Tag Archives: Share buybacks

Why The Measure Of “Savings” Is Entirely Wrong

In our recent series on capitalism (Read Here), we were discussing how the implementation of socialism, by its very nature, requires an ability to run unlimited deficits. In that discussion was the following quote:

Deficits are self-financing, deficits push rates down, deficits raise private savings.” – Stephanie Kelton

On the surface, there does seem to be a correlation between surging deficits and increases in private savings, as long as you ignore the long-term trend, or the reality of 80% of Americans in the U.S. today that live paycheck-to-paycheck.

The reality is the measure of “personal savings,” as calculated by the Bureau of Economic Analysis, is grossly inaccurate. However, to know why such is the case, we need to understand how the savings rate is calculated. The website HowMuch.com recently provided that calculation of us. 

As you can see, after the estimated taxes and estimated expenses are paid, there is $6,017 dollars left over for “savings,” or, as the Government figures suggest, an 8%+ savings rate. 

The are multiple problems with the calculation.

  1. It assumes that everyone in the U.S. lives on the budget outlined above
  2. It also assumes the cost of housing, healthcare, food, utilities, etc. is standardized across the country. 
  3. That everyone spends the same percentage and buys the same items as everyone else. 

The cost of living between California and Texas is quite substantial. While the median family income of $78,635 may raise a family of four in Houston, it is probably going to be quite tough in San Francisco.

While those flaws are apparent, the biggest issue is the saving rate is heavily skewed by the top 20% of income earners. This is the same problem that also plagues disposable personal income and debt ratios, as previously discussed  in “America’s Debt Burden Will Fuel The Next Crisis.” To wit:

“The calculation of disposable personal income (which is income less taxes) is largely a guess, and very inaccurate, due to the variability of income taxes paid by households. More importantly, the measure is heavily skewed by the top 20% of income earners, and even more so by the top 5%. As shown in the chart below, those in the top 20% have seen substantially larger median wage growth versus the bottom 80%. (Note: all data used below is from the Census Bureau and the IRS.)”

The interactive graphic below from MagnifyMoney shows the disparity of income versus savings even more clearly.

 

When you look at the data in this fashion, you can certainly begin to understand the calls for “socialism” by political candidates. The reality is the majority of Americans are struggling just to make ends meet, which has been shown in a multitude of studies. 

“The [2019] survey found that 58 percent of respondents had less than $1,000 saved.” – Gobankingrates.com

Or, as noted by the WSJ:

“The American middle class is falling deeper into debt to maintain a middle-class lifestyle.

Cars, college, houses, and medical care have become steadily more costly, but incomes have been largely stagnant for two decades, despite a recent uptick. Filling the gap between earning and spending is an explosion of finance into nearly every corner of the consumer economy.

Consumer debt, not counting mortgages, has climbed to $4 trillion—higher than it has ever been even after adjusting for inflation.”

When looking at the data, it is hard to suggest that Americans are saving 8% or more of their income.

The differential between incomes and the actual “cost of living” is quite substantial. As Researchers at Purdue University found in their study of data culled from across the globe, in the U.S., $132,000 was found to be the optimal income for “feeling” happy for raising a family of four. (I can attest to this personally as a father of a family of six)

A Gallup survey found it required $58,000 to support a family of four in the U.S. (Forget about being happy, we are talking about “just getting by.”) 

So, while the Government numbers suggest the average American is saving 8% of their income annually, the majority of “savings” is coming from the differential in incomes between the top 20% and the bottom 80%.

In other words, if you are in the “Top 20%” of income earners, congratulations, you are probably saving a chunk of money.

If not, it is likely a very different story.

The “gap” between the “standard of living” and real disposable incomes is shown below. Beginning in 1990, incomes alone were no longer able to meet the standard of living so consumers turned to debt to fill the “gap.” However, following the “financial crisis,” even the combined levels of income and debt no longer fill the gap. Currently, there is almost a $2654 annual deficit that cannot be filled.

That gap explains why consumer debt is at historic highs and growing each year. If individuals were saving 8% of their money every year, debt balances would at least be flat, if not declining, as they are paid off. 

We can see the inconsistency between the “saving rate” and the requirement to sustain the “cost of living” by comparing the two. Beginning in 2009, it required the entire income of wage earners plus debt just to maintain the standard of living. The gap between the reported savings rate, and reality, is quite telling.

While Stephanie Kelton suggests that running massive deficits increases saving rates, and pose not economic threat as long as their is no inflation, the data clearly suggests this isn’t the case.

Savings rates didn’t fall in the ’80s and ’90s because consumers decided to just spend more. If that was the case, then economic growth rates would have been rising on a year-over-year basis. The reality, is that beginning in the 1980’s, as the economy shifted from a manufacturing to service-based economy, productivity surged which put downward pressure on wage and economic growth rates. Consumers were forced to lever up their household balance sheet to support their standard of living. In turn, higher levels of debt-service ate into their savings rate.

The problem today is not that people are not “saving more money,” they are just spending less as weak wage growth, an inability to access additional leverage, and a need to maintain debt service restricts spending.

That is unless you are in the top 20% of income earners. 

Peak Buybacks? Has Corporate Indulgence Hit Its Limits

Since the passage of “tax cuts,” in late 2017, the surge in corporate share buybacks has become a point of much debate. As I previously wrote, stock buybacks are once again on pace to set a new record in 2019. To wit:

“A recent report from Axios noted that for 2019, IT companies are again on pace to spend the most on stock buybacks this year, as the total looks set to pass 2018’s $1.085 trillion record total.”

The reason companies spend billions on buybacks is to increase bottom-line earnings per share which provides the “illusion” of increasing profitability to support higher share prices. Since revenue growth has remained extremely weak since the financial crisis, companies have become dependent on inflating earnings on a “per share” basis by reducing the denominator. 

“As the chart below shows, while earnings per share have risen by over 360% since the beginning of 2009; revenue growth has barely eclipsed 50%.”

As shown by BofA, in 2019, cumulative buybacks are up +20% on an annualized basis, with the 4-week average reaching some of the highest levels on record. This is occurring at a time when earnings continue to come under pressure due to tariffs, slower consumption, and weaker economic growth.

While share repurchases are not necessarily a bad thing, it is just the “least best” use of companies liquid cash. Instead of using cash to expand production, increase sales, acquire competitors, make capital expenditures, or buy into new products or services which could provide a long-term benefit; the cash is used for a one-time boost to earnings on a per-share basis.

Yes, share purchases can be good for current shareholders if the stock price rises, but the real beneficiaries of share purchases are insiders where changes in compensation structures have become heavily dependent on stock-based compensation. Insiders regularly liquidate shares which were “given” to them as part of their overall compensation structure to convert them into actual wealth. As the Financial Times recently penned:

Corporate executives give several reasons for stock buybacks but none of them has close to the explanatory power of this simple truth: Stock-based instruments make up the majority of their pay and in the short-term buybacks drive up stock prices.

That statement was further supported by a study from the Securities & Exchange Commission which found the same issues:

  • SEC research found that many corporate executives sell significant amounts of their own shares after their companies announce stock buybacks, Yahoo Finance reports.

Not surprisingly, as corporate share buybacks are hitting record highs; so is corporate insider selling.

What is clear, is that the misuse, and abuse, of share buybacks to manipulate earnings and reward insiders has become problematic. As John Authers recently pointed out:

“For much of the last decade, companies buying their own shares have accounted for all net purchases. The total amount of stock bought back by companies since the 2008 crisis even exceeds the Federal Reserve’s spending on buying bonds over the same period as part of quantitative easing. Both pushed up asset prices.”

In other words, between the Federal Reserve injecting a massive amount of liquidity into the financial markets, and corporations buying back their own shares, there have been effectively no other real buyers in the market. 

Less Bang For The Buck

While investors have chased asset prices higher over the last couple of years on hopes of a “trade deal,” more accommodation from Central Banks, or hope the “bull market will never end,” the impact of share buybacks on asset prices is fading.

The chart below is the S&P 500 Buyback Index versus the Total Return index. Following the financial crisis, when companies changed from “splitting shares” to “reducing shares,” there has been a marked outperformance by those companies.

However, while corporate buybacks have accounted for the majority of net purchases of equities in the market, the benefit of pushing asset prices higher is waning. Outside of the brief moment in 2018 when tax cuts were implemented, which allowed companies to repatriate overseas cash, the buyback index has underperformed.

Without that $4 trillion in stock buybacks, not to mention the $4 trillion in liquidity from the Federal Reserve, the stock market would not have been able to rise as much as it has. Given high valuations, weakening earnings, and sluggish economic growth, without continued injections of liquidity going forward, the risk of a substantial repricing of assets has risen.

A more opaque problem is that share repurchases have increasingly been done with the use of leverage. The ongoing suppression of interest rates by the Federal Reserve led to an explosion of debt issued by corporations. Much of the debt was not used for mergers, acquisitions or capital expenditures but for the funding of share repurchases and dividend issuance.

The explosion of corporate debt in recent years will become problematic during the next bear market. As the deterioration in asset prices increases, many companies will be unable to refinance their debt, or worse, forced to liquidate. With the current debt-to-GDP ratio at historic highs, it is unlikely this will end mildly.

This is something Dallas Fed President Robert Kaplan warned about:

U.S. nonfinancial corporate debt consists mostly of bonds and loans. This category of debt, as a percentage of gross domestic product, is now higher than in the prior peak reached at the end of 2008.

A number of studies have concluded this level of credit could ‘potentially amplify the severity of a recession,’

The lowest level of investment-grade debt, BBB bonds, has grown from $800 million to $2.7 trillion by year-end 2018. High-yield debt has grown from $700 million to $1.1 trillion over the same period. This trend has been accompanied by more relaxed bond and loan covenants, he added.

It’s only a problem if a recession occurs.

According to CNN, 53 percent of chief financial officers expect the United States to enter a recession prior to the 2020 presidential election. That information was sourced from the Duke University/CFO Global Business Outlook survey released on Wednesday. And two-thirds predict a downturn by the end of next year. While a slight downturn may not amount to a recession, it certainly means CFOs are taking the initiative to prepare for the worst.”

This is a very important point.

CEO’s make decisions on how they use their cash. If concerns of a recession persist, it is likely to push companies to become more conservative on the use of their cash, rather than continuing to repurchase shares. If that source of market liquidity fades, the market will have a much tougher time maintaining current levels, or going higher.

Summary

While share repurchases by themselves may indeed be somewhat harmless, it is when they are coupled with accounting gimmicks and massive levels of debt to fund them in which they become problematic.

The biggest issue was noted by Michael Lebowitz:

“While the financial media cheers buybacks and the SEC, the enabler of such abuse idly watches, we continue to harp on the topic. It is vital, not only for investors but the public-at-large, to understand the tremendous harm already caused by buybacks and the potential for further harm down the road.”

Money that could have been spent spurring future growth for the benefit of investors was instead wasted only benefiting senior executives paid on the basis of fallacious earnings-per-share.

As stock prices fall, companies that performed un-economic buybacks are now finding themselves with financial losses on their hands, more debt on their balance sheets, and fewer opportunities to grow in the future. Equally disturbing, the many CEO’s who sanctioned buybacks, are much wealthier and unaccountable for their actions.

For investors betting on higher stock prices, the question is whether we have now seen “peak buybacks?”

The Disconnect Between The Markets & Economy Has Grown

A couple of years ago, I wrote an article discussing the disconnect between the markets and the economy. At that time, the Fed was early into their rate hiking campaign. Talks of tax cuts from a newly elected President filled headlines, corporate earnings were growing, and there was a slew of fiscal stimulus from the Government to deal with the effects of 3-major hurricanes and 2-devastating wildfires. Now, the Fed is cutting rates, so it is time to revisit that analysis.

Previously, the consensus for the rise in capital markets was the tax cuts, and low levels of interest rates made stocks the only investment worth having. 

Today, rates have risen, economic growth both domestically and globally has weakened, and corporate profitability has come under pressure. However, since the Fed is cutting rates, hinting at expanding their balance sheet, and a “trade deal” is at hand, stocks are the only investment worth having.

In other words, regardless of the economic or fundamental backdrop, “stocks are the only investment worth having.” 

I am not so sure that is the case.

Let’s begin by putting the markets into perspective.

Yes, the markets are flirting with “all-time highs.” While this certainly sounds impressive, for many investors, they have just started making money on their investments from the turn of the century. As we noted in “The Moment You Know You Know, You Know,” what is often forgotten is the massive amount of “time” lost in growing capital to meet retirement goals.

This is crucially important to understand as was something I addressed in “Stocks – The Great Wealth Equalizer:”

“By the time that most individuals achieve a point in life where incomes and savings rates are great enough to invest excess cash flows, they generally do not have 30 years left to reach their goal. This is why losing 5-7 years of time getting back to “even” is not a viable investment strategy.

The chart below is the inflation-return of $1000 invested in 1995 with $100 added monthly. The blue line represents the impact of the investment using simple dollar-cost averaging. The red line represents a “lump sum” approach. The lump-sum approach utilizes a simple weekly moving average crossover as a signal to either dollar cost average into a portfolio OR moves to cash. The impact of NOT DESTROYING investment capital by buying into a declining market is significant.”

“Importantly, I am not advocating “market timing” by any means. What I am suggesting is that if you are going to invest into the financial markets, arguably the single most complicated game on the planet, then you need to have some measure to protect your investment capital from significant losses.

While the detrimental effect of a bear market can be eventually recovered, the time lost during that process can not. This is a point consistently missed by the ever bullish media parade chastising individuals for not having their money invested in the financial markets.”

However, let’s set aside that point for the moment, and discuss the validity of the argument of the rise of asset prices is simply a reflection of economic strength.

Assuming that individuals are “investing” in companies, versus speculating on price movement, then the investment process is a “bet” on future profitability of the company. Since, companies derive their revenue from consumption of their goods, products, and services; it is only logical that stock price appreciation, over the long-term, has roughly equated to economic growth. However, during shorter time-frames, asset prices are affected by investor psychology which leads to “boom and bust” cycles. This is the situation currently, which can be seen by the large disconnect between current economic growth and asset prices.

Since January 1st of 2009, through the end of the second quarter of 2019, the stock market has risen by an astounding 164.90% (inflation-adjusted). However, if we measure from the March 9, 2009 lows, the percentage gain explodes to more than 200%. With such a significant gain in the financial markets, we should see a commensurate indication of economic growth.

The reality is that after 3-massive Federal Reserve driven “Quantitative Easing” programs, a maturity extension program, bailouts of TARP, TGLP, TGLF, etc., HAMP, HARP, direct bailouts of Bear Stearns, AIG, GM, bank supports, etc., all of which total more than $33 Trillion, the economy grew by just $3.87 Trillion, or a whopping 24.11% since the beginning of 2009. The ROI equates to $8.53 of interventions for every $1 of economic growth.

Not a very good bargain.

We can look at this another way.

The stock market has returned almost 103.6% since the 2007 peak, which is more than 4-times the growth in GDP and nearly 3-times the increase in corporate revenue. (I have used SALES growth in the chart below as it is what happens at the top line of income statements and is not AS subject to manipulation.)

The all-time highs in the stock market have been driven by the $4 trillion increase in the Fed’s balance sheet, hundreds of billions in stock buybacks, and valuation (PE) expansion. With Price-To-Sales ratios and median stock valuations near the highest in history, one should question the ability to continue borrowing from the future?

Speaking of rather extreme deviations, another concern for the detachment of the markets from more basic economic realities, the deviation of reported earnings from corporate profits after-tax, is at historical extremes.

These sharp deviations tend to occur in late market cycles when “excess” from speculation has reached extremes. Recessions tend to follow as a “reversion to the mean occurs.

While, earnings have surged since the end of the last recession, which has been touted as a definitive reason for higher stock prices, it is not all as it would seem.

Earnings per share are indeed an important driver of markets over time. However, the increase in profitability has not come strong increases in revenue at the top of the income statement. The chart below shows the deviation between the widely touted OPERATING EARNINGS (earnings before all the “bad” stuff) versus REPORTED EARNINGS which is what all historical valuations are based. I have also included revenue growth, as well.

This is not a new anomaly, but one which has been a consistent “meme” since the end of the financial crisis. As the chart below shows, while earnings per share have risen by over 360% since the beginning of 2009; revenue growth has barely eclipsed 50%.

While suppressed wage growth, layoffs, cost-cutting, productivity increases, accounting gimmickry, and stock buybacks have been the primary factors in surging profitability, these actions have little effect on revenue growth. The problem for investors is all of the gimmicks to win the “beat the estimate game” are finite in nature. Eventually, real rates of revenue growth will matter. However, since suppressed wages and interest rates have cannibalized consumer incomes – there is nowhere left to generate further sales gains from in excess of population growth.

Left Behind

While Wall Street has significantly benefited from the Fed’s interventions, Main Street has not. Over the past few years, as asset prices surged higher, there has been very little translation into actual economic prosperity for a large majority of Americans. This is reflective of weak wage, economic, and inflationary growth which has led to a surge in consumer debt to record levels.

Of course, weak economic growth has led to employment growth that is primarily a function of population growth. As I addressed just recently:

“Employment should increase to accommodate for the increased demand from more participants in the economy. Either that or companies resort to automation, off-shoring, etc. to increase rates of production without increases in labor costs. The chart below shows the total increase in employment versus the growth of the working-age population.”

While reported unemployment is hitting historically low levels, there is a swelling mass of uncounted individuals that have either given up looking for work or are working multiple part-time jobs. This can be seen below which shows those “not in labor force,” as a percent of the working-age population, skyrocketing.

If employment was indeed as strong as reported by government agencies, then social benefits would not be comprising a record high of 22% of real disposable incomes. 

Without government largesse, many individuals would literally be living on the street. The chart above shows all the government “welfare” programs and current levels to date. While unemployment insurance has hit record lows following the financial crisis, social security, Medicaid, Veterans’ benefits and other social benefits have continued to rise and have surged sharply over the last few months.

With 1/5 of incomes dependent on government transfers, it is not surprising that the economy continues to struggle as recycled tax dollars used for consumption purposes have virtually no impact on the overall economy.

Conclusion

While financial markets have surged to “all-time highs,” the majority of Americans who have little, or no, vested interest in the financial markets have a markedly different view. While the Fed keeps promising with each passing year the economy will come roaring back to life, the reality has been that all the stimulus and financial support hasn’t been able to put the broken financial transmission system back together again.

Amazingly, more than two-years following the initial writing of this article, the gap between the markets and the economy has grown even wider. Eventually, the current disconnect between the economy and the markets will merge.

I bet such a convergence will likely not be a pleasant one.

Powell Keeps The Bond Bull Kicking

In a widely expected outcome, the Federal Reserve announced no change to the Fed funds rate but did leave open the possibility of a rate hike next year. Also, they committed to stopping “Quantitative Tightening (or Q.T.)” by the end of September. 

The key language from yesterday’s announcement was:

Information received since the Federal Open Market Committee met in January indicates that the labor market remains strong but that growth of economic activity has slowed from its solid rate in the fourth quarter. Payroll employment was little changed in February, but job gains have been solid, on average, in recent months, and the unemployment rate has remained low.

Recent indicators point to slower growth of household spending and business fixed investment in the first quarter. On a 12-month basis, overall inflation has declined, largely as a result of lower energy prices; inflation for items other than food and energy remains near 2 percent. On balance, market-based measures of inflation compensation have remained low in recent months, and survey-based measures of longer-term inflation expectations are little changed.”

What is interesting is that despite the language that “all is okay with the economy,” the Fed has completely reversed course on monetary tightening by reducing the rate of balance sheet reductions in coming months and ending them entirely by September. At the same time, all but one future rate hike has disappeared, and the Fed discussed the economy might need easing in the near future. To wit, my colleague Michael Lebowitz posted the following Tweet after the Fed meeting:

This assessment of a weak economy is not good for corporate profitability or the stock market. However, it seems as if investors have already gotten the “message” despite consistent headline droning about the benefits of chasing equities. Over the last several years investors have continued to chase “safety” and “yield.” The chart below shows the cumulative flows of both ETF’s and Mutual Funds in equities and fixed income. 

This chase for “yield” over “return” is also seen in the global investor positing report for March.

Clearly, investors have continued to pile into fixed income and safer equity income assets over the last few years despite the sharp ramp up in asset prices. This demand for “yield” and “safety” has been one of the reasons we have remained staunchly bullish on bonds in recent years despite continued calls for the “Death of the Bond Bull Market.” 

The Reason The Bond Bull Lives

Importantly, one of the key reasons we have remained bullish on bonds is that, as shown below, it is when the Fed is out of the “Q.E” game that rates fall. This, of course, was the complete opposite effect of what was supposed to happen.

Of course, the reasoning is simple enough and should be concerning to investors longer-term. Without “Q.E” support, economic growth stumbles which negatively impacts asset prices pushing investors into the “safety” of bonds. 

As the Fed now readily admits, their pivot to a more “dovish” stance is due to the global downturn in economic growth, and the bond market has been screaming that message in recent months. As Doug Kass noted on Tuesday:

“Which brings me to today’s fundamental message of the fixed income markets – which are likely being ignored and could be presaging weakening economic and profit growth relative to consensus expectations and, even (now here is a novel notion) that could lead to lower stock prices. That message is undeniable – economic and profit growth is slowing relative to expectations as financial asset prices move uninterruptedly higher.

  • The yield on the 10 year U.S. note has dropped below 2.60% this morning. (I have long had a low 2.25% forecast for 2019)
  • The (yield curve and) difference between 2s and 10s is down to only 14 basis points.
  • High-frequency economic statistics (e.g. Cass Freight Index) continue to point to slowing domestic growth.
  • Auto sales and U.S. residential activity are clearly rolling over.
  • PMIs and other data are disappointing.
  • Fixed business investment is weakening.
  • No country is an economic island – not even the U.S.
  • Europe is approaching recession and China is overstating its economic activity (despite an injection of massive amounts of liquidity).”

He is correct, yields continue to tell us an important story. 

First, three important facts are affecting yields now and in the foreseeable future:

  1. All interest rates are relative. With more than $10-Trillion in debt globally sporting negative interest rates, the assumption that rates in the U.S. are about to spike higher is likely wrong. Higher yields in U.S. debt attracts flows of capital from countries with negative yields which push rates lower in the U.S. Given the current push by Central Banks globally to suppress interest rates to keep nascent economic growth going, an eventual zero-yield on U.S. debt is not unrealistic.
  2. The coming budget deficit balloon. Given the lack of fiscal policy controls in Washington, and promises of continued largess in the future, the budget deficit will eclipse $1 Trillion or more in the coming years. This will require more government bond issuance to fund future expenditures which will be magnified during the next recessionary spat as tax revenue falls.
  3. Central Banks will continue to be a buyer of bonds to maintain the current status quo. As such they will have to be even more aggressive buyers during the next recession. The next QE program by the Fed to offset the next economic recession will likely be $2-4 Trillion and might push the 10-year yield towards zero.

As I have discussed many times in the past, interest rates are a function of three primary factors: economic growth, wage growth, and inflation. The relationship can be clearly seen in the chart below.

Okay…maybe not so clearly. 

Let me clean this up by combining inflation, wages, and economic growth into a single composite for comparison purposes to the level of the 10-year Treasury rate.

As you can see, the level of interest rates is directly tied to the strength of economic growth, wages and inflation. This should not be surprising given that consumption is roughly 70% of economic growth.

As Doug notes, the credit markets have been right all along the way. At important points in time, when the Fed signaled policy changes, credit markets have correctly interpreted how likely those changes were going to be. A perfect example is the initial rate hike path set out in December 2015 by then Fed Chairman Janet Yellen. This was completely wrong at the time and the credit markets told us so from the beginning. 

The credit markets have kept us on the right side of the interest rate argument in repeated posts since 2013. Why, because the credit market continues to tell us an important story if you are only willing to listen. 

The bond market is screaming “secular stagnation.” 

Since 2009, asset prices have been lofted higher by artificially suppressed interest rates, ongoing liquidity injections, wage and employment suppression, productivity-enhanced operating margins, and continued share buybacks have expanded operating earnings well beyond revenue growth.

As I wrote in mid-2017:

“The Fed has mistakenly believed the artificially supported backdrop they created was actually the reality of a bright economic future. Unfortunately, the Fed and Wall Street still have not recognized the symptoms of the current liquidity trap where short-term interest rates remain near zero and fluctuations in the monetary base fail to translate into higher inflation. 

Combine that with an aging demographic, which will further strain the financial system, increasing levels of indebtedness, and lack of fiscal policy, it is unlikely the Fed will be successful in sparking economic growth in excess of 2%. However, by mistakenly hiking interest rates and tightening monetary policy at a very late stage of the current economic cycle, they will likely be successful at creating the next bust in financial assets.”

It didn’t take long for that prediction to come to fruition and change the Fed’s thinking.

On December 24th, 2018, while the S&P 500 was plumbing it’s depths of the 2018 correction, I penned “Why Gundlach Is Still Wrong About Higher Rates:”

“At some point, the Federal Reserve is going to step back in and reverse their policy back to “Quantitative Easing” and lowering Fed Funds back to the zero bound.

When that occurs, rates will not only go to 1.5%, but closer to Zero, and maybe even negative.”

What I didn’t know then was that literally the next day the Fed would reverse course. 

The chart below shows the rolling 4-week change in the Fed’s balance sheet versus the S&P 500. 

The issue for the Fed is that they have become “market dependent” by allowing asset prices to dictate policy. What they are missing is that if share prices actually did indicate higher rates of economic growth, not just higher profits due to stock buybacks and accounting gimmickry, then US government bond yields would be rising due to future rate hike expectations as nominal GDP would be boosted by full employment and increased inflation. But that’s not what’s happening at all.

Instead, the US 10-year bond is pretty close to 2.5% and the yield curve is heading into inversion.

Since inversions are symptomatic of weaker economic growth, such would predict future rate hikes by the Fed will be limited. Not surprisingly, that is exactly what is happening now as shown by yesterday’s rapid decline in the Fed’s outlook.

Why?

Let’s go back to that 2017 article:

“However, the issue of rising borrowing costs spreads through the entire financial ecosystem like a virus. The rise and fall of stock prices have very little to do with the average American and their participation in the domestic economy. Interest rates are an entirely different matter.

Since interest rates affect ‘payments,’ increases in rates quickly have negative impacts on consumption, housing, and investment which ultimately deters economic growth.”

All it took was for interest rates to crest 3% and home, auto, and retail sales all hit the skids. Given the current demographic, debt, pension, and valuation headwinds, the future rates of growth are going to be low over the next couple of decades – approaching ZERO.

While there is little left for interest rates to fall in the current environment, there is also not a tremendous amount of room for increases. Therefore, bond investors are going to have to adopt a “trading” strategy in portfolios as rates start to go flat-line over the next decade.

Whether, or not, you agree there is a high degree of complacency in the financial markets is largely irrelevant. The realization of “risk,” when it occurs, will lead to a rapid unwinding of the markets pushing volatility higher and bond yields lower. This is why I continue to acquire bonds on rallies in the markets, which suppresses bond prices, to increase portfolio income and hedge against a future market dislocation.

In other words, I get paid to hedge risk, lower portfolio volatility and protect capital.

Bonds aren’t dead, in fact, they are likely going to be your best investment in the not too distant future.

“I don’t know what the seven wonders of the world are, but the eighth is compound interest.” – Baron Rothschild 


Stock Buybacks Aren’t Bad, Just Misused & Abused

There has been a lot of commentary as of late regarding the issue of corporate share repurchases. Even Washington D.C. has chimed into the rhetoric as of late discussing potential bills to limit or eliminate these repurchases. It is an interesting discussion because most people don’t remember that share repurchases were banned for decades prior to President Reagan in 1982. 

Even after the ban was lifted, share repurchases were few and far between as during the “roaring bull market of the 90’s” it was more about increasing outstanding shares through stock splits. Investors went crazy over stock splits as they got more shares of the company they loved at half the price. Most didn’t realize, or understand the effective dilution; but for them it was more of a Yogi Berra analogy:

“Can you cut my pizza into four pieces because I can’t eat eight.” 

However, following the financial crisis stock splits disappeared and a new trend emerged – share repurchases. Like stock splits, share repurchases in and of themselves are not necessarily a bad thing, it is just the least best use of cash. Instead of using cash to expand production, increase sales, acquire competitors, or buy into new products or services, the cash is used to reduce the outstanding share count and artificially inflate earnings per share. Here is a simple example:

  • Company A earns $1 / share and there are 10 / shares outstanding. 
  • Earnings Per Share (EPS) = $0.10/share.
  • Company A uses all of its cash to buy back 5 shares of stock.
  • Next year, Company A earns $0.20/share ($1 / 5 shares)
  • Stock price rises because EPS jumped by 100%.
  • However, since the company used all of its cash to buy back the shares, they had nothing left to grow their business.
  • The next year Company A still earns $1/share and EPS remains at $0.20/share.
  • Stock price falls because of 0% growth over the year. 

This is a bit of an extreme example but shows the point that share repurchases have a limited, one-time effect, on the company. This is why once a company engages in share repurchases they are inevitably trapped into continuing to repurchase shares to keep asset prices elevated. This diverts ever-increasing amounts of cash from productive investments and takes away from longer term profit and growth.

As shown in the chart below, the share count of public corporations has dropped sharply over the last decade as companies scramble to shore up bottom line earnings to beat Wall Street estimates against a backdrop of a slowly growing economy and sales.

(The chart below shows the differential added per share via stock backs. It also shows the cumulative growth in EPS and Revenue/Share since 2011)

The Abuse & Misuse 

As I stated, share repurchases aren’t necessarily a bad thing. It is just the misuse and abuse of them which becomes problematic. It’s not just share repurchases though. In “4-Tools To Beat The Wall Street Estimate Game” we discussed how companies not only use stock repurchases, but a variety of other accounting gimmicks to “meet their numbers.” 

“The tricks are well-known: A difficult quarter can be made easier by releasing reserves set aside for a rainy day or recognizing revenues before sales are made, while a good quarter is often the time to hide a big ‘restructuring charge’ that would otherwise stand out like a sore thumb.

What is more surprising though is CFOs’ belief that these practices leave a significant mark on companies’ reported profits and losses. When asked about the magnitude of the earnings misrepresentation, the study’s respondents said it was around 10% of earnings per share.

cooking-the-books-2

The reason that companies do this is simple: stock-based compensation. Today, more than ever, many corporate executives have a large percentage of their compensation tied to company stock performance. A “miss” of Wall Street expectations can lead to a large penalty in the companies stock price.

As shown in the table above, it is not surprising to see that 93% of the respondents pointed to “influence on stock price” and “outside pressure” as the reason for manipulating earnings figures.

The use of stock buybacks has continued to rise in recent years and went off the charts following the passage of tax cuts in 2017. As I wrote in early 2018. while it was widely believed that tax cuts would lead to rising capital investment, higher wages, and economic growth, it went exactly where we expected it would. To wit:

“Not surprisingly, our guess that corporations would utilize the benefits of “tax cuts” to boost bottom line earnings rather than increase wages has turned out to be true. As noted by Axios, in just the first two months of this year companies have already announced over $173 BILLION in stock buybacks.  This is ‘financial engineering gone mad'” 

Share buybacks are expected to hit a new record by the end of 2019.

“Share repurchases aren’t bad. It is simply the company returning money to shareholders.”

There is a problem with that statement.

Share buybacks only return money to those individuals who sell their stock. This is an open market transaction so if Apple (AAPL) buys back some of their outstanding stock, the only people who receive any capital are those who sold their shares.

So, who are the ones mostly selling their shares?

As noted above, it’s the insiders, of course, as changes in compensation structures since the turn of the century has become heavily dependent on stock based compensation. Insiders regularly liquidate shares which were “given” to them as part of their overall compensation structure to convert them into actual wealth. As the Financial Times recently penned:

Corporate executives give several reasons for stock buybacks but none of them has close to the explanatory power of this simple truth: Stock-based instruments make up the majority of their pay and in the short-term buybacks drive up stock prices.

A recent report on a study by the Securities & Exchange Commission found the same:

  • SEC research found that many corporate executives sell significant amounts of their own shares after their companies announce stock buybacks, Yahoo Finance reports.

What is clear, is that the misuse and abuse of share buybacks to manipulate earnings and reward insiders has become problematic. As John Authers recently pointed out:

“For much of the last decade, companies buying their own shares have accounted for all net purchases. The total amount of stock bought back by companies since the 2008 crisis even exceeds the Federal Reserve’s spending on buying bonds over the same period as part of quantitative easing. Both pushed up asset prices.”

In other words, between the Federal Reserve injecting a massive amount of liquidity into the financial markets, and corporations buying back their own shares, there have been effectively no other real buyers in the market. 

As Jesse Felder wrote:

“Without that $4 trillion in stock buybacks and in a market where trading volume has been falling for decades they never would have been able to soar as high as they have. The chart below plots ‘The Buffett Yardstick’ (total equity market capitalization relative to gross national product) against total net equity issuance (inverted). Since the late-1990’s both valuations and buybacks have been near record highs. Is this just a coincidence? I think it’s safe to say it’s not.”

The other problem with the share repurchases is that is has increasingly been done with the use of leverage. The ongoing suppression of interest rates by the Federal Reserve led to an explosion of debt issued by corporations. Much of the debt was not used for mergers, acquisitions or capital expenditures but for the funding of share repurchases and dividend issuance. 

The explosion of corporate debt in recent years will become problematic if rates rise markedly, further deterioration in credit quality locks companies out of refinancing, or if there is a recessionary drag which forces liquidation of debt. This is something Dallas Fed President Robert Kaplan warned about:

U.S. nonfinancial corporate debt consists mostly of bonds and loans. This category of debt, as a percentage of gross domestic product, is now higher than in the prior peak reached at the end of 2008.

A number of studies have concluded this level of credit could ‘potentially amplify the severity of a recession,’

The lowest level of investment-grade debt, BBB bonds, has grown from $800 million to $2.7 trillion by year-end 2018. High-yield debt has grown from $700 million to $1.1 trillion over the same period. This trend has been accompanied by more relaxed bond and loan covenants, he added.

This was recently noted by the Bank of International Settlements. 

“If, on the heels of economic weakness, enough issuers were abruptly downgraded from BBB to junk status, mutual funds and, more broadly, other market participants with investment grade mandates could be forced to offload large amounts of bonds quickly. While attractive to investors that seek a targeted risk exposure, rating-based investment mandates can lead to fire sales.”

Summary

While share repurchases by themselves may indeed be somewhat harmless, it is when they are coupled with accounting gimmicks and massive levels of debt to fund them in which they become problematic. 

The biggest issue was noted by Michael Lebowitz:

“While the financial media cheers buybacks and the SEC, the enabler of such abuse idly watches, we continue to harp on the topic. It is vital, not only for investors but the public-at-large, to understand the tremendous harm already caused by buybacks and the potential for further harm down the road.”

Money that could have been spent spurring future growth for the benefit of investors was instead wasted only benefiting senior executives paid on the basis of fallacious earnings-per-share.

As stock prices fall, companies that performed un-economic buybacks are now finding themselves with financial losses on their hands, more debt on their balance sheets, and fewer opportunities to grow in the future. Equally disturbing, the many CEO’s who sanctioned buybacks, are much wealthier and unaccountable for their actions.

This article may be best summed up with just one word:

Fraud – frôd/ noun:

Wrongful or criminal deception intended to result in financial or personal gain.


United Technologies (UTX) Faces Reality- Will Other Companies Follow Suit Before It’s Too Late.

On November 27, 2018, the CFO from United Technologies (UTX) stated that his company will focus on deleveraging and not stock buybacks. This announcement comes as General Electric (GE) is struggling mightily to retain investment grade status and its stock is nearing levels last seen during the depths of the financial crisis. While there is much to attribute to GE’s decline, massive stock buybacks in 2016 and 2017 are largely to blame.

To wit: “The root problem at GE — and why the stock is where it is — is poor capital allocation,” said RBC Capital Markets analyst Deane Dray.

Corporate debt now stands at record levels versus GDP as shown below. While the debt has been used to fund expansion and R&D it has also been used to fund record numbers of share buybacks. The pitfalls of such a strategy are now encroaching upon GE’s ability to survive. We suspect that UTX is the first of many companies to acknowledge this realization.

In February of 2016 we wrote an article on Conoco Phillips (COP). The missive, which is one of six articles we have written criticizing stock buybacks, describes how COP was forced to cut a reliable dividend and capital expenditures as they were strapped for cash. The price of oil at the time was hurting cash-flows. Unfortunately COP, like GE, had previously bought back a significant number of shares which greatly reduced their liquidity status when it was needed most.

While the article is nearly three years old we think it is every bit as important today as it was then. It exemplifies how precarious a company’s ability to survive financial weakness and/or an economic downturn is when capital is squandered in efforts to temporarily boost share prices. This story is likely to become a common theme for the next few years especially if, as we suspect, economic growth declines and stocks prices fall.


As the Tide Goes Out, Effects of Buybacks are Exposed  :  The ConocoPhillips Poster Child

 “The words of men may temporarily suspend but they do not alter the laws of financial dynamics. The fundamentals always take precedence eventually”- 720 Global 11/30/2015

The quote above was from an article we wrote that scrutinized stock buybacks and the unforeseen impacts they may have. In that piece as well as an earlier missive, “Corporate Buybacks; Connecting Dots to the F-word”, we rebuked the short-termism stock buyback fad. Both articles made the case that corporate executives, through buybacks, promote higher short-term stock prices that serve largely only to benefit their own compensation. The costs of these actions are felt later as the future growth for the respective companies, employees and entire economy are robbed.

This case study details how the “the laws of financial dynamics” have caught up with ConocoPhillips (COP) and demonstrates how shareholders are suffering while executives prosper.

COP

On February 4th, 2016 COP, in reaction to their fourth quarter earnings release, slashed its quarterly dividend from $0.74 to $0.25 per share, a level not seen since March 2005. COP also lowered its current year capital expenditure (capex) budget by $1.31 billion, marking the second reduction in as many months. The actions are a direct response to the plummeting price of oil and the damage it is having on COP’s bottom line. The company’s net loss for the fourth quarter 2015 was $3.50 billion or $0.90 per share.

While the losses and expense cuts are not shocking given the severe decline in oil prices, the dividend cut was a jolt to many investors. COP has consistently paid a dividend, as shown below, since 1990. During that 25 year period the dividend was increased 19 times but COP had never decreased it, until now. Even during the financial crisis of 2008/09, COP raised its dividend despite the price of crude oil dropping $100 per barrel.

Maybe the biggest cause for the shock is not the steadfastness of their prior dividend policy, but official corporate presentations.  On the first page of their 2016 Operating Plan (Analyst & Investor Update – December 10, 2015) they make the following statements: “Dividend is highest priority use of cash” and “DIVIDEND Remains Top Priority”. The statements are repeated in the summary on the final page. The cover of their most recent annual report has a word cloud diagram with “dividend” shown among other key corporate values.

What Could Have Been

The dividend and capex reductions are prudent measures undertaken by management to help manage corporate assets and bolster their financial conditions during an historic swoon in revenue. This article does not question those actions, it instead asks if such drastic measures would be necessary had management not spent enormous sums of capital on stock buybacks in the preceding years.

Since 2011, COP repurchased 251.316 million shares representing roughly 20% of their shares outstanding, at an approximate cost of $14.168 billion. The majority of these purchases occurred between 2011 and 2012 when the stock traded between $48 and $58 per share.  Today the stock trades at $32 per share, matching prices last seen 12 years ago.  The graph below charts the share price of COP with an overlay of the share repurchases by quarter.

Now let us contemplate what COP’s current financial situation might look like had management and the board of directors not engaged in repurchases. First of all, COP would still have the $14.168 billion spent on buybacks since 2011, which could be used to support the $0.74 per share dividend for almost 5 years.   More importantly, the company could be in the envious position of employing the capital to buy assets that are being liquidated by other companies at cents on the dollar.  Shareholders are suffering in many ways from the abuses of management in years past and will continue to do so for years to come.

The Rich Get Richer…

Fortunately for James Mulva, COP’s CEO during the 2011/2012 stock buyback era, his overly generous compensation is beyond COP’s ability to reclaim. Mr. Mulva retired in June of 2012 after repurchasing approximately 20% of the company’s outstanding shares. Upon retirement he received a $260 million golden parachute from the company. That was on top of $141 million in total compensation he received in 2011.

The board of directors and shareholders must have been enamored with Mulva’s performance despite poor earnings trends in his final 2 years.  From 2011 to 2012 the company earnings per share fell 25% from $8.97/share to $6.72/share. Had the board factored in the effect of buybacks on earnings per share when determining Mr. Mulva’s compensation, they would have realized that earnings per share were actually 40% lower at $5.37 per share.

We provide the following snippets on James Mulva to better gauge the potential motivations behind the tremendous buyback program.

Summary

While the financial media cheers buybacks and the SEC, the enabler of such abuse idly watches, we continue to harp on the topic. It is vital, not only for investors but the public at-large, to understand the tremendous harm already caused by buybacks and the potential for further harm down the road. Unfortunately, COP is not an isolated case. Hess Oil, for instance, just sold 25 million shares at $39 per share to improve their capital position. Sadly for Hess shareholders, many of whom likely supported buybacks, this shareholder dilution was unnecessary had Hess not bought nearly 63 million shares at a price of nearly $60 per share in the 3 years prior. Money that could have been spent spurring future growth for the benefit of investors was instead wasted only benefitting senior executives paid on the basis of fallacious earnings-per-share.  

As stock prices fall, companies that performed un-economic buybacks are now finding themselves with financial losses on their hands, more debt on their balance sheets, and fewer opportunities to grow in the future. Equally disturbing, many CEO’s like James Mulva, who sanctioned buybacks, are much wealthier and unaccountable for their actions.

This article may be best summed up with the closing to our first article on buybacks.

Fraud – frôd/ noun:

wrongful or criminal deception intended to result in financial or personal gain.

Cliff Asness On Buybacks – Boosting Returns or Liquidating Companies?

Asset manager Cliff Asness recently wrote an op-ed piece in the Wall Street Journal wondering if those who decried companies buying back their stock didn’t suffer from “buyback derangement syndrome.”

Asness allowed that net investment, normalized by total assets or total market capitalization, was recently lower for companies in the Russell 3000 Index than it was in the 1990s, “but positive and much higher than during the 2008 financial crisis.”

It seems strange to crow that investment is better now than during the financial crisis.

And Asness offers no opinion or interpretation on why investment should be lower now than in the 1990s, especially given that low interest rates after the financial crisis were supposed to stimulate investment. Granted, his purpose isn’t to comment on Federal Reserve policy, but one might think he’d have something to say about lower investment immediately after a financial crisis – when investment is most needed. Asness also doesn’t say how much lower investment is now. That’s strange, given that he will conclude by asserting the buyback arguments amount to “innumerate nonsense.”

Asness mentions that companies aren’t shrinking away by buying their stock, because they are also borrowing a lot of money. “Think of this as a debt-for-equity swap,” he says – again neutrally or flatly. Is it good or bad – and for whom? — that companies are exchanging equity for debt? Asness doesn’t say. Moreover, later Asness will defend the argument that buybacks are indeed a form of liquidation.

Next, Asness argues that investors do not spend the money paid out in buybacks frivolously. Instead, investors buy other stocks and bonds with their buyback bounty, thereby shifting capital from companies that don’t need it to those that do. But that’s a little too neat. An investor buying stock on the secondary market isn’t giving money to a company in exchange for shares. Rather the investor is buying from another investor a claim to profits on capital already raised by a company previously.

Then things get stranger in Asness’s article. He argues that there’s no way to tell how much buybacks have boosted stock market returns since the financial crisis. And returns have been prodigious – around 15% annualized. But in making this argument Asness admits that it’s possible buybacks have boosted stock returns. Yet when turning to arguments about Apple – that the firm is a scam fueled by buybacks – he relies on the argument that buybacks are a form of liquidation that reduce market capitalization.

So do buybacks boost stock market returns or reduce market capitalization? It’s hard to know what Asness thinks. Clearly reducing share count and elevating earnings-per-share – the obvious immediate effects of buybacks — should increase the share price. But Asness doesn’t say whether a higher share price should compensate for fewer shares precisely and keep market capitalization stable, or whether it should alter market capitalization.  He only says that it’s difficult to know if buybacks have boosted stock market returns, but also that it’s crazy to think Apple’s market capitalization shouldn’t be reduced instead of elevated by share buybacks.

Perhaps Asness is consistent is asserting that buybacks probably haven’t boosted market returns and certainly haven’t boosted Apple’s market capitalization. But he doesn’t think it’s impossible that buybacks have boosted stock returns, leaving himself vulnerable to the charge that he is confused about whether buybacks boost returns (and market capitalization) or amount to a liquidation and shrinkage of market capitalization.

Ultimately, Asness is upset that people are examining what corporations do with their profits when Americans have so many other things to debate. But when profit margins are so persistently high and a higher percentage of profits are returned to capital, perhaps he shouldn’t be so naïve to think a political debate wouldn’t commence about corporate profits and share buybacks. Moreover, despite calling the buyback arguments “innumerate nonsense,” it seems Asness has some thinking to do about whether buybacks boost market returns or are a form of liquidation.