During 2013, many smart analysts and money managers voiced their puzzlement of why the stock market continued to rise in spite of the lack of revenue growth of many companies, a stagnating economy, and looming problems in 2014. I wrote in our Wellington Letter that this year it would have been more productive for analysts to just “go with the flow” and head for the golf course each day then to do tedious analysis.
Let’s look at the possible answer to the above question.
This year, companies have been buying lots of their own stocks. That has been a major driving force in this rally. Just about every other big investment group has been a net seller this year. Until May this year, $286 billion of buybacks had been announced. That’s up 88% from the same period last year, according to Birinyi Associates, a market research firm. They stated that at that rate, buybacks will exceed the record set in 2007.
Bill Gross, founder of PIMCO, the largest bond manager in the world, puts the amount of buybacks at $1 trillion per year over the past five years. He wrote recently:
“The U.S. economy – thanks to the Fed – has been operating a $1 trillion share buyback program nearly every year since late 2008, buying Treasuries but watching much of that money flow straight into risk assets and common stocks instead of productive plant and equipment.”
My goodness! If X can’t grow revenues any more, if X company’s stock has only gone up because of expense cutting and stock buybacks, what does that say about the U.S. or many other global economies? Has our prosperity been based on money printing, credit expansion and cost cutting, instead of honest-to-goodness investment in the real economy?
The Web site Zero hedge.com states on the subject:
“Nearly every other big player (other than buybacks) in the stock market has been selling more than they’ve been buying. Pension funds have been selling. Local and state governments have been selling. Investment brokerages have been selling. And, yes, until recently, even Main Street investors.”
Yes, it’s a shocking realization. I have not verified Bill Gross’s number, and in fact it’s much higher than that of Birinyi. I believe it’s more like $1 triillion over five years, not per year. Furthermore, I don’t know if they counted “announced” or actually executed buybacks. But even $1 trillion over five years is an amazing number. It’s an incredible thought that the driving force of the bull market in stocks may have been these buybacks. It has important implications for investors.
The Fed has not only been the great ‘enabler’ of the bull market, but also of Congress’s big deficit spending. Without the Fed buying up all these securities, Congress would have been much more frugal in running up the deficit. The limiting factor would have been the ability to sell the U.S. Treasury securities around the world. With the Fed buying almost all that is offered by the Treasury, there is no reason for the politicians to stop spending.
Currently, the Fed buys 80% of Treasury securities. Next year, it’s estimated to be around 120%. In other words, the stockpile of Treasurys in investors’ portfolios would shrink. Imagine, the Fed does all this with freshly created “cyber-money.” This is a big game changer in the 100 year history of the Fed. And that is the Bernanke legacy.
The buybacks have been enabled by the Fed’ ZIRP (zero interest rate policy). It doesn’t make sense for the companies to put hundreds of billions at less than 1% interest in CDs, money market funds, etc. Therefore, companies buy their own stocks.
Why is that a better investment? If you own the shares, like management or big investors, it’s great. Buybacks reduce the shares outstanding, and thus increase the earnings per share even if there is no real increase in profitability for the company. Therefore, stock prices rise, as we saw this year. It’s a beautiful game.
At the same time, corporate “insiders,” i.e. top executives, have engaged in massive, record selling of their own stocks. Could it be that another reason for the buybacks is to enable insiders to sell at better prices? Someone should write a book, “How to make billions in stock profits without any performance gains in the company. “
The above would explain rising stock prices and rising earnings per share while sales are disappointing, and even declining for many firms.
Therefore, we must ask, what happens when these buybacks stop? Or, what would cause them to stop?
Perhaps, buybacks would slow if the economy picks up and the money can better be used for expansion. Conversely, if the economy worsens, there will be more buybacks to support the stocks, possibly helped along with an even greater QE by the Fed.
Thus we have a situation where a bad economy would be better for stocks than a stronger one. We will explore this topic further in future posts.
It’s a fact that the largest number of such buybacks don’t occur at market bottoms, when stocks are cheap, but closer to market tops, when they are expensive. Billionaire investor Carl Icahn wants to push Apple AAPL +0.77% into doing a big buyback, presumably so he can get out of the stock. He may have difficulty with that exit strategy.
Companies are sitting on piles of cash and don’t find any other way to use it. Expanding their own business apparently isn’t attractive in today’s slow economic environment, where local, state and federal government policies are making business increasingly less attractive. U.S. companies are leaving in droves, establishing headquarters abroad.
Some members of Congress want to reduce corporate taxes because an increasing number of U.S. firms are moving their headquarters offshore. Congress should hurry. If the United States had a 15% corporate tax rate, companies from around the world would locate here. It would create a hiring boom and a strong economic recovery. But don’t hold your breath for that to happen. The people in Washington can only think about higher taxes and punishing entrepreneurs.
Many politicians, economists, and top Federal Reserve people express puzzlement that the U.S. economy is having the weakest post-crisis recovery in history. Blame the universities that only teach Keynesian economics and the many alleged benefits of socialism. To get the economy moving would be so easy. It would not only create jobs, but also significantly reduce the growth of the Federal budget deficit.
Teaching Austrian free market economics at the universities would be the first step to properly educating future politicians. But that may never happen.
In the meantime, hope for the best, but prepare for the worst in 2014. Ben Bernanke’s successor may have been appointed to be the equivalent of the captain of the Titanic.
Bert Dohmen, Founder
Dohmen Capital Research, Inc.