The Buyback Bubble Will End Badly
- With the stock market at historically high valuations and earnings peaking, lower share counts are important to keeping stock prices rising.
- Buybacks had started to fall in the second half of 2017, but were invigorated by the Trump/Republican Congress tax cuts.
- The demand for stocks is falling, except for the buybacks, and intermittent foreign demand, which are supporting share prices.
- Buybacks will fall dramatically once the economy starts to slow and the impact of repatriated money dissipates - as soon as Q1 2019.
- Sell highly valued, slow growth and high debt stocks ASAP into stock market strength this year.
Supply and demand for stocks are the ultimate key drivers of stock prices. Reduce demand for stocks and prices fall, unless of course, the supply of stocks available to buy falls more - as has been the case recently.
In recent years, the total stock outstanding in the U.S. has fallen substantially due to buybacks. Ultimately, those buybacks have kept the market from falling inline with reduced demand for stocks by other investors.
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For 2018, stock buybacks are surging on the back of tax cuts. But, how long can that last? Once money is repatriated, will there be enough tax savings to continue to drop cash to the bottom line? Unless there is a sudden surge in revenue and earnings, the answer is no.
Who's Been Buying Stocks?
Corporate stock buybacks have been the only real driver of stock demand in recent years. Households, despite a sharp rotation from mutual funds to ETFs, have only very recently started adding to their stock holdings.
Here it is important to understand that households for these statistics include hedge funds, nonprofits, private equity funds and personal trusts. Clearly, hedge funds often quickly change their net positions and private equity can become net sellers quickly as well.
In Q4, we also saw a surge in foreign investment again after a slump for a couple of years. This foreign appetite could be sustainable and we need to monitor it closely. If the dollar continues to fall, foreigners may continue to buy American stocks.
If there is a surge in the dollar several months out, as LIBOR-OIS spreads suggest, then that foreign demand can dry up quickly [more on this in my Macro Monday article on March 19th].
Institutions, as opposed to households, have been net sellers of U.S. stocks. This a case of big guys selling to little guys - not good for the little guys.
The clear buyer reducing stocks outstanding has been corporate buybacks in recent years. Per Birinyi, via the Financial Times, U.S. companies are on track to approach $1 trillion in buybacks in 2018. Bloomberg Intelligence agrees, stating share repurchases will jump as high as $875 billion for the year - a clear record.
About 42% of those buybacks have been in the banking sector, which had a massive recapitalization after the financial crisis and has barely made a dent reducing their shares outstanding versus pre-crisis levels.
That leaves about 58% of buybacks in other sectors. According to Bank of America Merrill Lynch (BAC), consumer discretionary, healthcare, information technology and industrials were other significant buyers of their own shares in the recent past.
Who's Buying Stocks Now
Clearly, those that are repatriating cash or seeing substantial corporate tax cuts have an opportunity to buy back shares. I would argue this flies in the face of the "invest in America" theme of the White House and ultimately does little good for the U.S. economy, however, it was what happened after the Bush repatriation and clearly is what is happening with the Trump repatriation.
There have been a myriad of new and added stock buybacks announced in the past two months. Among them are these of at least $1 billion:
- AbbVie Inc. (ABBV) $10 billion
- Alphabet Inc. (GOOGL) $8.6 billion
- American Tower (AMT) $2 billion
- Amgen Inc. (AMGN) $10 billion
- Anthem (ANTM) $5 billion
- Applied Materials Inc. (AMAT) $6 billion
- Baker Hughes (BHGE) $3 billion
- Bank of America (BAC) $5 billion
- Boeing Co. (BA) $18 billion
- Cardinal Health (CAH) $1 billion
- Celgene (CELG) $5 billion
- Cisco Systems Inc. (CSCO) $25 billion
- CSX Corp. (CSX) $5 billion
- Devon Energy (DVN) $1 billion
- Dover Corp. (DOV) $1 billion
- eBay Inc. (EBAY) $6 billion
- Hess Corp (HES) $1 billion
- Home Depot (HD) $15 billion
- Honeywell (HON) $8 billion
- Humana (HUM) $3 billion
- Juniper Networks (JNPR) $2 billion
- Kellogg Co. (K) $1.5 billion
- Lear (LEA) $1.5 billion
- Liberty Global (LBTYA) $2 billion
- Lowe's Companies Inc. (LOW) $5 billion
- Mastercard (MA) $4 billion
- Merck (MRK) $10 billion
- Mondelez International Inc. (MDLZ) $6 billion
- NRG Energy (NRG) $1 billion
- Oracle (ORCL) $12 billion
- O'Reilly Automotive Inc. (ORLY) $1 billion
- PepsiCo Inc. (PEP) $15 billion
- Phillips 66 (PSX) $3.3 billion
- PPG Industries (PPG) $2.5 billion
- Prudential Financial (PRU) $1.5 billion
- Sirius XM (SIRI) $2 billion
- Skyworks Solutions (SWKS) $1 billion
- The TJX Companies (TJX) $3 billion
- United Continental (UAL) $3 billion
- Valero Corp. (VLO) $2.5 billion
- Visa Inc. (V) $7.5 billion
- Waste Management Inc. (WM) $1.25 billion
- Wells Fargo & Co. (WFC) $22.6 billion
[I may have missed a few big ones, but here is a good free resource to track share buybacks.]
Here's a question to ask company by company: how many of those BODs would have been better served paying down corporate debt in an era that threatens to have tighter liquidity? I would venture most. I know which companies I will target as shorts as the next bear market approaches (coming sooner than most think, I think). I will discuss that in coming months as well.
There are more buybacks coming, and of course, Apple (AAPL) had the biggest stash of cash overseas so we should expect a massive announcement soon on how big their buyback might be. We should also note that virtually all of the buybacks are coming from about 100 companies in the 500 company index.
Take a look at the companies with the most cash overseas as of last summer according to Bloomberg:
Now, while many would argue the wave of buybacks is reason that stocks should continue to surge into the land of overvaluation, I would suggest that maybe the January surge was overdone. After all, the stock market is at historically high valuations. I think it's important to consider that this tax cut was needed just to keep stocks at their current valuations.
The total market cap being retired from the S&P 500 in 2018 is nearing 1 trillion dollars and as of January 31st the market cap of the S&P 500 was $7.8 trillion. Let's round our math and call that a cool 12%.
What if somebody like Jeff Gundlach is right and rising interest rates, tightening liquidity and geopolitical disruptions mean that 2018 will be down year for stocks. Would the one-time blue pill from tax cuts propping up the stock market only be an offsetting factor to an otherwise down year?
I think it's important that investors keep an open mind about how strong the stock market really is at this point. Demand for stocks is drying up ex-buybacks and earnings are going to be challenged going forward by slowly rising wages, inflation and limited revenue growth. The potential for expanding valuations at this point is almost nil and the odds of negative surprises is rising.
Sell These Buyback Stocks ASAP
The key motivation of executives buying back stock is to support the share price. I often argue onto deaf ears that presents a conflict of interest for executives to act in the interest of this year's share price in order to get a bonus vs. the interests of long-term shareholders. Here are three stocks to sell (there's more I'll get to soon) now that should be paying down debt or fortifying their businesses rather than buying back stock.
Sell Devon Energy (DVN): I am a confirmed bull on a rebound in oil imminently, however, Devon carries total long-term liabilities of $17 billion, it is insane they are buying back shares. Their debt to equity stands at about 1.1 and let us remember, or in some of your cases, accept, that oil isn't forever anymore. While the company is right to forego "growth at any cost," they ought to be plowing all excess money back into debt repayment.
Devon's balance sheet reflects assets in the Rockies that carry very little net value. Their sale of Barnett assets came in lower than expected already. I question their oil sands property values as well. The company's liabilities are only $10 billion less than assets (which I question the value of) and yet the company has a market cap of $17 billion.
Further, the STACK assets of the company are overrated and highly risky given the earthquake problems in Oklahoma. Again, while I like certain oil plays, this isn't one of them and Devon shares could easily see a 20-30% drop in value in time. Use the buyback to sell Devon Energy shares and buy a stock like Encana (ECA) which I discussed in depth here and mentioned recently in Oil Price's Goldilocks Moment.
Sell Wells Fargo (WFC): Yes, I know that Warren Buffett owns a bunch of Wells Fargo, but the company has massive exposure to subprime auto loans that are going delinquent at an increasing rate. The bank is also one of the largest originators of mortgages and their fraud problem is no small issue.
Add to that their other recent legal issues and the company has a lot of clean-up to do. The $22.6 billion buyback makes no sense in light of their anemic revenue growth and exposure to a potentially slowing economy in the next few years. One of the few bright spots with Wells is a low derivative risk; however, the car debt and mortgage exposure at this point can't be overlooked.
Sell Boeing (BA): Is the poster child for a company priced to perfection in an imperfect world. The stock trades at a P/E ratio in the mid-20s and its PEG ratio has soared to around 10 on the lack of growth. It makes little sense for management to buy shares at these valuations.
If that wasn't enough (it is), I think Boeing's growth will be challenged in coming years. Here's why: Not only do the trade tariffs I discussed in "Will Protectionism Be Different This Time?" have a potential large impact for the company, but their year-over-year annual revenue growth is already a shade into the negative. Add the next recession to a list of growing negatives for the short to intermediate term for this company.
Further, the company has mind-boggling long-term liabilities of $35 billion while its assets are overstated in my opinion. The company has inventories of over $44 billion that won't fetch that much and $12.6 billion of PP&E that there are few natural buyers for. Boeing ought to be plowing money in paying down debt and further modernization. Shareholders are going to have a bumpy ride with Boeing in the foreseeable future.
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