The Fed is not the only one inflating asset prices
by Raul Elizalde - 2016-05-20
The 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.
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.
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.
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.
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.
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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