The Corporate Buyback Story

Pushing their luck, stock investors enjoyed another notable jump in the S&P500 last week. The index jumped 1.5% pushing what was already a commonly accepted overvalued market to an even more severe overvalued condition. Confirming that this increase is not some sort of exuberant movement by investors to jump in with both feet is the fact that volume fell. This means that while stocks keep rising, it’s not because there’s a lot of enthusiasm behind the move. S&P volatility crept up; this contradicts the recent price jump. And the price of the US dollar (which tends to rise when equity or risk markets fall), also crept higher to close near multi-year highs. So the strength of the US dollar over the last 24 months also contradicts the jump in US stock prices over the last several months.

US economic reports were mixed last week. Retail sales, the Empire State manufacturing survey, and leading indicators all beat expectations. Industrial production and the housing market index missed expectations. At the same time, consumer prices came in higher (or worse) than expected.

In terms of technical analysis, the S&P500 is almost as stretched as it was in the period leading up to the peak during the dot-com bubble. In no way does this mean that another burst is imminent. but it does suggest that prior major retreats began from technical conditions similar to the one we see today.

In Seeking Alpha, writer Eric Parnell recently analyzed the run-up in US stock prices over the last five years and found a striking correlation between corporate buybacks of their shares and the prices of those stocks. He notes that aggregate corporate earnings have barely budged between 2011 and 2016, but the price PER SHARE has gone up substantially because corporations—through buybacks—have been consistently reducing the number of shares over which this static aggregate corporate earnings figure is spread. And while the earnings per share has gone up, so has the price multiple associated with this EPS. Clearly, this has made the stock market advance look more normal (ie. not so out of whack) because it has artificially increased the earnings per share levels.

How have corporations done this?  Simple—they’ve not only used the bulk of their free cash flows (operating cash flows less net capex) but they’ve borrowed massively. The result is that book equity has been driven down; at the same time, total debt has been driven higher, to replace the reduced equity capital. In fact, the ratio of corporate debt to total capital reached multi-decade highs in the period between 2014 and 2016.

And corporations have gotten away with this massive increase in leverage because the Fed had driven down interest rates to record lows. This kept the total dollar interest expenses manageable. the problem is that while leverage is reaching an “upper bound” of reasonableness, interest rates have jumped substantially since bottoming in June 2016. They rate on the US 10yr Treasury is now about 100 basis points higher than it was back then.

The result is that corporate buybacks have started to slow down massively. Something similar happened in early 2008, well before the stock market collapsed later that year.

The bottom line is that one of the greatest sources of fuel behind the run-up in stock prices over the last five years is now clearly going away, leaving the US stock market at super-stretched prices and more vulnerable than ever to a severe pullback.

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