Peak Buyback And Peak Balance Sheet: Thinking Beyond The Great Asset Price Squeeze
As the most recent equity bull market celebrates its tenth birthday (and almost quadrupling since the lows of 2009) this month, I looked back to see if I could identify one or two factors that might have driven the rally. One important conclusion: corporate treasurers got it right when it came to buybacks. They took advantage of cheap valuations, low interest rates, and an accommodative policy environment almost optimally. But as the buyback euphoria now breaks records, will it now become the proximate cause of a broader equity market euphoria, and what the consequences might be if, as in 2007 and 2008, an unforeseen shock hits the system from out of nowhere.
Easy money and financial conditions in the aftermath of the financial crisis created a perfect scenario for corporations to back up the proverbial truck and load it with their own stock. Even as corporations have bought back their own stock and central banks have bought back their own bonds, the net supply in both asset classes for ordinary investors does not seem to have increased: demand for stocks and bonds did not bring in much more excess free supply. When there is more demand than supply, prices go up, as they have done. Bond buying by central banks and stock buying by corporations have ratcheted off each other as there is too much money chasing too few assets.
And yes, there has been much political discussion on the pros and cons of buybacks for society and income (in)-equality. I will not address that debate in this forum except to note that stock repurchases are indeed a legitimate allocation of corporate cash. In any case, one of my points here is that discussion of stock buybacks cannot be had without a discussion of the ability of central banks to buy bonds.
Before the reader hurries to buy stocks of the corporations that have aggressively been buying back their own stock, or bonds of countries where central banks have cornered their own bond markets, note that the data shows little difference between the performance in the average return of companies that bought back their own stock to the overall stock market (similarly for bonds). In other words, even though the market has gone up due to buybacks, buybacks have benefited the whole market, not just the buyback stocks. Similarly bond buying by Central banks has benefited all bonds, as level of yields have compressed everywhere. Finally, since rising equities generally reduce perceived default risk, and reduces implied volatility, bond spreads have compressed. We should thank the buyback companies and buyback central banks for raising the tide for all boats, even though I doubt they have explicitly coordinated to achieve one of the most profitable decades for owners of financial assets, ever. The biggest beneficiaries in the last decade from the buybacks have been large passive holders of equities (and corporate insiders with stock options), and passive holders of bonds, and what an awesome decade it has been as long as you were not short or in cash! A large component of equity beta is thus “buyback beta” and can be traced to easy financial conditions and various accounting benefits. Similarly a lot of the duration in the bond markets is captive duration due to Central Bank buying. If the two are linked, then a consequence for risk managers is that equities, especially in tech, which has seen the highest growth in authorized buybacks since the crisis, have a large amount of interest rate “duration” risk.
A year ago, in March 2018, I suggested in this column that buying the stock market was betting on buybacks (https://www.forbes.com/sites/vineerbhansali/2018/03/13/buying-stocks-now-is-betting-on-buybacks/#7af3616c6fa6):
It is no secret that a large portion of the rally in equities over the last few years, and especially the rebound from the lows of early February, has been bolstered by the record amounts of capital sitting in the coffers of American corporations which, has naturally found its way into the stock market. This cash had three main sources. First, corporations built a large precautionary hoard of cash in the aftermath of the financial crisis to prevent being buffeted by credit markets, choosing to recycle their income into savings rather than spending. Some of this cash is now being unleashed. Second, the extremely low level of yields and spreads in the corporate bond markets allows the issuance of longer term bonds to willing yield-starved bond buyers and take in even more cash. And finally, the tax reform unlocked foreign cash that came flowing back into the US – a good fraction of which has gone into the stock market. This trifecta of positives (for the stock market) has created a systematic bid whenever markets correct downwards. The big question for investors is whether we can count on the buybacks to continue to provide the support on dips as the economic cycle matures. The question really is whether “Buying the Dip” is the same as “Buying the Buyback”.
Between 2009 and the first quarter of 2019, corporations bought back almost five trillion dollars of their own stock, with almost one fifth of it in the last year and a half (source: dealer research)! Bond yields rose globally in the middle of last year, but the Fed pivot and the continuation of quantitative easing in Europe and Japan brought yields down by 50 basis points in a matter of weeks (source: Bloomberg). By all estimates, corporates are the marginal price setters for the stock market as a whole, and central banks are the marginal price setters for the bond market. These two biggest sources of asset price appreciation are obviously correlated.
The stock market saw a significant and sharp (almost 20%) pull-back in the fourth quarter of 2018, but to the amazement of many investors, has bounced almost 20% from the lows, even as traditional asset holders including pensions, have reduced their equity exposures (source: Bloomberg). So we can hypothesize that: (1) corporate stock buybacks have been the proximate cause of the rebound, (2) the Fed’s astonishing 180 degree flip from their now ancient “two-tightenings in 2019” to “patience” has turbo-charged the buyback bid to both bonds and stocks (as corporate yield spreads and perceived risk have both receded) (3) these two events have mutually reinforced each other and reduced perception of risk, which is no wonder why the VIX has plummeted from 35 in December to below 14 now (source for all market data quoted: Bloomberg).
One of the key beneficiaries of stock buybacks are employees with exercisable stock options, which also explains why per share earnings have not exceeded total earnings (corporations buy back stock on the open market, retiring stock that is owed against stock options). If buybacks are a primary reason for the ongoing equity market rally, what is an investor supposed to do as we make new highs on buybacks? What are the risks if the mutually reinforcing cycle of central bank bond buying and corporate stock buying hits a big bump? For tech, which dominates most equity indices, this correlated risk from buyback liquidity dropping is possibly THE variable to watch, not unlike the sharp correction of December 2018 following a hawkish statement from the Fed chair.
First, let us understand the incentives of the participants. Since the purchase of stock behind the buybacks is in the open market, there is no disincentive, at least in the short run, for the corporation buying back stock to do so at increasingly higher prices, since in the short run the recipient of the proceeds receives a higher mark to market value. For most stock option plans, stock option based compensation also shifts the tax liability from the corporation (which can write off the value as an expense), to the employee (who has to recognize the mark to market as a gain and is usually accompanied by a “lockup period” that restricts selling by the owner within a finite period of time. This creates a temporary shortage of stock, and as a consequence the stock price is higher with less risk of selling pressure).
The recent phenomenon of stock buybacks has happened, by coincidence, with the epochal surge in the switch from active equity management to passive equity management. Since most corporate pensions (and many public pensions) hold passive equity exposure, even as the value of the stock market rises, they are forced to buy stocks at higher and higher prices. Everyone is happy (except shorts!) as long as prices keep rising. This collective dynamic is virtuous as long as the market is going up; that is, until the stock market corrects and there are no buyers. We saw this type of dynamic during the dotcom bubble, where many employees found themselves holding loss-making equities received through option exercise and also massive tax liabilities against evaporating paper gains.
Compare and contrast the equity buyback phenomenon with the similarly massive purchase of fixed income assets by the global central banks. Between 2008 and 2019, more than ten trillion dollars of bonds have been bought by global central banks (Fed, ECB, BOJ, PBoC) at market prices (source: Haver). This, similar to the equity buybacks, has squeezed out the marginal investor of bonds who looks at yields to make their decisions whether or not to invest in a bond.
In Europe, as yields have gone and stayed in negative territory, the ECB, already the largest public bond buyer in the market, has continued to buy these low yielding bonds at negative yields. They did their own 180 degree flip last week as a possible reduction in monetary stimulus was deferred even further out (source: ECB press conference, February 2019). Part of the money that is being pushed out into the system via low and negative yields finds its way into the equity market directly, and also pushes up the demand for stocks. Economic gains from the monetary stimulus have been moderate at best, but the belief in doing “more of what has not yet worked but might work in the future”, is so strong that we don’t see re-tightening of policy any time soon. There are unintended negative outcomes, such as the continued underperformance of banks who depend on the level and steepness of the yield curve for profits. But for now, low government bond yields have driven down corporate bond yields, and as I wrote in 2018, creates perfect conditions (and tax-advantages to boot), for more buybacks and higher prices.
So what, if anything, upsets this apple cart (no pun intended against Apple, despite their massive buybacks) where everyone who is long assets is winning?
A long term structural trend does not reverse in a year. Ultimately the arbitrage between stock returns and borrowing rates depends on three underlying factors: (1) level of yields, (2) earnings growth, (3) regulation.
It is not easy to see a short term spike in yields. As discussed, the ECB certainly has kept buying long term bonds in Euroland even as inflation has picked up somewhat, confirming that their actions are less driven by market considerations and valuation levels, and more by the monetary channel transfer of wealth within the EU, which is a social benefit for that region. Unless there is a meaningful rise in inflation that drives buyers away from long term bonds, this dynamic will likely continue. All indications show that data dependence of central banks means that they will be willing to cut rates and expand balance sheets to keep markets afloat.
Earnings growth has moderated somewhat, but it remains moderately positive. It is hard to see an environment in which earnings fall off a cliff unless there is an economic recession or an unanticipated geo-political shock. But good earnings growth appears to be already baked into prices, which makes a purely earnings based case for equities neutral at best.
This leaves regulatory risk as possibly one of the largest risks facing buybacks and the upward march of the equity markets. As we enter the election cycle in the US, populist sentiment, indeed what is being termed “socialism”, is something to watch very closely. Editorials by candidates notwithstanding, any visitation of the tax treatment of option-based compensation, accounting of such compensation, or even the timing and disclosure of buybacks could easily provide corporate buyers of stock reason to pause and maybe even change their minds on how to best deploy capital. History teaches us that these regulatory inflection points repeat every generation, but are not visible until they have already caused significant impact on markets.
Unfortunately for investors, while yield spikes and perhaps even earnings can be hedged with various derivative securities, hedging political risk is not quite so easy to achieve directly. Given the low levels of volatility on the back of the massive stock market rally, and return of “Buy The Dip”, “Fear of Missing Out”, and a resurgent faith in the “Fed Put”, downside risk-management strategies and hedging are attractive again, especially in the tech sector. Bond market volatility has also reached historic lows. If we have indeed reached peak buyback and peak balance sheet in the stock and bond markets, investors looking to be proactive in managing their risks may want to consider availing themselves of these opportunities to build some portfolio protection.