By Path Financial President and Chief Investment Officer Raul Elizalde
Two sources of demand that contributed to driving up stock prices are going away.
Strong buying came in the last few years from the very companies who issued those stocks. Finding it cheaper to borrow money than pay dividends, they issued a large number of corporate bonds and used the proceeds to buy back significant portions of their outstanding shares.
Alongside companies buying stocks were retail investors who just wanted income, but could not find it anywhere as interest rates hovered around historical lows for years.
There are indications, however, that both reasons for buying stocks are becoming less compelling.
To begin with, there are fewer shares. This was the logical result of having interest rates at historical lows, which resulted in companies buying back stocks. This gave more fuel to an already booming stock market.
According to the Fed, a net value of $3.1 trillion of corporate equity was retired by repurchases and mergers & acquisitions since 2011. This enormous amount is comparable to the entire GDP of Germany. The number of shares in the S&P 500 calculated by Standard & Poors shows the same trajectory as the Fed data. And the first quarter of this year set a new buyback record, even as rates rose.
But the feverish pace of repurchases may be starting to ease.
The 2-year US Treasury rate is now above the average dividend yield of S&P 500 companies. Some companies may still be able to issue bonds at cheaper rates than their dividends, but the margins are getting thinner and fewer can still do this profitably. This may be the reason why the portion of companies retiring more than 4% of their outstanding stock fell to its lowest level since tracking started in 2014. If rates continue to climb, we believe that this portion will fall further.
Additionally, conservative retail buyers who had gravitated to stocks as the only source of income are now able to access the safety of bonds that offer higher yields. While rates are still relatively meager by historical standards, they are now at least at par with inflation. Investors who until recently had no choice other than dividend stocks to produce income may be warming up to bonds, thus reducing another source of demand for stocks.
Stocks went up for various reasons in addition to corporate buybacks and dividend-seeking retail investors, but there is no doubt that both have played an important role in driving up prices. As rates return to more normal historical levels, these two sources of demand may well evaporate. While this may not be enough to sink the market, at the very least it paves the way for higher volatility in the months ahead.
This analysis originally appeared in Raul Elizalde’s Forbes.com investment column. Click here to follow Raul on Forbes.
Raul Elizalde is the Founder, President, and Chief Investment Officer of Path Financial, LLC. He may be reached at 941.350.7904 or firstname.lastname@example.org