CapEx Is Still MIA

 | Aug 27, 2014 12:41AM ET

Ho hum! Another month, another miss on Business Insider ):

Add Jim Chanos' to the number of voices worried that American companies are running out of gas and in need of real consumer demand to create revenue.

In an interview with Bloomberg's Masters in Business, hosted by Barry Ritholtz, Chanos explained how corporate buybacks were less a sign of strength and more a cry for help from American companies.

He said: "What worries me is that corporate America in aggregate, has pre-tax returns on capital in the mid to high teens. The long-term expected rate of the equity markets, is roughly half that. And when corporations embarked on massive buybacks across all industries and all companies, in effect these CEOs are buying the stock market. So what they’re telling you then, is unequivocally that they think that either they’re happy to earn the stock market rate of return or maybe something hopefully better. Or their rate of return on the margin of any new capital project is much much lower, in fact half or less of what is stated. And that does not bode well for the future of profits, or for the quality of earnings reported as current profits."

He concluded:

Chanos says that corporate balance sheets are looking healthier because analysts aren't deducting acquisitions from a company's cash flow as they should.

“Increasingly we’re seeing acquisitions, which are not taken out of most analysts for cash flow numbers, acquisition are replacing CapEx or R+D," Chanos said. "So companies are buying their R+D or their capital, and that should [be] properly deducted from cash flow, because in aggregate corporate America is not growing. So by buying each other and buying divisions of each other, in effect, they’re capitalizing their R+D … and that particularly applies for big tech, which are perceived as very cheap companies. If you actually look at them, the only reason their revenues aren't declining at a reasonable rate is because they’re buying other companies.”

Is Chanos right? Is Corporate America substituting financial engineering for actual capital spending, which should be occurring during this phase of the economic expansion? Are there insufficient number of capital projects that beat their WACC (weighted average cost of capital) to warrant investment?

I have no idea. What I do know is that Mr. Market is reacting to these developments. The chart below of the performances of the capital goods intensive Industrial sector, cap weighted or equal weighted (which reduces the effects of heavyweight GE), is rolling over relative to the SPX.