Back in early 2014, we first explained how it was possible that with the Fed's QE tapering, the S&P kept rising higher despite declining intervention by the Fed in capital markets: the answer was corporate buybacks, which had then soared to the highest level in history.
This artificial stock-support by CFOs and Treasurers only increased in the subsequent year, with buyback announcements hitting a record high one year later, in May 2015, as also profiled previously.
Then after the early euphoria of 2015, repurchase activity slowed down. As Factset observes in its just released quarterly buyback report, the dollar-value of share repurchases amounted to $134.4 billion over the second quarter (July), which represented a 6.9% decline from the first quarter (April) and a 0.4% decline year-over-year. On a trailing twelve-month basis (TTM), dollar-value share repurchases totaled $555.5 billion, which was approximately flat with the first quarter.
On the surface, this is good news, but, and here there is a huge "but"... because the reason for the drop off in buybacks has nothing to do with corporate executives reigning in their desires for higher stock prices and thus, higher equity-linked compensation, and everything to do with funding limits. Because while buyback activity may be slowing down it is only due to one thing: a collapse in free cash flow among S&P500 companies, with energy companies at the forefront, but increasingly all sectors being hit by a dramatic slow down in FCF creation. According to Factset while LTM buybacks declined by 1.3%, Free Cash Flow over the same period plunged by a whopping 29%!
In fact, as Factset notes, in the past 12 months, for the first time since October 2009 the amount spent by companies on buybacks has surpassed the Free Cash Flow of the S&P 500 itself! In other words, the only use of funds for the 500 or so companies in the biggest stock index in the world is to... push their stock even higher. It also means that any incremental "use of funds" such as M&A, dividends, capex or just plain organic growth, would have to be funded through issuance of debt.
Although the aggregate dollar-value of share buybacks declined sequentially in the second quarter on a TTM basis, companies in the S&P 500 still spent more on buybacks than they generated in free cash flow. Free cash flow is defined as cash from operating activities minus capital expenditures from fixed assets and cash dividends paid. The aggregate Buybacks to Free Cash Flow ratio for the S&P 500 exceeded 100% for the first time since October 2009. The ratio hit 108% on a TTM basis at the end of Q2, which represented a 12.9% increase quarter-over-quarter and a 42% increase year-over-year. The 10-year median ratio was 72.2%. At the sector level, four out of the ten GICS sectors had a ratio greater than 100% at the end of Q2 (Consumer Discretionary, Consumer Staples, Industrials, and Materials).
What is driving this ratio to such high levels? As mentioned earlier in this report, the TTM dollar-value share repurchases in Q2 amounted to $555.5 billion, which was a 1.3% increase year-over-year. This partly contributed to the higher ratio, but the main driver was free cash flow. TTM free cash flow at the end of Q2 totaled $514.4 billion, which represented a 28.6% decline year-over-year. The aggregate FCF for Q2 was the lowest level for the S&P 500 since Q3 2009, when FCF amounted to $140.2 billion.
The sectors leading the decline in free cash flow were Energy and Financials. Financials saw a 50.2% decline in FCF year-over-year, with State Street Corporation heavily contributing to this decline. State Street reported cash flow from operations of -$5.1 billion in the TTM ending Q2 2015 after reporting a $907 million inflow in the TTM from the year ago quarter. The Energy sector, which typically has high levels of fixed capital expenditures, saw free cash outflows totaling -$65 billion in the TTM ending Q2. Free cash outflows amounted to -$7.1 billion in the TTM ending Q2 2014. Southwestern Energy was another large contributor, as it increased its fixed capital expenditures by almost 250%, leaving it with free cash outflows of -$5.7 billion in in the TTM ending Q2. The company reported free cash inflows of $4 billion in the TTM from the year ago quarter. Due to decreases in free cash flow, buyback spending for the S&P 500 is now 1.08 times TTM free cash flow, which has surpassed the 10-year average of 1.05 times free cash flow.
And that, in a nutshell, is why the market is tumbling today: it is not so much longstanding fears of a Chinese collapse (although these are certainly relevant), nor the threat of a European recession due to the Volkswagen scandal (which is certainly an issue but will be resolved promptly once enough congressional palms are greased) nor the long-telegraphed plunge in Glencore and other miners (this too will get much worse before it gets better) - no, the catalyst for today's dump is that the biggest buyers of stock in the past 2 years, the corporations themselves, just priced themselves out of the market and no longer generate the cash needed to push their own stock to new all time high levels in a thin, illiquid market in which the orders from Goldman's buyback desk are the marginal price setter.
It is very possible that the current quarter may well be the last push to keep stocks levitated, and until and unless there is a substantial increase in free cash flow (unclear what would cause this), companies will slam shut the buyback spigot, especially when the vast majority of CFOs realize that the returns on the latest year of buybacks just turned negative and the board says "no more."
As for what happens when companies decide to proceed with buybacks anyway and issue billions in debt just to fund these and keep the party going a little longer (even if if means risking their Investment Grade rating in the process) look no further than IBM and HP for the outcome.
FRA Co-Founder Gordon T. Long sits with BCA Research Chief Economist, Martin Barnes, a highly decorated and well renowned economist of 40+ years to talk Financial Repression and Barnes most recent work, Low Growth and High Debt: Financial Repression is Here to Stay.
Barnes defines Financial Repression as,
“An environment where interest rates are kept below levels which most people would consider being normal.”
In a recent publication, Low Growth and High Debt: Financial Repression is Here to Stay, Barnes focused on the problems of continued high debt levels and argues Financial Repression as a legitimate solution to the global debt crisis.
“If you can’t easily get your debt burdens down, then at a minimum you have to make the debt easier to live with, and the only way you can make your debt easier to live with is through Financial Repression. In other words, financial repression is the inevitable result of a world with low growth and stubbornly high debt.”
CONSEQUENCES OF LOW INTEREST RATES
“If money is free, very clever people at some point are going to do stupid things with it. There is no question that low interest rates will encourage some misbehaviour, and speculation. However it is hard to make the claim that today’s interest rates are low enough to be causing economic problems.”
Despite already low interest rates, economic growth around the world has been relatively low. Barnes states, “Economies should be booming with current interest rates but they’re not, we are living in a world that I would argue needs lower interest rates.”
“The by-product is financial distortion which has powerful implications for certain groups of people such as people trying to live off of fixed incomes. But you can’t push interest rates up to protect the interest of those people if the global economy is screaming for even lower rates. We cannot have a level of interest rates that will have everyone happy.”
THE PENSION FUND DILEMMA
A major mistake with the development of pension funds is that governments did not increase the pension age with the increase life expectancy.
“In a world of low returns, and people living much longer, the promises that were made a long time ago can no longer be kept. Everyone needs to understand that at some point those promises have to change, either by raising retirement age or increasing contribution rates. The logic behind these pensions is unsustainable and therefore it must change.”
SITUATION IN CANADA
In the midst of falling commodity prices, devalued currency and the housing market bubble, Barnes states the Canadian economic situation
“…is not disastrous; just like so many other economies, we are stuck in low growth. Exports are battling against moderate global growth and world trade. The big drop in the Canadian dollar has not lead to a big pick up in exports as we would have hoped. We are very tightly linked with the US economy and they are slowly growing so that is a positive.”
“Housing by every standard is incredibly overdone, especially in Toronto and Vancouver, it’s hard to get away from the fact that house prices are extraordinarily high here and it will likely erode.”
“China is moving away from its commodity oriented growth to a more service oriented model. The world is moving away from its commodity dependence which is not great for Canada, but we’ll adjust to that.”
Check out his interview with Gordon T Long which covers this and much more.
Low interest rates create an environment that encourages debt based spending. In regards to monetary policy, this is how you grease the wheels to get the economic engine spinning. As part of your financial arsenal this can be used in moderation but the Fed has been using maximum credit leverage since the economy imploded and this short-term fix is now running into its seventh year. The outcomes are expected with inflation running rampant in credit heavy items like housing, cars, and college tuition. But with housing, big banks and investors have crowded out regular buyers thus pushing the homeownership rate lower. So credit based spending has been in full effect with auto loans and student debt. As many credit worthy Americans were deep in debt, the temptation to go into subprime loans has accelerated dramatically. Subprime auto debt is running rampant. Student debt is now the most delinquent debt class in America. Subprime debt is once again super charging the debt fueled market.
Subprime debt is back in a big way
Over the last seven years courtesy of the Fed’s low rate policies, auto and student debt has surged in dramatic fashion. While the shrinking middle class is unable to purchase homes with inflated values, many are still chasing the dream by going into debt for cars and college.
The debt growth in these markets is nothing short of fantastic:
This right here is the manifestation of low interest rates and the impact it has had on consumer spending. We’ve essentially allowed Americans to buy cars on borrowed money and go to college on big debt while making it tougher for them to purchase homes. Inflation is real if you look carefully.
What is scarier about this sudden growth is that much of the debt is being made to people that are having a difficult time paying it back. Take a look at subprime auto debt:
This chart tells it all. For auto loans since 2010 the growth in lending has come to consumers with credit scores of 620 or less. Those with higher credit scores of 720 have seen modest growth. Those with lower scores have seen nearly a 100 percent increase in loans while those with better scores have seen less than a 40 percent increase. In other words, the bulk of new cars are being bought with financing with those having trouble managing their current debt.
With cars costing $30,000 and higher, this is no small price tag. Any tiny little hiccup in the economy and this is enough to send their auto purchase into repossession. Do people remember the cash for clunkers and auto industry bailouts? These things did not happen too long ago. It appears that we are setting ourselves up perfectly for another kind of these scenarios.
The results of prolonged artificially low rates is that the market is now fully addicted to this environment. The Fed is backed into a corner and they really have very little ammo left. Speculative lending is already dominating the market. You can see the subprime booms very clearly:
I would argue that many college loans are subprime especially if they are made to students going to for-profit paper mills. At least with subprime auto debt, you are getting a tangible item in a car. With a for-profit, you are getting nothing, not even an education. The only education you are getting is the shady under belly of subprime student loans for a subprime degree.
The economy is clearly slowing down. Recessions happen. And once again we have saddled a large enough group of Americans with debt where the pain will be deeply felt when the correction hits again.
The Fed released its Q2 Flow of Funds (FOF) report on Friday. There's always plenty of interesting developments that are chronicled by this voluminous data dump. I was particularly struck by the data on net equity issuance by US nonfinancial corporations, US financial corporations, and foreign issuers. On balance, the data somewhat diminish the bullish share buyback story that I have been telling since early on during the current bull market. Consider the following:
(1) Three players. Corporate buybacks along with M&A activity have most noticeably reduced the supply of shares issued by nonfinancial corporations in the FOF tally. Over the past four quarters, their net equity issuance was minus $490 billion. This is the most negative this series has been since Q2-2008, and it has been in negative territory since the mid-1990s.
On the other hand, US financial corporations had net equity issuance of $250 billion over the past year. This series has been in positive territory since the beginning of the previous decade. There’s been a significant increase in net equity issuance by foreign corporations, which rose to a record $549 billion over the past four quarters.
(2) Grand total. The sum of these three series adds up to $309 billion over the past four quarters. While the S&P 500 data show that buybacks have been increasing throughout the current bull market, the FOF data on total net equity issuance was positive during 2009 and 2010, when financials had to raise lots of capital. Then it turned negative during 2011 and 2012 as financials significantly reduced their issuance. Since 2013, it has been increasingly positive as foreign equity issuers raised record sums in the US stock market.
Gordon T Long is not a registered advisor and does not give investment advice. His comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. Of course, he recommends that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that, we encourage you confirm the facts on your own before making important investment commitments.
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