Every time I look at the chart below, I have mixed feelings and I am not sure which of them dominates. On one side, I am delighted with the spectacular rise in equities seen since 2009. In just six years, the market fully recovered from losses that pushed the S&P 500 back to its 1996 value. In fact, the movement is even more spectacular than that!
The losses were reverted into gains, as the S&P 500 tripled in value in the period. The 2009-2015 period make us forget about the previous 50 years of data, such was the strength of the uptrend. But, on the other hand, the near vertical slope that delights me makes me uncomfortable about the future. The 1990s showed us that the limit for share prices is far below the sky and that, in the end, what really matters is fundamentals. But, with the Shiller P/E ratio now showing a reading north of 27 times (almost double its historical mean), it is becoming ever more difficult to justify the current uptrend on the basis of underlying fundamentals.
With so much intervention from the Federal Reserve, allowing its balance sheet to grow from around $0.9 trillion in 2008 to the current $4.5 trillion today, it should not come as a surprise the magnificent uptrend that delights every investor, which is very well justified in the chart below.
At the hands of Ben Bernanke and with the eyes put on the failed Bank of Japan intervention, the Fed did not hesitate to lower interest rates to around zero and inject money into the economy through three large-scale asset purchase programmes, which unfolded across several years. While bond yields were pushed down, asset prices in general were pushed higher through the so-called asset price channel, which derives from monetary policy.
But the current uptrend doesn’t come from monetary policy and its wealth effects alone. Chief executives from corporate America have given some extra help to the Fed by paying out 95% of what their companies have been earning, either in the form of dividends and in the form of share repurchases. In the end, after discounting for specific tax treatments and some subtle differences, a share repurchase is just another way of paying dividends, as it propels asset prices, allowing shareholders to sell part of their shares for the extra income.
While share repurchases are not uncommon and are indeed a very effective tool to solve conflicts between shareholders and management, its use is usually limited. At times share prices are depressed, and in particular below the company’s fundamental value, management may decide to repurchase shares to signal confidence to the market. This helps align share prices with fundamental value. But when share repurchases plus dividends on the S&P 500 amount to $900 billion in a single year ($550 in repurchases and $350 in dividends), it just doesn’t sound right.
So, in a single year S&P 500 companies paid out almost $1 trillion of their earnings. Had this been seen in 2010 I would say that management were repurchasing shares at depressed values to boost market confidence and align prices with fundamentals. As we know, the panic that followed the Lehman collapse went too far, and some companies were trading at bargain prices then. But we are talking here about 2014, five years after the market bottom.
If we add the data in the chart above together, between the Lehman collapse and today, we come up with what Orrin Sharp-Pierson, a strategist at BNP Paribas, very well observes:
“…[S&P 500] companies have bought back around 20 per cent of market capitalisation since Lehman’s collapse, or around $3.8 trillion using today’s equity prices”
These are stunning figures, meaning that America’s chief executives constitute some kind of a second Federal Open Market Committee, who decided to unfold a silent QE4 to help boost equity prices. The total amount of share repurchases reported in the period after the Lehman’s collapse is equivalent to the increase experienced in the Fed’s balance sheet – $0.9 trillion to $4.5 trillion – or $3.6 trillion. Add the two figures together and you end up with an excellent justification for the six-year market rally. With $7.5 trillion being directly injected in the US equity market, Draghi’s €1.1 trillion programme seems like small change.
So, share repurchases are a good way of signalling to investors the good prospects a company may have and how confident management may be about the future.
But, when management uses such a tool uninterruptedly for over six years, one wonders why they aren’t investing the money in the projects instead of paying out every cent earned? If the US economy is in such a good shape as advertised, then why are companies like Apple, Qualcomm and GM, just to name a few, announcing massive share repurchase plans? At a time when the unemployment rate is around 5.5%, they should be investing in new projects. But that is not the case. Why?
US shares are rising fast but not because of increased overall profits or higher sales and revenues.
After three large asset purchase programmes unfolded by the central bank, and with interest rates now near zero around the globe (when not negative), companies are sitting on a cash pile without knowing what to do with it. While the latest data for the US economy seems promising, managers still feel unconfident due to the negative developments in Europe, a potential slowdown in Asia and a sluggish US consumer, such that they opted to pay back shareholders. Such a policy makes shareholders happy and has at least two other good incentives:
1) higher share prices increase the value of management compensation schemes that are made up of call options on the company’s shares.
2) when you can’t make earnings grow, reducing the number of shares is the best way to increase earnings per share. Share prices rise but, rather than reflecting an increase in value, they now reflect earnings management and other smart engineering.
Additionally, the very low interest rate charged on borrowed funds (if any), is seducing companies to not only pay out their earned money but to go the extra mile of borrowing funds and paying out the proceedings to shareholders as well. Capital is being reallocated between equity and debt, in the direction of the second. This is one of the desired effects deriving from monetary policy. It is the balance sheet effect working at its full strength. But, there is collateral damage deriving from it, in the form of exponential increases in leverage that will lead us to revisit the years before the financial crisis.
The largest and most solid companies like Nestle are issuing bonds at negative rates. But, as central banks around the world are making it impossible to obtain any positive yield from investing in safe assets, the zombifiedhybrid securities market has been given life again. Many companies are now issuing low ranked debt securities that offer higher yields and equity features to seduce investors. This market will grow again and the risk profile will be ignored. A new bubble is forming…thanks to central bank intervention.