Thursday, September 24, 2015

How Corporations Are Inflating the Equity Asset Bubble By Share Buybacks

In a previous post (Sept. 9) I noted:

"Right now those in the stock market, especially in equities, are riding a huge asset bubble. The bubble has two components that are perilous but which too few - high on the nose candy of their share prices - ignore. One is the very excess price of equities, or more exactly, the high price to earnings (P/E) ratio of most of them. "

This ought to be of concern for us all, especially as Martin Feldstein has noted the role of such  mispriced assets in feeding the current asset bubble.  And one huge contributor has been the practice of stock buybacks by big corporations - which artificially inflates their share prices and P/E ratios. Columnist Jonathan Clements in a WSJ piece last year observed:

"Many companies were big buyers of their own stock before the 2007-09 market decline, only to scuttle their buyback programs during the market crash. In recent years with share prices up sharply they have begun to voraciously buy back."

And why not, because they are then reaping the bounty of their own high share prices? Buy backs also make management's stock options more valuable - so what better way to compensate the Street's honchos?  Strangely, all this has selectively blinded investors to the lack of dividends. As Robert Arnott, quoted by Clements, stated:

"Dividends are reliable, You cut them at your own peril - but you can cut a buyback and hardly anyone notices."

Why? Why aren't the little guys more aware of how they're being shafted?  Because generally they're happy just to see higher share value, unaware of the risk being taken in enabling mispriced assets.

This has been abetted by the Fed's ginormous QE (quantitative easing) program - purchasing over $4 trillion in the bond market. Now we know corporations have been taking advantage of this strategy to use bond sales for buybacks.

As noted in The Wall Street Journal (Sept. 22, p. C2):

"U.S. companies are increasingly using the bond market for the benefit of shareholders, a move that is starting to raise alarm among some debt investors.

Proceeds from some of the largest bond sales, including those from Microsoft Corp., Qualcomm Inc. and Oracle Corp., were earmarked for share repurchases...

Buybacks can boost stock prices by reducing the number of shares available. Some analysts warn that the tactic risks eroding corporate financial health by diverting cash that can be used to fund debt repayments and make investments that can boost corporate earnings power over time."

Thus share buybacks are in fact undermining corporate health for short term gain, even as they fuel the ongoing equity asset bubble to absurd proportions. This is now made worse as the Fed, instead of raising interest rates to temper borrowers' insanity,  has dispensed yet more borrower's crack. As Feldstein has also noted, while these same investors may have realized the rapid increase in share prices are a bubble waiting to pop - they still invested "on the mistaken belief they would know when to pull out".  But they were deluded, as the 2007- 08 financial meltdown showed.

To her credit, as the WSJ piece notes, Hillary Clinton has called for "greater disclosure of buybacks amid concerns they come at the expense of longer term investment"

She is spot on and the WSJ  points out that companies are effectively transferring capital from bondholders to shareholders without investing to expand their business. This cannot be right, and it shows again how the Fed's nose candy QE bond buying program is actually backfiring on bond buyers.

Hopefully, at its next meeting the Fed will do the right thing and raise rates. I'd like to see at least a raise of 50 basis points, not merely 25.

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