Druckenmiller Warns That IBM Is The Poster Child For Bad Fed Policy

Druckenmiller Warns That IBM Is The Poster Child For Bad Fed Policy

Lost amid the geopolitical headlines in the Ukraine and Israel were comments from Stan Druckenmiller, formerly of Duquesne Capital, this past week at CNBC’s Delivering Alpha Conference in NYC. Druckenmiller proclaimed that the Federal Reserve’s “baffling” interest rate policy is doing long term harm via a flawed interest rate policy that encourages “financial engineering” rather than long term capital spending.

Druckenmiller (61) has been retired from professional management for three years, though that may not be permanent. For those of you who might not be aware of who Druckenmiller is, he is the founder of Duquesne Capital and former managing director of George Soros Quantum Fund. As a hedge fund manager Druckenmiller was among the 10 best hedge fund operators in the past 50 years with an average annual return in excess of 20% for his entire career. His professional performance demands that his opinions should be taken seriously.

Druckenmiller made a passionate speech in NYC last week that he feels the Federal Reserve is making a monumental error in keeping monetary policy much too easy for far too long and that the eventual result will end quite badly. Again, Druckenmiller is uniquely qualified to make such allegations given that the bulk of his career his biggest trades were made betting against various central banks that he felt were engaged in policy errors. The most infamous example was his bet against the Bank of England in 1992 that netted Druckenmiller/Soros $1 bln in a single month.

Druckenmiller stated that IBM is the poster child for bad Fed policy. To support his argument he highlighted that IBM’s sales are approximately flat for each of the past six years. Over that time, however, IBM has tripled their debt load via corporate bond sales through overseas subsidiaries in order to finance a massive stock buyback plan. Buying back stock is a way that companies can improve their earnings per share, as it reduces the number of shares outstanding, thereby reducing the denominator when computing earnings per share — a company's net income divided by its shares outstanding.

Much of Druckenmiller's critique is made against the backdrop of what he sees as harmful Fed policy that is encouraging companies to engage in financial engineering rather than invest in their business. Interest rates are at 500 year lows in western Europe and the USA so it is extraordinarily cheap to borrow.

IBM’s response to Fed policy is not unique. About 2/3 of the S&P 500 constituents have engaged in large stock buybacks financed by increased debt offerings at very low rates. Gross sales for the S&P 500 has risen only 23% since 2009 while the S&P 500 index has rallied over 295% from the 2009 low of 667. These divergent stats would imply that stocks are extremely overvalued but that is not the case. Corporate America has reduced the supply of shares enough to offset the lack of gross sales so valuations are wither fair or mildly overvalued.

That being said, corporate investing in a stock is not beneficial in the long term. The benefit of corporate stock ownership is nowhere as great as investment in research & development or investment in plants & equipment. In this regard Druckenmiller is unapologetically accurate.

The chart above shows how corporate America has accelerated their stock buybacks since the last financial crisis in 2008-2009. The last time corporate America had this large of an appetite for their own stock was in 2007. The surge in stock buybacks also hints that stock performance going forward will likely be sub-par due to the bulge in stock ownership. Again, stock ownership is not a productive use of capital relative to capital investment spending.

Druckenmiller continued, "Every ounce of intuition in my body is that the potential costs have crossed the potential benefits in Fed policies. I made a living analyzing the future, not the past. The Fed's monetary experiment will be more disruptive down the road than anticipated,"

If Druckenmiller is right, does this mean that it is time to dump your stock holdings? Absolutely not. I completely agree with Mr. Druckenmiller that Fed policy is inducing companies to use debt to buy their own stock. This will slow rates of corporate growth for a long time and leaves corporate America very vulnerable to interest risk in the future.

However, it is not sufficient reason to abandon stocks just yet. The rate of stock appreciation is apt to slow but it take the specter of rising interest rates to dull corporate stock buying and turn the tide the other way. Until that occurs (and it may be no more than one quarter away) there is little reason to expect a meaningful decline in the broad stock market.

More to follow soon.

Jack