The Independent Market Observer

IBM’s Woes Highlight a Major Risk to the Market

Posted by Brad McMillan, CFA®, CFP®

Find me on:

This entry was posted on Oct 21, 2014 3:23:00 PM

and tagged In the News

Leave a comment

MarketOutlook_1And he woke up, and it was all a dream.

With a six-year-old son, I admit I’ve been forced to end stories in that way on more than one occasion, when I get stuck and run out of ideas (or energy). Looking at the market today, though, the events of last week have certainly taken on a dreamlike quality. What just happened?

After watching the S&P 500 bottom and bounce on the 15th, we’ve seen a steady recovery, with the market now more than 1 percent above its 200-day moving average and seemingly headed higher.

Was the past week just a dream?

I don’t think so. I think it was a warning shot that we need to heed, even if the market does continue higher. The risks that drove the market down remain—and, in many respects, continue to intensify. Let’s look at some examples from today’s headlines:

  • France and Germany continue to face off over whether austerity or reflation is the way to go.
  • China has printed the lowest growth figure since the financial crisis.
  • And, most important for the U.S. stock market, IBM is struggling, with much of its success in recent years coming from financial engineering, including stock buybacks, rather than organic growth.
The IBM illusion

To summarize, IBM sales were down 4 percent for the last quarter, and earnings were down even more. Shares dropped 7 percent. Over a longer period, IBM has had multiple quarters of flat or declining sales, and revenues are about the same as they were in 2008, even as the share price continued to climb through 2013.

 IBMs_woes

How did the company manage to grow earnings, and its share price, even as revenues were stable at best? Mostly by buying back shares. Buybacks are generally a good thing; by reducing the number of shares outstanding, the earnings for each of the remaining shares go up. But, as with IBM, such buybacks can create the illusion of a growing business when that’s not really the case.

Since 2000, IBM has spent $108 billion on its own shares, financed with debt. Over the same time period, the company also spent $59 billion on capital expenditures and $32 billion on acquisitions, for a total of $91 billion invested in the business. Over 14 years, management decided that, on balance, it was better to buy back company shares than to invest in growing the business—not a good sign for the future.

Mind the gap between sales and earnings growth

IBM isn’t the only company where this is true; many have the same issues. As the narrative shifts, we may have hit the end of the runway for financial engineering strategies to lift share prices. Actually having to grow business in order to boost share prices is a much bigger challenge for companies than writing a check for stock buybacks. It also makes it much harder to meet market expectations for earnings increases.

The gap between sales growth and earnings growth expectations now presents the biggest risk to the market, in my opinion. Financial engineering has been used, very successfully, to generate earnings gains that were multiples of revenue growth. If that gap starts to close, we could enter a much more difficult market environment.


Subscribe via Email

New call-to-action
Crash-Test Investing

Hot Topics



New Call-to-action

Conversations

Archives

see all

Subscribe


Disclosure

The information on this website is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Please contact your financial professional for more information specific to your situation.

Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets.

The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. All indices are unmanaged and investors cannot invest directly in an index.

The MSCI EAFE (Europe, Australia, Far East) Index is a free float‐adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of 21 developed market country indices.

One basis point (bp) is equal to 1/100th of 1 percent, or 0.01 percent.

The VIX (CBOE Volatility Index) measures the market’s expectation of 30-day volatility across a wide range of S&P 500 options.

The forward price-to-earnings (P/E) ratio divides the current share price of the index by its estimated future earnings.

Third-party links are provided to you as a courtesy. We make no representation as to the completeness or accuracy of information provided on these websites. Information on such sites, including third-party links contained within, should not be construed as an endorsement or adoption by Commonwealth of any kind. You should consult with a financial advisor regarding your specific situation.

Member FINRASIPC

Please review our Terms of Use

Commonwealth Financial Network®