By: Raul Elizalde
When 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.
This 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.
This 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.
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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