Falling number of shares a key factor behind the market rally

By: Raul Elizalde
today's photoWhen a stock pays a dividend rate higher than the interest at which the company can borrow money, it makes sense for that company to issue debt and buy back its own stock. This is exactly what happened as interest rates fell to historic lows. We believe that the retirement of equities is a key factor in the stock market rally, making them look “expensive” when compared to traditional measures of value, but not when considering their shrinking supply.

We measured changes in the number of outstanding shares of about 350 stocks with an aggregate market capitalization of $17.4 trillion (the total market is currently around $28 trillion). We found that since the beginning of 2011, the number of shares dropped by about 8%. If those shares had not been retired, this group would have a $1.7 trillion larger market capitalization. This extrapolates to a $2.8 trillion shortfall for the total market of US equities due to corporate buybacks.

image 1This estimation is remarkably similar to the $3.0 trillion retired equities calculated by the Federal Reserve. In addition, the Fed tallies the value of shares retired due to mergers and acquisitions, which adds up to another $2.3 trillion, for a total of $5.3 trillion in that period. This was only partially offset by $2.9 trillion of new issues coming to market. On balance, therefore, corporate America retired $2.4 trillion of equities value, which is on par with the GDP of the United Kingdom.

image 2This has vast implications. Stock prices go up disproportionately to the number of shares retired, meaning that a 1% reduction in supply causes a price appreciation much larger than 1%. More precisely, the marginal change in price due to the marginal change in supply is very high. This effect is not easy to isolate and measure, but it is undoubtedly present, and we believe that it is an important factor behind the market rally.

It also helps explain why equities seem expensive against traditional measures of value, such as P/E ratios. A corporation finds value in buying its own stock if it reduces its cost of capital, regardless of what those indicators show. The fact that top management compensation is often linked to the price of their stock may also play a role in a company’s decision to repurchase stock.

As long as this activity continues, the market will continue to seem “expensive”, and it may become more so if the Trump administration’s attempts to reduce the corporate tax rate eventually succeed.

Many US corporations with profitable global operations have not brought back those funds because they are subject to taxation once they come in. According to Moody’s, non-financial US companies hold close to $2 trillion abroad. If a corporate tax cut persuades companies to bring back their overseas profits, the likelihood is that they will be used to repurchase company stock. It is quite doubtful, as proponents of the tax cut argue, that they will be invested in their respective lines of businesses. Given that businesses have easy access to historically cheap credit, money sitting abroad does not seem to be a hindrance to financing any investments that seem promising.

Most recently, both our numbers and the Fed’s numbers show a slight decline in the pace of equity retirement. It could be “noise”, or it could be due to the modest interest rate rise of late last year.

It is reasonable to assume that if interest rates or equity prices go up much further, the economic benefits of retiring shares will end. The danger of higher rates is small, in our view, because it is difficult for the Fed to justify lifting rates much more when inflation has been falling further and further away from its target. As much as the Fed wants to “normalize” monetary policy, hiking rates when inflation is falling is risky.

On the other hand, earnings-per-share have been climbing, both on a trailing and (especially) on a forward basis. Moreover, Europe looks stronger and global GDP projections have improved. These fundamental factors support higher equity prices everywhere, regardless of the impact of corporate demand for equities.

These fundamental factors could make equities seem less expensive in the medium term when compared to traditional measures of revenue and earnings, and could well spur a new wave of demand from retail investors who, because of low interest rates, have few other places to go for returns. The market rally will end one day, but the combination of corporate demand, improving fundamentals, benign outlook for rates and a potential for growing retail demand are pushing that day further into the future.

What now?
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Raul cropped for facebookRaul Elizalde is the Founder, President, and Chief Investment Officer of Path Financial, LLC. He may be reached at 941.350.7904 or raul@pathfinancial.net.

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The Fed is not the only one inflating asset prices

balloon3sThe US Federal Reserve, along with central banks around the world, has been accused of artificially pumping asset prices with low interest rates and large injections of money. But when it comes to US stocks, the private sector has played an important role keeping prices high: Simply stated, corporations have been major buyers of their own stock. But this activity could come to an end if interest rates rise, thus removing a key support for stock prices.

The economy has recovered from the devastating financial crisis of 2008/2009, but by many measures the improvement has been weak. Several indicators still do not show a full recovery, most notably GDP, which although it is about 15% higher today than at the end of the Great Recession, it grew much less than in the last five recessions since 1975. Other measures still below their pre-recession levels include capacity utilization, industrial production, housing starts, and the labor participation rate, to name a few.

But in the last six years the US stock market staged a stunning bull market with few parallels in history. Corporate profits grew strongly during that period, and are today significantly larger than prior to the financial crisis, but much of the profit growth took place in the first couple of years of the recovery. In the last few years, the stock market kept going up without a corresponding increase in earnings, and this is true even leaving out the beleaguered energy sector.

first graph

The surge of US large caps has been somewhat of a puzzle and a source of much lamentation among investment strategists who believed all along in diversification as a basic matter of sound investing, only to see their returns dragged down by anything other than US stocks. For six years straight, Blue Chips outperformed virtually every other asset class, making diversification seem unnecessary and, in fact, a detriment to returns.

second graph

A likely contributor to the spectacular performance of US Large Caps above other asset classes is the commitment of companies to repurchase their own equity.

Repurchased stock appears in the shareholders’ equity section of balance sheets with the confusing name of “Treasury Stock.” A small, random sample shows the enormous extent of this activity: Exxon is a prime exhibit, having repurchased a staggering $220bn of its own stock. Other companies include MacDonald’s ($40bn), Procter & Gamble ($83bn), Boeing ($33bn) and Citigroup ($8bn), all familiar names.

Virtually all of this activity took place as interest rates fell to historic lows – which is understandable, because it made it cheaper for company treasurers to issue low-rate debt than to pay dividends. As a result, corporate debt issuance exploded, as we reported elsewhere (This is where the next crisis will come from, 8/21/2015). A significant portion of the proceeds was earmarked to buy back stock and bury it back in the companies’ books.

This activity has not shown signs of abating and, according to Standard and Poors, the number of companies reducing their outstanding stock by 4% or more has accelerated in the last two quarters. In addition, the much-smaller number of companies increasing their outstanding stock by the same amount has gone down.

third graph

This may help explain the resiliency of the US stock market despite falling earnings. It also explains the rise in the Price-to-Earnings ratio, a measure of how expensive stocks are relative to their profits. According to data compiled by prof. Robert Shiller of Yale University, US stocks appear to be increasingly more expensive relative to their earnings in recent quarters, a fact consistent with our preceding discussion.

fourth graph

It is interesting to note that companies that have been the most aggressive buyers of their own stock have nevertheless underperformed their counterparts. The S&P buyback index (made up of companies with a high buyback ratio) lagged the broader market in recent times.

fifth graph

Companies with poor results stand most to gain from supporting their stock price through buybacks, even if this activity cannot fully offset dismal earning numbers. Indeed, among the top 10 holdings of the buyback index we find LNC (with GAAP earnings falling by 19.9% in 2015), LLL (-51.5%), NOV (-134.9%), AIZ (-68.1%), DE (-33.2%), MON (-8.6%) and JEC (only -3.1%, but after -28.3% in 2014).

According to the latest minutes, Fed officials said they feel that the economy is ready for higher rates, maybe as early as June. Interest rates have been expected to go up anytime now for years, but they have largely ignored these predictions and are still hovering close to their long-term lows. But if the Fed raises rates and finally starts pushing them higher over the next few months, the buyback activity is bound to decline as debt issued for that purpose becomes more expensive.

The double blow of a less accommodating central bank and fewer corporate buybacks could be felt across the US stock market unless profits stage a recovery. Both are linked: higher rates hamper profits, while lower rates help them recover sooner. Analysts remain optimistic that profits will climb quickly in upcoming quarters regardless, judging by their forward earnings projections. Time will tell if they are right.

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As we were saying – “Fed should wait with liftoff to see firm inflation signs: IMF note” [Reuters]

“The U.S. Federal Reserve should wait to see firm signs of rising inflation as well as a stronger labor market before hiking benchmark interest rates, an International Monetary Fund paper said on Thursday.” (November 12, 2015)

This is according to Reuters, and agrees broadly with our October newsletter, “Low inflation should keep the Fed on hold.” (October 27, 2015). Inflation remains low, and yet the market seems convinced that the Fed will hike rates soon, and Fed officials seem poised to do just that. We remain unconvinced that this is the right move.

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No reason to fear the Fed

One day, the Federal Reserve’s long-running stimulus will  end. This means that  interest rates will start to go up and that the Fed will  begin to sell trillions of dollars’ worth of securities it bought during Quantitative  Easing, or QE.

The market is afraid that interest rates could go up a lot, or  that the Fed will dump the securities quickly, or both. Either scenario could be  quite disrupting. Fortunately, those fears are overblown. Read the full report

Written by Raul Elizalde

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Bulls and bears fight it out

After two years of virtually uninterrupted gains, the stock market took a scary tumble in  October. Opinions are highly divided on what this means.

The bulls think that the dip is a buying opportunity because the economy is strong and  the Fed’s ongoing stimulus places a bottom on asset prices. The bears say that the economy is vulnerable to serious global challenges against which the protection that Fed policy supposedly provides will come short. The fight between the sides is closely contested, and investors are caught in the middle. Erring on the side of prudence may be the way to go. Read the full report

Written by Raul Elizalde

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Don’t sell your bonds yet: weak wages will keep rates low

While headline employment numbers have been good, a darker picture comes into view once you dig a little deeper. Wages are weak, and Fed boss Janet Yellen has repeatedly indicated that this ranks among her top concerns. It follows that under her guidance the Fed will keep monetary policy loose for a long time to come, most likely longer than people expect.

The question is whether the Fed’s easy monetary policy has made any progress towards bringing up wages. Some say that its only effect has been to inflate asset prices. If they are right, Yellen’s efforts to improve employee compensation – and therefore reduce “inequality” – may well be self-defeating.

Yellen can’t be blamed for the limited impact of monetary policy. There are reasons for this, and it means that the environment of low rates – and high asset prices – may stay for longer than people think possible. Read the full report

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