Q3 2024 US Stock Market Commentary

The third quarter of 2024 marked what seems to be the beginning of the interest rate easing cycle with a 0.5% cut in the federal funds rate. Market commentators are split on where rates will ultimately settle, but the consensus is that at least one more interest rate cut will happen in 2024.

The big question is what level of real interest rates can be considered “normal.” Prior to the 2008 financial crisis, real borrowing rates were generally in positive territory, meaning that the interest rate paid on debt is above the inflation rate. Since 2008, real rates have been mainly negative, raising the question of whether real rates should be positive or negative and the consequences of each scenario.

In his excellent book, “The Price of Time”, Edward Chancellor looks at interest rates through the centuries. The historical experience suggests that artificially low interest rates rarely result in a higher level of economic activity (since lenders are concerned about lending to barely profitable projects) but can lead to asset bubbles e.g. the South Sea bubble in the 1720’s when official interest rates in the UK were at around 2% and ownership of South Sea company shares promised a 6% annual return.

Negative real interest rates benefit the borrowers while hurting the savers whose savings are losing value in real terms. Theoretically, they should also allow companies to invest in less profitable projects since lower returns would be acceptable. However, as Yogi Berra said, “In theory, there is no difference between theory and practice - in practice, there is…”

On a recent episode of the “Invest Like the Best” podcast, Michael Mauboussin and Bill Gurley discussed a CFO survey that showed that lower interest rates do not impact their investment decisions. Most CFOs use a hurdle rate, which does not change with prevailing interest rates and is often set at 15%. What does change with interest rates is the profitability of buybacks – if you have a chance to buy back your own shares at a higher Free Cash Flow yield than the cost of borrowing or interest rates on deposits, then it is EPS accretive.

Looking at buybacks in the S&P 500 index, there is a clear negative correlation between the amount of capital channeled into buybacks and prevailing real interest rates. The annualized buyback of roughly 2.7% of the market cap has been one of the major contributors to the S&P 500's performance over the last decade.

Source: Bloomberg, S&P Global, Firebird Value Advisors Research

We can divide the 12.4% return generated by the S&P 500 between December 2013 and September 2024 into its main drivers. In this case, non-fundamental factors such as multiple expansion and buybacks generated more than half of the total return, while dividends, cash flow profit margin, and sales growth added up to just 4.8% of the 12.4% annualized return.

Source: Bloomberg, Firebird Value Advisors Research

Thanks to multiple expansion, the free cash flow yield of the S&P 500 has fallen from 6.5% in 2012 to under 3% right now, putting it at a level well below the prevailing interest rates. In fact, based on this measure, the buybacks for the index have not been EPS accretive since the second half of last year. This would suggest that the S&P 500 has been destroying value by channeling more than half of its recent earnings into buybacks.

Source: Bloomberg, S&P Global, Firebird Value Advisors Research

Steve Gorelik is a portfolio manager for Firebird Management LLC ("Firebird"). This report was prepared based upon information from sources that are believed to be reliable. However, neither Mr. Gorelik nor Firebird make any representation or warranty as to the accuracy or completeness of the information contained in this report. This report may include estimates and projections. No representation is made as to the accuracy of such estimates or projections or that such projections will be realized. Mr. Gorelik and Firebird have no obligation to update or keep current any information or projections contained in this report. Firebird is registered as an investment adviser with the US Securities and Exchange Commission.