Archive for May 26th, 2018

The Thinker

The stock buyback warning: stormy economic times are likely ahead

Remember when Trump’s tax cuts were going to put money back into the pockets of working class Americans and create more jobs for them too? Unsurprisingly, this turned out to be a load of peanut butter. With gas now around $3 a gallon, whatever new modest tax cuts trickled down to working America are probably being eaten up in higher transportation costs. As for businesses reinvesting their tax cuts in their businesses and bumping up wage rates for employees, well, there’s not much evidence of that. According to this March report from the Roosevelt Institute, just six percent of these corporate tax cuts are going to wage increases and bonuses for employees. Just twenty percent of this money is going toward capital investments that will result in more jobs.

So what are companies doing with the extra money from this enormous windfall? There is little reason for CEOs to spend most of it investing on the long-term futures of their companies. That’s because CEO compensation tends to be based on making short-term profits. These days many CEOs make far more compensation from exercising stock options than they do from a salary.

So we should not be surprised that CEOs are trying to make money the easy way instead. And the easy way is to take this money and buy back their stock. It’s good for them and it’s good for shareholders. Or so it seems. Experts are questioning if these buybacks are just artificially inflating the price of corporate stocks. One traditional measure is a stock’s price to earning’s (P/E) ratio. The higher the ratio, the longer it takes for earning from owning the stock to be used to buy a new share of company stock. High P/E ratios are a sign that stocks are overvalued and due for a correction. We are now at a P/E ratio about where we were before the Great Recession.

If it were just a handful of companies, this would not be particularly worrisome, but it’s part of a large and broad general trend among American corporations. Bloomberg reports a record $800B in stock buybacks are expected in 2018. So how are these buybacks inflating the value of a company artificially? It’s quite simple. When a company buys back its own stock, the supply of the stock for purchase diminishes. Of course as supply diminishes, price increases for any shares that are traded. If a CEO has $5 million in his company’s stock, by channeling these tax cuts and profits to buybacks, all other factors being equal the price of the stock will go up. So his $5M might easily turn into $6M. And what work had to be done? Simply redirecting these tax cuts and profits to create “buy” orders for his company’s stock.

That’s a whole lot easier than creating new products, expanding into new markets or figuring out how to run the business more efficiently. Shareholders probably aren’t going to complain when they see the value of their investments rise. Smarter CEOs will be systematically selling their stock when its price goes up, so they can capture its inflated wealth. This gives them money in the bank that can’t be taken away and shifts the risks of owning this stock to other stockholders.

Which is why these record stock buybacks really worry me. They do nothing to actually make a company more profitable in the long run and actually add to a company’s vulnerability. They allow more agile competitors (if there are any) to get a leg up on their market. That adds risks to a company’s value. Companies are essentially betting on the profitability of corporate inertia. Traditionally, this has not worked well for companies in the long run.

Stock corrections are inevitable. There was evidence earlier this year that we had reached correction territory, but markets have recovered much of these losses. For now though these tax cuts seem to be juicing the markets instead of your pocketbooks. I get the feeling that a true correction will happen sooner rather than later, in part because of the volatility of the market so far this year. This suggests there is a general nervousness among investors.

Stock buybacks though are a clear symptom of corporate greed. Greed is simply the lust for more wealth, and the truly greedy will want to increase their riches now rather than wait for improbable future profits. Congress is aiding and abetting this greed through these tax cuts in the first place, but also by removing regulations that were put in place after the Great Recession to prevent these things from happening in the future. You can see this through Trump’s attack on the Consumer Financial Protection Bureau. You can see it in recently passed legislation that will remove more higher reserve requirements on midsize banks. And you can see it in record consumer debt levels, bigger even than before the Great Recession. I believe that these large stock buybacks are another sign that this financial house of cards is moving toward another correction.

This time we can hope that it won’t be as bad as 2008. It shouldn’t, but who can say? The Trump Administration is being both being reckless and shortsighted, and Congress is fine with this. Their insatiable greed means they simply don’t care about fulfilling their primary function. The primary function of government is to be fiduciaries for the nation, making sure it is properly managed for both the short and long term. To the extent they are interested, it is to convince them that their timeworn strategies that just do the opposite will somehow work in the long term this time.

You would be wise not to take their bet. Rather than practicing greed, you might want to practice prudence instead. My take: this is a good time for less market exposure. I’m not alone. When the Treasury bill rate made it above 3% for the first time in years, it pushed up other interest rates. Many investors saw this as a sign and began moving more money into bonds for the surety of a return.

I don’t think Republican governance is going to change any fundamentals of the economy. Needless to say, I’m limiting my market exposure now and putting more money into bond funds. Maybe you should too.

 

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