Are We In A Buyback Bubble?

|
Includes: DDM, DIA, DOG, DXD, EEH, EPS, EQL, FEX, FWDD, HUSV, IVV, IWL, IWM, JHML, JKD, OTPIX, PSQ, QID-OLD, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWL, RWM, RYARX, RYRSX, SCHX, SDOW, SDS, SFLA, SH, SMLL, SPDN, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU-OLD, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TNA, TQQQ, TWM, TZA, UDOW, UDPIX, UPRO, URTY, UWM, VFINX, VOO, VTWO, VV
by: Erik Conley

Corporate America is flush with cash from the tax cuts. Instead of creating new jobs and expanding their businesses, companies have embarked on a massive stock buyback campaign.

This chart is from Yardeni Research. It shows the total amount spent by S&P 500 companies on buying back their own stock, since 1999. The chart shows that buybacks hit their all-time high in 2007, just before the market crashed. Did that buyback bubble cause the market to crash? I don't think so, but it was without doubt an indication that asset prices had become so inflated that companies had nowhere else to go with their free cash flow. Maybe the best way to say this is that the buyout bubble of 2007 was one of several warning signs for what was to come.

Today's reading on the chart is high, but not as high as the 2007 number. Does that give you any comfort? Me neither. This indicator by itself is not a flashing red light, but it should be kept in mind as we move forward. Forewarned is Forearmed.

Goldman Sachs weighs in

US companies have plowed more than $267 billion into stock buybacks this year, according to research firm Birinyi Associates. That's up 34% from the same point last year.

But Goldman Sachs (NYSE:GS) is voicing skepticism about companies focused on returning vast amounts of cash through buybacks and dividends instead of investing in the future through new factories and equipment.

"We expect cash return strategies will lag going forward," David Kostin, chief US equity strategist at Goldman Sachs, wrote in a recent report.

Forbes weighs in

Record stock buybacks - driven in part by the recent tax cuts - have sparked a media and political furor. Unfortunately, they've also created a great deal of confusion. To help sort it all out, here are two things you should know.

Repatriated overseas profits are the main way the tax cuts are boosting buybacks

Slashing corporate taxes will boost after-tax profits and cash flow. Companies will use some of that cash to buy back shares. But that is not what is fueling today's record buybacks.

The big reason is the "liberation" of around $3 trillion in overseas profits. Our old system taxed the earnings of foreign affiliates only when the domestic parent company made use of them. To avoid that tax, many companies left those earnings in their affiliates. They could reinvest them in their foreign operations or hold them in U.S. financial institutions and securities, but they couldn't use them for dividends to parent company shareholders or stock buybacks.

By imposing a one-time tax on those accumulated profits, the TCJA freed companies to use the money wherever they wanted, including in the United States. And multinational firms are leaping at the chance.

Repatriated profits will account for two-thirds of this year's increase in stock buybacks, according to JPMorgan (NYSE:JPM). Stronger earnings, due to both improved before-tax profits and lower taxes, make up only one-third.

Buybacks do not automatically boost stock prices

The common story is that buybacks boost stock prices by reducing the number of shares outstanding. That sounds like basic economics: Reduce supply, increase price. But buybacks have a second effect that pushes the other way.

When companies pay out cash, their value falls. This effect is easy to see when companies pay dividends. On the morning after a dividend, a company's stock price usually drops. One day the stock price reflects the company's operating value plus the cash it will use for the dividend. The next day it's just the operating value.

That also happens when a company buys back stock. It spends its cash, so the value of each share declines. But this decline isn't conspicuous. It doesn't happen on an announced day (as with a dividend payment), and it happens at the same time the supply effect is pushing the other way. So commentators tend to overlook the stock price hit from cash going out the door.

Shareholders might worry executives will squander extra cash, perhaps through empire building, executive perks, or just taking their eye off the ball. Investors might, therefore, treat a dollar of cash inside this company as worth less than a dollar, perhaps 90 cents or even as little as 40 cents. In these cases, stock buybacks would drive the value of the stock up. Shareholders value a dollar on their own balance sheets more than a dollar inside the companies buying back stock.

Are we in a buyback bubble?

Not yet, but we're getting closer every quarter. The downside of massive buybacks is their impact on the economy. Or, more to the point, their lack of impact. Every tax cut is framed and sold to the people in the promise that rich people and corporations will go on a spending spree, which will invigorate the economy, which will help everyone. It's a nice narrative, and it always works, but the track record of tax cuts is spotty, at best.

In almost every case, the windfall from a big tax cut bypasses the working class and instead, goes right into the stock market. The evidence, at least so far, is that this is happening once again. Stock buybacks give a temporary boost to corporate profits, but this is not sustainable. It's a one-off accounting entry on the books. We need real investment in the economy, not taxpayer-funded bonuses for companies.

What do you think? Leave your comments below.