Don’t Judge a Book by Its Cover

Don’t Judge a Book by Its Cover


It’s the end of July and has been hot as hell for much of the world this week, around 107 Fahrenheit in Paris yesterday! So I’ll do my best to keep this look into economy and markets a bit shorter than my usual. When economies and markets are near a turning point, often the headlines tell a very different story than is revealed by digging deeper into the data – you can’t judge a book by its cover. In this week’s issue of Context & Perspectives:

  • Budget Debate Off the Table Until 2020
  • Investors Just Not That into the Stock Market
  • Global Manufacturing Weakness Continues to Spread
  • Next Week, the Fed Re-Takes Center Stage


Budget Debate Off the Table Until 2020

Apparently, the Democrats were also feeling the heat as they managed to work out a deal on a 2-year budget with the President, so at least that drama is off the table until after the elections. Maybe at some point during the elections, someone will mention the enormous level of debt the government has accumulated, while Social Security remains a massively underfunded elephant in the room. Or maybe not. We live in interesting times.


Investors Just Not That into the Stock Market

While the market continues to grind higher, digging into the details we find that investors have really not been loving this stock market. Over the past 52 weeks, according to data from the Investment Company Institute (ICI), investors have pulled $329.4 billion out of equity funds, another $94.0 billion out of hybrid funds and put $75.7 billion into bond funds. So how has the market continued to march higher? Over the past five years, investors have been net sellers of the market with corporations themselves the net buyers through stock buybacks, which isn’t quite as rosy as it may first seem.

Some of these buybacks are being funded through debt, which has led global corporate debt to reach unprecedented heights, as I discussed in my last piece when I pointed out the proliferation of not just corporate debt, but also the increasing numbers of zombie corporations. There are a few others also concerned with this, as was discussed in a Barron’s article yesterday, you might recognize just a few of these names.    

Part of why investors are selling while corporations are buying back their own shares is likely a function of demographics. As the Baby Boomers move adjust portfolios as they move into retirement, their portfolio construction will naturally have to change and that shift, in a period of central bank interest rate suppression, is much harder than it was for generations past. The level of income that can be feasibly generated from a portfolio today is much less than what the Baby Boomers’ parents enjoyed. At the other end of the spectrum, Millennials are saddled with unprecedented levels of student debt, so they aren’t exactly big buyers of shares either. Between central bank manipulations and demographics, this is a very different investing environment.

Given the relative strength of the US economy compared to the global economy, which is slowing more dramatically, it is interesting to note that large-cap stocks, (which tend to have more international exposure) have been outperforming small-cap stocks at a level not seen since January 2008 – ahem, share buybacks, anyone? 



Global Manufacturing Weakness Continues to Spread

This week’s Markit manufacturing PMI came in at 50.0, meaning no change in output, and was the weakest level since March of 2009. The United States wasn’t alone as Germany’s Markit Manufacturing PMI was the lowest since July of 2012 and the Euro Area as a whole came in at the lowest level since December 2012. A composite of the five Federal Reserve manufacturing activity indices (courtesy of Bespoke Investment Group) reveals that all nine subcomponents have declined year-over-year, with Prices Paid leading the decline, down -24.2% and New Orders coming in the second worst, down -22.2%. New Orders are also down -10.2% from just this past April. That is not exactly a rosy leading indicator. The International Monetary Fund has cut global growth forecasts four times this year.

When looking at manufacturing globally, the first company to come to mind is Caterpillar (CAT). The company reported results for the June quarter that confirmed the overall slowing we’ve been seeing in the global industrial sector. Sales growth for the company has weakened along with various indicators of slowing we’ve been seeing come in from all over the world. We aren’t seeing an imminent crash, but Caterpillar’s results certainly support the theory of spreading weakness. Sales for the bellwether company peaked in North America in February 2018 at 30% year-over-year and have been falling ever since, with June’s 12% year-over-year growth rate the weakest in 18 months. North America remains the strongest region for the company and one of only two posting positive growth. The rolling three-month average global sales growth rate is down to its lowest level in about 14 months and the company’s streak of 28 consecutive months of rising sales is being threatened. This tells you an awful lot about the global economy.


The Consumer & Government Props Up GDP . . . with Debt

Friday morning the first estimate for GDP for the second quarter was released, rising 2.1% versus expectations for 1.8% – 2.0% and up from 3.1% in the first quarter. This quarter was all about the consumer with personal consumption expenditures up 4.3% (annual rate), the strongest performance in six quarters. At the same time, American Express (AXP) and Capital One Financial Corp (COF) reported an increase in the number of accounts overdue by 30+ days in the second quarter. Personal Savings also declined -3.6%. Spending up, debt up and savings down – not exactly a sustainable trend?

Looking further at the consumer, on the positive side, the solid quarterly earnings report from short-term staffing provider Robert Half (RHI) provided evidence that we are seeing domestic wage growth with the bill rate (which is basically the cost of waters for the company’s customers) was up 5% year-over-year in the past three quarters. That’s good news for the consumer, but keep in mind this is not a leading indicator. On the other hand, employment at small businesses, which does tend to be a leading indicator as small businesses are quick to respond and adjust to the changing economy, fell by 23k in June after having fallen 38k in May. The last time we saw back-to-back drops of that magnitude was in early 2010. For all the hoopla over employment, the last Job Openings and Labor Turnover Survey found that job openings were down -4% from the cycle high and new hires were down -4.4%. Again, not saying we are falling off a cliff here, but we are looking for indicators that the trend is changing direction and these data points clearly point towards that assessment.

Friday’s GDP report also found that gross private domestic investment declined -5.5%, the worst showing since the December quarter of 2015 with spending on non-residential structures falling -10.6%. This drop on business investment took a full percentage point off of GDP – to be fair, they are awfully busy buying back their own shares. If businesses are cutting back on investments in machinery and structures, isn’t hiring going to be affected? That will affect consumer spending. When looking at that fall in domestic investment, keep in mind the trade wars and how Chinese foreign direct investment has declined by about 90% over the past two years. 

Along with a jump in consumer spending, government spending also jumped, rising 5% on an annual basis. That is the biggest increase in spending since the second quarter of 2009 when the economy was literally falling off a cliff. Not to be a negative Nancy here, but digging into the math a bit we see that consumer spending and government combined rose at a 4.4% annual rate while the rest of the economy contracted at a -12.1% rate.

In the end, and I’m doing my best to wrap this up quickly for all of you struggling with the heat, all eyes remain on the entities most responsible for the health of the stock market these days – central banks. The European Central bank policy announcement this week kept the benchmark despite the rate at negative 40 basis points but indicated the bank is considering additional quantitative easing and potentially a tiered deposit rate scheme to help protect bank profitability – not exactly a shocker given the poor condition of many of the region’s banks. The outgoing head of the ECB, Mario Draghi, stated that the outlook “is getting worse and worse.” In response, the German 10-year yield traded as low as negative 42 basis points. For context, the US 10-year closed the same day at 2.075%. 


On Tap Next Week, the Fed Re-Takes Center Stage

Next week the Federal Reserve is expected to cut its key rate by at least 25 basis points and the market is pricing in further cuts to follow. Many are arguing that the Fed needs to be Gretzky and move to where the economy is going to be, not where it is today. They may be right, but the Fed has backed itself into a really tough corner. A typical rate-cutting cycle sees 525 basis points of cuts. Today, it has about half of that to work with and over the coming months the economy is facing quite a few potential shocks:

  • Brexit – now that Boris is in charge it could get ugly.
  • The feud between the odd-couple political coalition in Italy is intensifying at a time when European leadership is particularly weak and facing Brexit. Just what the EU needs, more instability.
  • Trade wars. 
  • Iran tossing around missiles and threats in the Strait of Hormuz

The Fed may want to keep some of those precious few arrows in its quiver. It is also facing competition in the race to the bottom as many of the world’s central banks are either cutting or are looking to begin cutting rates in the near future. Meanwhile, the market continues to grind higher.

Mornings with Maria

Mornings with Maria

On Friday October 21st I was on set with Maria Bartiromo, Kat Timpf and Dagen McDowell with a variety of guests. Here are a few clips from those three hours on set… with only one bathroom break… starting at 6am… and a lot of coffee…know my pain.

We spoke with JMP Securities President Mark Lehmann on the stocks to watch in the tech sector and the election’s impact on the markets.

Screen Shot 2017-01-26 at 2.27.56 PM

We also spoke with Alan Dershowitz, author of ‘Electile Dysfunction,’ on the impact of WikiLeaks on Hillary Clinton’s campaign. While I’m not a fan of lawbreakers, and hackers certainly count amongst those, these days the electorate is reasonably mistrustful of those in power and these hackers are giving us confirmation that we are correct to mistrust …which is one of the reasons I am in favor of smaller government. The more power government has, the more opportunities there are for graft, and the bigger the temptation to give into such. I prefer smaller government out of respect for the frailties of human nature. I’m in good company here with James Madison who explained it best in Federalist Paper #51.

It was a long chat with Mr. Dershowitz…

As a proponent of the free markets, which also means free trade, I’m a fan of Donald Trump’s plans to reduce taxes, but not a fan of his threats to significantly reduce free trade and to use the power of the presidency to force private companies to bend to his will. As the second largest exporter in the world, our economy needs a healthy level of international trade. We spoke with political economist Andy Busch on Donald Trump’s and Hillary Clinton’s competing plans.

Finally we spoke with S&P Global Market Intelligence’s Rich Peterson concerning the outlook for M&A activity, particularly given the current political environment. As we discussed earnings results so far, I brought up my concerns that the improvement in earnings per share really doesn’t tell the whole story, as companies have been buying back their own shares at record levels. This means the denominator, shares outstanding, keeps falling which makes EPS look artificially stronger than it actually is. I call this the spanx-and-push-up-bra strategy, whereby things may look better from afar, but fundamentally they really haven’t improved.

Santa Rally on Its Way?

On December 17th, I appeared on air with Stuart Varney to discuss a potential year-end rally in the stock market after the Fed’s rate hike came in around what was expected. I think a year-end rally is unlikely, and expect to see weakness in the stock markets as we move into 2016. We’ve already had three quarters in which revenues for the S&P 500 have declined and two quarters in which earnings have declined. We are seeing signs of weakness in the economy and the Fed’s rate hike impacts interest rates going forward.

One of the biggest factor pushing stock prices higher has been corporate buy backs, in which companies buy back their own shares, often issuing debt to do so. Think of just how destructive it is for a company to borrow money to buy back shares that then fall BELOW the price at which the company bought them! We are also seeing companies buy back shares while executives are selling their personal holdings – always something to look at if you are considering buying shares in a company. Higher interest rates make it more difficult for companies to issue debt in order to buy back shares and without corporate buy backs, we would have seen a net outflow from the equity markets. Tough to have prices go up when more people are leaving the stock market than buying into it!

Earnings Season

Revenue growth for US companies hasn’t been terribly inspiring, yet earnings have been respectable. So far this earnings season, as of Friday, 90% of the companies in the S&P 500 have reported actual results for Q2.

  • 74% have reported earnings above estimates, which is above the 5-year average
  • 50% have reported sales above estimates, which is below the 5-year average

That sound pretty good right? Earnings per share is above the long-term average so we should be happy right?  That’s a lot of headlines you’ll read, but it misses an important part of the bigger picture.

Earnings growth for the quarter, across all companies in the S&P 500 that have reported so far, is currently running at -0.7%.  That means that while 74% of companies are beating on earning growth estimates, those estimates were for a decline in earnings!  Well that paints a slightly different picture now doesn’t it?

On top of that, revenue growth for the second quarter is currently running at a drop of -3.4%. Yup, revenues are falling.  This is also the first time we’ve seen two consecutive quarters of year-over-year revenue declines since Q2 and Q3 2009.  If we look at forward guidance, analysts are expecting earnings to continue to fall year-over-year through the next quarter while revenue is expected to continue to fall through the end of the year. Now you see why we’ve been concerned.

Sales and earnings have been falling while stock prices are rising.

Those earnings have also been the result of considerable cost cutting and financial engineering.   The cost cutting is a bit like going on a diet, always a good idea to trim and tone where things have gotten flabby, but it isn’t something that can be done indefinitely.  At some point you simply aren’t getting enough nutrition, or in the case of a company, investing sufficiently in the future, and you start to harm longer-term health/growth.

As for financial engineering with things like stock buybacks, that is the corporate equivalent of Spanx and a push-up bra; looks good out in public, but back home the fundamentals really haven’t changed.

GDP Numbers Keep Getting Worse

GDP Numbers Keep Getting Worse

tumblr_m9fgrhrwCG1rdzt86o1_1280Yesterday we received the first estimates for GDP in Q2 and along with it some major revisions to the numbers for 2012-2014 and Q1 2015 went from a contraction to a bit of growth – very little bit, but still better than a contraction.  Yup, the US GDP numbers keep getting worse!

The financial press was all a twitter with this, but I’ve noticed that in mainstream, there isn’t much useful discussion. I suspect this is because most people haven’t been taught much, if any economics, and the way this material is presented is often less exciting than a symposium on medieval sewing techniques.

So let’s see what these new numbers tell us.  In the 138 years from 1870 to 2008, the US economy expanded by about an average of 3% a year.  After the revisions to GDP data from 2012-2014, we see that the U.S. economy since the financial crisis has been growing an average of 2.0% a year versus the earlier 2.3%.  The difference between 3% and 2% may not sound like much, but think of it this way:

At a 3% growth rate the economy doubles in about 24 years

At a 2% growth rate the economy doubles in about 36 years – 50% MORE time!

The chart below breaks out growth by quarter on an annualized basis.  So we can see that growth rates in the first quarter are typically the lowest, in the second quarter usually strongest, down a bit in the third and then a bit stronger to finish the year in the fourth quarter.

Looking back at data to 1990, the years 1990-2000 were the strongest on average in every quarter and we can see an overall decline in every time frame since then.  Please note I excluded the years 2007-2008 from the data below as the recession was so dire that it makes the data more difficult to interpret.  Most importantly, 2010-2014 was weaker in every quarter except the second and 2015 so far has been the worst yet!

2015-07-31 US GDP by Quarter


Next we look at Private Consumption Expenditures, which is basically the stuff households buy.

2015-07-31 PCE by Quarter


Not looking good either.  That one’s been falling since the 1990-2000 period as well.  This past quarter it looks to have given a better showing, but with all the revisions we’re seeing, I have to say I’m a bit skeptical that this one may be revised downwards later. This isn’t too surprising when you think about the fact that the percentage of the population actually employed is at multi-decade lows as are household income levels. Not many people have a lot left over at the end of the day to buy fun stuff!

As a matter of fact, wages and salaries in the U.S. rose in the second quarter at the slowest pace on record! The 0.2% in Q2 was the smallest since the data began being tracked in 1982 and follows a grim 0.7% increase in Q1.  So much for the headlines touting a healthy labor market – yet one more reason to think the Fed won’t raise rates in September.

2015-07 Q2 Wage Growth

This next chart helps to explain the lack of productivity growth as this metric includes things like the construction of new offices and factories, and the purchase of machinery, computers, and any other equipment used to assist labor in the production of goods and services. Business investment counts as gross investment, which includes purchases of machinery to replace worn-out equipment; if a firm replaces one machine with another that does not increase output, then nothing is added to the nation’s economy. You’ll notice that during the 1900s, there was considerable investment in future productive capacity.  Post dot-com investments lagged, but were increased a bit again post financial crisis.  For 2015 investment by businesses has been particularly weak.  You’ve probably seen in the headlines that an unprecedented level of publicly traded firms have chosen to use their cash to buyback shares rather than invest in future growth.  This says a lot about the perception of future opportunities!

2015-07-31 Non Residential by Quarter


Last quarter it looks like businesses sold a lot less stuff than they’d expected, as inventories rose an unusual amount.

2015-07-31 Inventory by Quarter


In the second quarter, it looks as though expectations were better established, so some of that excessive build up was able to be drawn down. This tells us that spending in the first quarter was much weaker than had been anticipated.  They were not surprised in the second quarter and were even able to draw down a little bit of that excessive built up from the first quarter.

Finally, the strong dollar is definitely having an impact on exports, with last quarter’s drop really hurting GDP.  The negative numbers mean that we are buying more stuff from the rest of the world than selling to it.

2015-07-31 Net Exports by Quarter


Now that we’ve looked at the highlights, talk about what makes an economy grow. After all, most people make their decisions at the polls based on either what or who they think is better economically or socially.

An economy is really just about 2 things: People and the stuff they produce.

An economy grows if

  • There are more people making stuff
  • The people making stuff can make more stuff
  • Or both

So how many people are making stuff today in the U.S.?

2015-07 Employment Population Ratio


What this tells us is that the portion of the population making stuff is a lot less than it used to be. That means that those who do make stuff, earning a living, have a bigger burden for support, which means there is less money left over to invest in the future.

We also have an aging population, meaning a higher percentage of the population is in or about to be in retirement, which also affects how many people can or want to work. Plus, when people are in retirement, they usually spend their savings rather than saving for the future and investing.

Like much of the rest of the developed world, US fertility rates are not quite at replacement rates, meaning that for the population to growth, we need to have immigration. Keep that in mind when you hear the politicians, (or former Reality TV characters) work themselves into a frenzy over immigration.

So how do people make more stuff?

  • Better equipment (businesses investment in the tools used)
  • Or improved skills (better at what you do)

The third chart from above showed that businesses have been investing less and less in their own future productivity.  Post financial crisis most have chosen to repurchase their own shares in order to improve their EPS (earnings-per-share) numbers rather than invest in future productive capabilities, so we won’t be gaining much ground with this.

The other option is to have improved skills, but the American skill set is a serious problem, which is evident in the employment data but rarely talked about as the reasons behind the problem can get pretty contentious. This problem is visible in the JOLTS Report (Job Openings and Labor Turnover Survey) from the BLS (Bureau of Labor Statistics) which shows that the rate of job openings is reaching a 15 year high, but the percentage of the population employed remains near 30+ year lows. There are jobs available, but companies can’t find the right fit.

2015-07-31 JOLTS Openings

According to the NFIB (National Association of Independent Businesses) June 2015 Small Business Optimism Report, 24% of all business owners reported job openings they could not fill in the current period, down 5 points, after reaching the highest level since April 2006 in February – another confirming data point.

Why is this such a problem? First, the housing bubble had entirely too many people develop skills in industries that were going to have a lot less jobs after the crisis. Think about all the construction jobs, mortgage-related and residential housing-related jobs that are not likely to return in our lifetime.

We also have a welfare system that punishes people for getting any kind of job by reducing their benefits by more than their newly earned income, dis-incentivizing those who are receiving aid from ever developing the skills necessary to become self-sufficient.

So there you have it in a not-so-small nutshell.  US growth continues to slow and those factors that could induce better growth in the future are giving us no reason to think things will improve.  Overall businesses are choosing to boost their share prices today through financial engineering (through share buybacks and the like) rather than by investing in future capabilities. This affects the productivity potential for Americans, who are already feeling pretty dour with income levels that have been stagnant for decades and a government that keeps telling them they need more and more help taking care of themselves.

Today there are 136 people receiving some sort of government benefit for every 100 people employed in the private sector.

American confidence is so low that the nation once built upon the sweat of immigrants risking it all for a better life, now sees those same immigrants as a threat. The nation founded on the principles of self-determination now looks to the government, preferring endless false promises of security over risks that were once inspiring, but are now viewed as insurmountable with rewards unobtainable.

America has lost its mojo. The entire world desperately needs her to get it back.

Just what data is the Fed seeing?

Just what data is the Fed seeing?

Funny-Images-33On Monday March 3rd, the NASDAQ closed above 5,000 for the first time since 2000, while the S&P 500 and the Dow Jones Industrial Average also reached new record highs, which would lead one to think that things are going pretty darn well. According to Chris Verrone of Strategas Research Partners, 70% of US stocks are currently in an uptrend. In comparison, at the NASDAQ’s previous March 2000 peak only 25% of stocks were in an uptrend.

Unfortunately outside of the US, central bankers don’t look like they are feeling quite as rosy as American equity investors. So far in 2015 at least 21 central banks have lowered their key interest rates in an attempt to strengthen their economies. China surprised the markets with a rate cut last weekend, after having early in February made a system-wide cut to bank reserves. India cut its main interest rates just last week for the second time in less than two months followed by Poland, which cut rates March 4th. So much for a growing global economy, and our view is if the guys in the center of it all think the punch bowl needs to be spiked, perhaps we need to look deeper.

Just what data is the Fed seeing?

Last week Janet-I’m-not-tellin-Yellen reported the domestic economy is looking better, not great, but better. We’re wondering just what data she was looking at because so far this week alone we’ve seen the following:

  • Monday we learned that Personal Income rose less than expected, (0.3% vs. expectations of 0.4%) while Personal Spending came in below expectations, (-0.2% vs. expectations of -0.1%) in January. That’s two in a row for spending whiffing it.
  • Markit Manufacturing PMI beat expectations, up from 53.9 to 55.1 vs. expectations of 54.3.
  • ISM manufacturing index fell in February to 52.9 from 53.5, for the fourth consecutive monthly decline
  • ISM non-manufacturing index beat expectations at 56.9 in February vs. 56.5 estimates.
  • Construction spending unexpectedly fell1% in January.
  • Six of the top seven auto manufacturers on Tuesday reported year-over-year sales increases in February, but all fell short of expectations.
  • This morning we learned private-sector job creation for February was below expectations with companies adding 212,000 positions versus expectations of 220,000 while also dropping from the 250,000 in January.
  • U.S. crude oil supplies rose to yet another record high last week, with crude-oil stocks at their highest level since 1982 on a weekly basis. Stockpiles rose by 46,000 barrels during the week versus expectations of a 1.8 million drop; keep in mind we’ve already seen operational oil rigs drop by about 1/3.

Well what about prior reports? From the economic data released during the month of February, forty-two were below expectations, (the aforementioned personal spending, construction spending, factory orders, retail sales, business inventories, housing starts, building permits, industrial production, and capacity utilization) while only six beat expectations, (including nonfarm payrolls, Case-Shiller Home prices and Markit Manufacturing PMI). Kinda makes one wonder exactly what Yellen was looking at let alone feeling good about.

Oh wait, there’s the love! Turns out there is no lack of (at least) self-love in the markets as companies last month announced a record $104.3 billion in planned repurchases, which is the most since TrimTabs Investment Research began tracking the data in 1995 and nearly twice the $55 billion from last year. To put that number in context, buybacks will amount to about $5 billion in purchases every day, which is about 2% of the value of all shares traded on U.S. exchanges, according to Bloomberg, which also estimates that earnings from S&P500 members will decline by at least 3.2% this quarter and next, with full year growth at 2.3% versus 5% in 2014.   With executive pay often linked to share price, it shouldn’t come as a surprise that companies in the S&P 500 spent about 95% of their earnings on repurchases and dividends in 2014… oh did we just say that out loud?

In the bond market, negative bond yields currently account for about $2 trillion of debt issued across Europe. Just this week Germany sold five-year bonds at a negative rate for the first time ever. Why would anyone buy bonds with negative yields? The ECB is set to begin rather large purchases of sovereign bonds in the coming months, which will likely push yields even lower. That could allow a negative yielding bond to actually experience a capital gain as bond prices are pushed lower. The ECBs move is also likely to push the euro even lower against the dollar, and as we discussed at the opening of this piece, central banks around the world are lowering their rates, which devalue their currencies… at least relative to currencies that aren’t lowering rates, which right now is basically the dollar. All this is a surreptitiousness form of monetary tightening, of which we are sure the Fed is well aware.

But what about last Friday’s (March 7th release) February Employment report.  The headline for the jobs report boasted 295,000 jobs being created during February, a big beat relative to the 240,000 jobs economist forecasted. The second headline pointed to a drop in the Unemployment Rate to 5.5%. That got everyone in an excited tizzy that the economy is finally really going strong and oh goody-goody-goody we can’t wait to see the next retail sales report!

As always, it pays to dig a bit deeper.  When we do, we find a lot of people continued to drop out of the labor force in February and that was the real driver behind the drop in the unemployment rate. Tough to argue that the jobs situation is all champagne and roses when lots of people decide it just isn’t worth it.  The chart below says it all – unemployment rate falling right along with those who simply leave the workforce.

umeployment and participation

Additionally, wage growth was once again modest in February with a pittance 0.1% increase. Hours worked during February declined, which could be thanks to the snowy weather and port disruptions – we continue to hear from companies like Macy’s (M), Gap (GPS) and others that both will weigh on growth in the current quarter.  The number of construction jobs created in February fell 40% month-over-month.

Most importantly the quality of jobs created remains problematic as leisure & hospitality was the big winner in February, continuing the trend we’ve been watching for some time as a good portion of the post-crisis job creation has been of lower quality than the jobs that were lost. For example, mining/logging lost 8,000 jobs, (which tend to be higher paying) while retailers (which tend to be lower paying) contributed 32,000 jobs. Makes you think about just how many “Do you have this in a small” jobs it takes to replace one highly skilled mining job. On that note, if the job situation is so rosy, why has personal spending declined for two months in a row?

Impact of share repurchases

Impact of share repurchases

I’ve discussed before on this blog the trend for companies to issue debt then use the proceeds to buy back their own shares.  Today I’m going to look at the impact of share repurchases on equity markets.  The chart at right shows the increase in share repurchases.2015-02 Share Repurchase

When the interest rate paid on the bonds is lower than the dividend yield on the shares being repurchased, this is a cash-flow positive strategy. Here’s the math, using small numbers just to keep it simple.

A company’s stock is trading at $100. The current stock dividend is 4% on an annual basis, which means it is paying $4.00 in dividends on every share per year.

The company issues $1,000 worth of bonds yielding 2.5%. This means that if you bought $100 of this bond, you would receive $2.50 a year in interest payments. The company uses the proceeds of the bond issuance, (the $1,000) to repurchase 10 shares of its own stock (10 * $100/share = $1,000). Now the company is paying only $25 a year in interest versus the $40 it was paying previously.

Looking at those equations one can see how low interest rates, (a la Federal Reserve Quantitative Easing) could make it more attractive for companies to buyback their shares and would put downward pressure on dividend yields. So let’s look at the magnitude of share buybacks.

2015-02 Biggest Repurchasers

Well that sure seems like a lot of money going into share buybacks, and that is just the top 12 by volume (number of shares).   Let’s look at the top 10 companies by dollar-value and their share returns.

Repurchasers by dollar

Looks like overall, this proved to be a strategy that is at the very least, correlated to shareholder-pleasing stock price gains. (Keep in mind that executives often have their compensation tied to improvements in share price.) How could these share buybacks affect share prices and not just reduce the amount of money companies pay out in dividends?

The price of a stock on any given day is just a function of supply and demand. The greater the demand (buyers) the more the stock price is pushed up until no more buyers are interested at the higher price. The converse is also true, the more that want to sell, the lower the price will go until no more sellers are interested in selling. (Real world example – when home prices are high, lots of people consider selling their homes, but when home fall, more people are happy to stay just where they are.)

So how big of an impact do these share buybacks have on demand? We can answer this buy looking at fund flows, meaning money going into and coming out the markets.

2015-02 Equity flows

The chart above shows that the single largest source of funds going into the equity markets came from corporations.   Households on the other hand were net sellers. This chart shows that in 2014, household took $183 billion out of the stock market while corporations put $415 into the equities market. If no corporations had purchased equities, there would have been a net outflow of $237 billion dollars! Talk about a reduction in overall demand.

Now let’s go back to the company making the decision to issue bonds, (borrow money) and use the proceeds to buyback shares of their own stock. There are a few things to keep in mind:

  • This is not a sustainable process. Companies cannot endlessly issue debt then use the proceeds to buyback shares – rather intuitive, but something to keep in mind as it is not a long-term way for a company to generate returns for shareholders.
  • If stock prices fall, then the entire equation we did above falls apart. How’s that? Well I left out the impact of share price and the company’s balance sheet in that analysis. (Tricky aren’t I!)   So let’s revisit that equation taking share price into account.

The company issues $1,000 worth of bonds and immediately buys $1,000 worth of stock, or 10 shares since the stock was trading at $100/share. So on the company’s balance sheet there is now a liability worth $1,000, but an asset that is worth $1,000 counters it.

If the company’s stock were to decline by say 15%, then those shares would be worth $850. The company now has a liability worth $1,000 that is countered by an asset worth only $850. This negative change in the company’s net worth makes it less attractive than before the share price decline, so now it has a double hit. Its shares have been falling and now its balance sheet looks less attractive. That can put further downward pressure on the company’s share price, which results in an even less attractive balance sheet and so on. This is another example of how debt can exacerbate problems when asset prices fall.

Now that I’ve mentioned asset prices… well that brings up the Fed and for that matter, most all central banks these days. The goal of loose monetary policy is to induce borrowing which is intended to generate economic activity and drive asset prices up, so if there is a material decline in asset prices, we wouldn’t be surprised to see the Fed step in to try and push prices back up… that is if/until monetary policy is no longer capable of doing so. As the saying goes, “We live in interesting times.”

One more little bit to contemplate is the relationship between company profits and the growth of the economy.  The chart at right shows how the six-month change in 12-month forward earnings per share is closely correlated with changes in real GDP. Notice how most every time the change in EPS goes negative, the economy contracts – again we work with probabilities, not certainties, but one must always keep an eye on the data and the correlations.

2015-02 EPS to GDP