap money policy was supposed to reduce returns to cash and bonds and force investors to take risks in real assets. It hasn’t worked out that way. It’s only encouraged investors to apply more leverage to existing assets. No investment, no jobs. That’s part of the reason employment refuses to recover. Another is Obamacare, which drastically increases the cost of new hiring for small and medium-sized businesses.
The rally is making Americans richer on paper but poorer in terms of income. Suppose you owned a portfolio of BBB-rated corporate bonds yielding 4.4% in June 2011, and sold it to buy stocks. Your stock portfolio would have gained 20% since then. If you sold the portfolio to buy bonds at the present yield of 3.2%, you would be able to buy 20% more bonds, so your portfolio would yield 1.2 X 3.2%, or 3.84% — less than you received before. In terms of income, you lost money by selling bonds to buy stocks back in June 2011. In fact, you would have lost on a current-income basis if you sold bonds to buy stocks on almost any day during the past five years.
Fed easing hasn’t brought about recovery. Government spending won’t bring about recovery. Supply-side incentives to investors (lower corporate and capital gains taxes in particular) and regulatory rollback, starting with Obamacare, are the only way out of this morass.