Corporate Share Buybacks

What If I told you that 40% of the bull market rally over the last decade was from buybacks alone? That may not be as crazy as it sounds.

Such is not surprising given the low interest rate environment. But, as we now know, there is a point where low rates deter economic activity. Companies become unwilling to “invest” due to the low return environment.

The problem for companies in a weak economic environment is the lack of topline revenue growth. Given higher stock prices compensate corporate executives, it is not surprising to see companies opt for a short-term benefit of buybacks versus investment.

Understanding Buybacks

While it may seem like “share repurchases” are a non-event, they are more insidious than they appear. Let’s start with a simplistic example.

Company A earns $1 / share and there are 10 / shares outstanding.
Earnings Per Share (EPS) = $0.10/share.
Company A uses all of its cash to buy back 5 shares of stock.
Next year, Company A earns $1 again, however, earnings are now $0.20/share ($1 / 5 shares)
Stock price rises because EPS jumped by 100% on a year-over-year basis.
However, since the company used all of its cash to buy back the shares, they had nothing left to grow their business.
The next year Company A still earns $1/share and EPS remains at $0.20/share.
Stock price falls because of 0% growth over the year.

Yes, this is an extreme example but shows that share repurchases have a limited, one-time effect on the company. Such is why once a company engages in share repurchases, they get inevitably trapped into continuing to repurchase shares to keep share prices elevated. The problem is the continued diversion of ever-increasing amounts of cash from productive investments that could create long-term growth.

The reason that companies do this is simple: stock-based compensation. Today, more than ever, many corporate executives have a large percentage of their compensation tied to company stock performance. As a result, a “miss” of Wall Street expectations can lead to a hefty penalty in the companies stock price.

In a previous Wall Street Journal study, 93% of the respondents point to “influence on stock price” and “outside pressure” as reasons for manipulating earnings figures. Such is why the use of stock buybacks has continued to rise in recent years. Following the “pandemic shutdown,” they skyrocketed.

Share buybacks only return money to those individuals who sell their stock. Such is an open market transaction. If Apple (AAPL) buys back some of their outstanding stock, the only people who receive any capital are those who sold their shares.

So, who primarily sells their shares?

As noted, it’s the insiders, of course, as changes in compensation structures since the turn of the century have become heavily dependent on stock-based compensation. Insiders regularly liquidate shares “granted” to them as part of their overall compensation structure. Such allows them to convert grants into actual wealth. As the Financial Times previously penned:

“Corporate executives give several reasons for stock buybacks but none of them has close to the explanatory power of this simple truth: Stock-based instruments make up the majority of their pay and in the short-term buybacks drive up stock prices.”

A recent report on a study by the Securities & Exchange Commission found the same:

SEC research found that many corporate executives amounts of their own shares after their companies announce stock buybacks,Yahoo Finance reports.

What is clear is that the misuse and abuse of share buybacks to manipulate earnings and reward insiders has become problematic.

For much of the last decade, companies buying their own shares have accounted for all net purchases. The total amount of stock bought back by companies since the 2008 crisis even exceeds the Federal Reserve’s spending on buying bonds over the same period as part of quantitative easing. Both pushed up asset prices.

In other words, between the Federal Reserve injecting a massive amount of liquidity into the financial markets, and corporations buying back their shares, there have been effectively no other real buyers in the market.

Exactly how much are we talking about?

The Market Should Be 40% Lower

The chart below via Pavilion Global Markets shows the impact stock buybacks have had on the market over the last decade. The decomposition of returns for the S&P 500 breaks down as follows:

21% from multiple expansion,
4% from earnings,
1% from dividends, and
5% from share buybacks.

Before you scoff at a 3% annualized return, such equates to an economy growing at 2% with a 1-2% dividend yield. Moreover, that calculation aligns with historical norms going back to 1900.

While share repurchases by themselves may indeed be somewhat harmless, it is when they get coupled with accounting gimmicks and massive levels of debt to fund them in which they become problematic.

Michael Lebowitz noted the most significant risk:

“While the financial media cheers buybacks and the SEC, the enabler of such abuse idly watches, we continue to harp on the topic. It is vital, not only for investors but the public-at-large, to understand the tremendous harm already caused by buybacks and the potential for further harm down the road.”

Money that could get spent spurring future growth, benefitting shareholders, instead got wasted benefitting only senior executives.

As stock prices fall, companies that performed un-economic buybacks are now finding themselves with financial losses on their hands, more debt on their balance sheets, and fewer opportunities to grow in the future. Equally disturbing, the CEOs who sanctioned buybacks are much wealthier and unaccountable for their actions.

For investors betting on higher stock prices, the question is what happens if “stock buybacks” reverse?

The Jobs Report

The US jobs report was expected to be strong after a few weak months. This might make the Federal Reserve’s decision to start tapering look well-timed, but we are not so sure.

October US payrolls grew 531,000, more than expected. The two prior months had upward revisions totaling 235,000.
The headline unemployment rate fell to 4.6%, getting closer to the 3.5% pre-pandemic level.
The disappointing news is the participation rate which held at 61.6%, vs. 63.3% in February 2020.
Average hourly earnings rose further, with wage growth in the leisure/hospitality segment still particularly strong.
After losing 22.3 million jobs in March/April 2020, the US economy has now added back 18.2 million jobs.

The labor market remains tight, and the Fed’s idea of “tightening” is to expand its balance sheet another $500 billion over the next 8 months and still keep short rates at zero. More reports like this one may force the Fed to tighten faster than markets presently expect.

The Laffer Curve

Speaking of taxes… The Laffer Curve shows that if taxes are raised above a certain point, tax revenue actually drops. For example, history has shown that tax rates of around 28% bring in MORE total revenue than tax rates of around 40%. The reason is that the higher the rate, the more people look for ways to NOT pay tax, or retire, or work elsewhere with lower taxes, etc. Would you work if tax rates were 90%? 70%? 50%? At some point people say that it is not worth it and drop out of the labor force.

The Laffer Curve says that if President Joe Biden is going to raise taxes like he says he is, he’s going to be very disappointed. That’s because the economy’s going to slump, and revenues will go down – not up.

Zillow, Part 2

Zillow (Z) is winding down its Zillow Offers iBuying Service after the real-estate fintech decided forecasting home prices is too unpredictable. The company’s Q3 results include a $304M writedown of inventory as a result of purchasing homes in Q3 at higher prices than its current estimates of future selling prices, while it expects to take an additional $240M-$265M of losses in Q4. It will sell its portfolio of roughly 7,000 homes over the next several quarters, which will also include a reduction of Zillow’s workforce by around 25%.

Zillow shares closed down 10% on the news on Tuesday, and are off another 17% in premarket trading to $72. That’s down from last week’s peak of nearly $104, bringing losses over the three sessions to 30%.

“We’ve determined the unpredictability in forecasting home prices far exceeds what we anticipated and continuing to scale Zillow Offers would result in too much earnings and balance-sheet volatility,” said Zillow Group (NASDAQ:ZG) co-founder and CEO Rich Barton.

“We went into the business as a big swing on the bet that we could accurately predict the price of a home six months into the future, and what happened was… COVID happened,” he later told CNBC. The company also noted that market watchers shouldn’t interpret Zillow’s decision as a call of a top in the housing market, but it rather stemmed from higher-than-expected volatility. In fact, fundamentals of the housing market remain “quite strong,” according to Barton, who stressed that the firm will “wind down our inventory in an orderly way.”

Interest Rates

Short-term Treasury yields continue to climb as the market prices in a more aggressive rate hike schedule next year. The first hike is now priced in for next July. Interestingly, risk markets (such as stocks) are ignoring this trend for now.

The Fed Announcement

As expected, the Fed left the target range for the fed funds rate near zero and said it would reduce net asset purchases by a total of $15 billion this month ($10 billion for Treasury securities and $5 billion for agency mortgage-backed securities). The central bank went one step further and said it would taper by another $15 billion in December.

Fed Chair Powell talked down rate-hike questions with an observation that it’ll still take some time to reach maximum employment (perhaps by the second half of 2022) and that inflation should be less of an issue by the second or third quarters of next year. He emphasized that policy will be adaptive to the data.

The 2-yr yield, which is sensitive to expectations surrounding the fed funds rate, settled two basis points higher at 0.46% after hitting 0.51% during the start of Mr. Powell’s press conference. The 10-yr yield settled three basis points higher at 1.58%. The U.S. Dollar Index fell 0.2% to 93.90.

World Energy Price Issues

The rise in US gasoline prices has been driven by local refinery disruptions and climbing international prices for oil. However, gasoline prices are only part of the US energy story. Prices for the natural gas used to generate 40% of US electricity show wild distortions, with three-month forward prices for New England almost four times the benchmark price for Louisiana.

China’s electricity shortages are all the result of Beijing’s ban on imports of Australian coal coupled with controls on domestic mining. India’s impending power cuts stem from a reluctance to pay international market prices for coal imports and capacity constraints on domestic production. Brazil’s troubles can be blamed on low water levels at the country’s hydroelectricity plants. And in Europe the finger is being pointed at Russia, which has not stepped up natural gas deliveries in response to depleted inventories and rising demand.

But although the causes of these crises may appear to differ widely, there is a common thread: around the world shortages and price rises are typically the result of market distortions caused by deliberate policies.

The motives behind these decisions vary, but two stand out. First, there is the desire to go green: to shift to less polluting energy sources with fewer greenhouse gas emissions. Second, there is the urge to improve efficiency: to provide the energy needed with the smallest possible capital investment.

Both aims are in tune with the spirit of recent years. Viewed in isolation, both are laudable. But together, they have led to the creation of inflexible and fragile systems, highly vulnerable to disruptions in the supply of single energy sources.

Politicians are maintaining that the price rises are the result of Covid-induced disruptions and that they will be short-lived. Therefore, they are sticking to their longer-term policy agendas. Few appear to worry that those very agendas are responsible for much of the rise in prices. Until they do, economies will remain exposed to similarly disruptive policy-induced energy crises.

Clean energy technology is improving but is still a long way from replacing fossil fuels. Each alternative has limitations. Solar doesn’t produce at night. Wind depends on the weather. (Europe had the least wind on record last year.) We don’t yet have large-scale ways to store the power they produce, and won’t for quite a few years. In the meantime, we’ll still need reliable, 24/7/365 production from coal, natural gas, and nuclear power. Phasing them out too quickly invites the kind of shortages and high prices we are now seeing.

I’m a bit sad to admit China is facing this situation more intelligently than the US. That may be surprising, since we know China is by far the world’s worst carbon emitter. The regime knows this can’t continue, but also that it must continue until something else can be arranged.

So, for the moment, China remains reliant on coal, oil, and natural gas, importing vast quantities of all three. But the government is also planning a gradual transition to cleaner power, which will include not just solar and wind but a massive nuclear power program, amounting to $440 billion over the next 15 years.

According to Bloomberg, China presently has 51 nuclear plants in operation, with 46 more planned or under construction. The US has 93 operating plants, many of them decades old, and only two under construction.

I certainly don’t want more Chernobyl or Fukushima disasters. New designs that don’t depend on externally powered water cooling systems eliminate much of that risk. Other technologies like thorium reactors and nuclear fusion are coming. Nuclear is the perfect bridge to move us from carbon to a world of clean, sustainable, abundant energy.

Bill Gates founded a company called TerraPower to develop advanced nuclear power technology. Their “Natrium” design uses liquid sodium rather than water to cool the reactor chamber. The high pressure that causes explosions simply doesn’t build up. The sodium doesn’t need pumps that can fail in an emergency, as happened in Fukushima. It circulates passively via hot air. It can even store heat in tanks of molten salt, which act as a giant battery that further increases power output.

TerraPower’s plant designs are smaller and much less expensive than conventional nuclear power plants. This lowers the capital cost for utilities, as well as the risk. They produce much smaller quantities of hazardous waste, too.

That makes a huge difference because most of the cost of atomic energy is in upfront construction. At 1.4% interest, about the minimum for infrastructure projects in places like China or Russia, nuclear power costs about $42 per megawatt-hour, far cheaper than coal and natural gas in many places. At a 10% rate, at the high end of the spectrum in developed economies, the cost of nuclear power shoots up to $97, more expensive than everything else.

At the current pace, China will deploy their technology far faster than the US does. I should point out that this is going to give the Chinese an enormous edge in nuclear facility production. They will be able to drive costs down because of the sheer quantity they are producing internally along with the enormous amount of research and development that must accompany such an effort. The West will rapidly fall behind and it will be hard to catch up.

This is really about national security as well as economics. A world in which China is energy-independent while the US grid gets less reliable every year is not going to work well.

As I said, this is a complex problem. Nuclear alone isn’t the answer, nor are solar and wind, nor are oil, gas, or coal. We haven’t even talked about the technologies that may help us keep using fossil fuels while greatly reducing harmful emissions. A lot is happening on that front.

Higher interest costs for utilities means higher energy costs for consumers.

Bank of America’s $120 oil forecast is not all that outrageous. If we keep discouraging capital investment in oil and gas production, not just in the US but everywhere, while we are in the process of transition, we will see the same kind of high energy prices which cause riots in France and countries all over the world.

Failing to plan and finance a realistic transition will mean much higher and more volatile energy prices. We may one day wish for the good old days of $120 oil.

Inflation Explained..

The common thread between rising inflation and growing supply chain problems seems to be increased US consumer goods demand. People want to buy more stuff because they have higher incomes. This chart illuminates the timing of recent income growth. We can see that real disposable personal income was rising at a generally steady pace in the years leading up to 2020. Then came the pandemic, after which we see three sharp income peaks. These coincide with the three rounds of stimulus payments most Americans received, the first in 2020 and two more in early 2021.

Disposable income dropped after all three payments but far faster in the two 2021 installments. The last few months show it roughly back to the pre-COVID trend. If personal income goes back to this pace, the supply chain problems and inflation may also recede. For now, we can only observe massive distortions, with consequences not yet fully understood.

US Economy

Consumer spending has been robust, running well above the pre-COVID trend. However, adjusted for inflation, the spending trajectory looks less impressive.
Excluding government support, incomes continue to grow.
By the way, households are optimistic about their incomes one year out, according to the U. Michigan survey.
The US savings rate is back to a more typical level.
The Employment Cost Index (ECI) jumped by most on record last quarter, exceeding expectations

The biggest ECI gains came from wage increases
Inflation has been surprising to the upside (a global trend).
The Chicago PMI (Chicago-area business activity) surprised to the upside in October. This report bodes well for the ISM report at the national level.
The ISM Manufacturing PMI was roughly in line with expectations, indicating brisk factory activity in October.
However, growth in new orders slowed sharply, with some customers frustrated by shortages and delays.
This slowdown in orders points to softer production ahead.

Consumer confidence has been deteriorating.

But households are concerned about inflation, not jobs.
Buying conditions for durables and vehicles have deteriorated further in October due to prices gains.
Online job-seeking activity has improved.
Residential and non-residential construction spending trends have diverged sharply.
Homebase small business employment data point to substantial job gains in October.
The market consensus is a gain of 450k, according to Bloomberg.
The ADP private payrolls report surprised to the upside at 571K.
Job gains were broad, with every major sector seeing an increase in employment.
Supply chain issues are becoming more extreme.
Costs continue to surge.
Factory orders keep rising.
Mortgage applications to purchase a house remain healthy.
But refinancing activity has been easing.
CoreLogic sees home price appreciation slowing sharply next year.
Productivity was dragged down by slower growth in Q3
The trade deficit hit a record high, with imports surging and exports moderating.
US retail gasoline prices continue to climb, which will weigh on consumer sentiment.

Market Data

Indices continue to hit record highs, as market technicals look increasingly stretched.
By the way, it’s been nearly 500 days since the S&P 500 dipped below its 200-day moving average.
Some analysts are increasingly nervous about valuations.
Shiller PE Ratio (3 charts):