By Ryan Graves on Dec 31, 2019
After finishing the decade, it is always fun to look at some metrics to see how far we have come (or fallen). One of my favorites to look at is market returns over ten years. Some economic theories suggest the growth of the underlying economy flows through to shareholders. If the economy is doing well, firms should have sales growth, which leads to profits, which go to shareholders, increasing share prices. Many models suggest that over the long-run, corporate profits should grow at about the same rate as the economy (GDP).
Looking at the graph above, we can see that the S&P 500 has done quite well over the past decade, growing almost 3x. We can also see that GDP growth and real disposable income have lagged quite handily. Why has the stock market exploded over the last decade while the economy has limped behind?
The stock market usually grows at a faster rate than the economy as a whole. The stock market can be thought of as broadly representing a claim against companies' future profits. If the economy is growing, one would expect the stock market to perform well, and therefore pay more for it, increasing its total price. However, this post-recession recovery has been anemic, and indexes continue to hit record highs. This phenomenon raises a big question: If the economy is not booming, what is driving the record market highs?
At the beginning of the decade, the economy was emerging from the Global Financial Crisis and the subsequent Great Recession. Things were not great for the global economy or stock market. Whenever things are not going well for the economy, the Federal Reserve Bank cuts interest rates to stimulate growth. The post-Great Recession era has seen historically low-interest rates, allowing businesses and homeowners to refinance their debts to add some spending power back to the economy.
Ideally, companies would use the extra cash from refinancing to fund new projects, invest in new plants and equipment, and make new hires. All of these things would grow the economy. The problem over the past decade is that companies have returned that money to investors in the form of share buybacks and dividends instead of investing.
Generally, companies issue shares to raise money for their future growth. So, a share buyback may seem counterintuitive. There are a few reasons that share repurchases might make sense: to consolidate ownership, to increase equity value during some pessimism, and to make the company's financial statement look better. That last reason has been very prevalent. If a company has the same profit, but fewer shares outstanding, its earnings per share will increase. A company that looks more profitable and is supporting its share prices through buybacks will look favorable to investors. It is also an excellent way to return money to shareholders.
Low Cost of Debt
A decade of extremely low interest rates has led to debt-financed share repurchases. In fact, more than half of all share buybacks are now financed with debt. Perhaps just as concerning, companies are more effectively generating cash for investors by issuing debt to buy shares than they are in making cash from profits. Share buybacks have been a more significant source of this bull market than economic output. In 2018, buybacks hit $806.4 billion for companies listed on S&P 500. Investment banks are expecting about another $700 billion in buybacks for 2019.
Tax Cut and Jobs Act
The Tax Cut and Jobs Act of 2017 had two main components affecting corporate profits. It reduced the graduated schedule from a maximum of 35% to a flat rate of 21%. There was also a change in the way foreign profits are taxed. Before, foreign profits were not taxed until a corporation brought that money back to the US. In fact, an estimated $2.8 trillion was in profits was being stored outside the US. Now, earnings are only taxed where earned, and there is a tax 'holiday' on pre-2018 foreign earnings at a reduced rate, encouraging firms to bring that money back over.
The whole argument for the TCJA was to allow companies to keep more of the profits was to stimulate investment and long-term growth. But as you may have guessed, the vast majority of that extra cash has gone into share buybacks.
Buybacks were already chugging along before the TCJA and then surged nearly 35% after the law passed. Companies listed on the S&P 500 returned $1.26 trillion through buybacks and dividends 2018. Unfortunately, capital investment, the kind that was supposed to stimulate growth and job creation, was only up around 10%. Astonishingly, research by Societe Genereale shows that S&P 500 companies have repurchased 22% of the index's market capitalization since 2010.
Why Share Buybacks Instead of Capital Investment?
To understand, we need to look a bit deeper at the capital investment process. Theory suggests that if firms have access to more cash through cheap financing or tax cuts, it will lead to more investment in factories, equipment, and technology. For companies to invest in capital and jobs, companies first need to determine which opportunities are most promising through the research and development process (R&D).
The reason why we have seen more share buybacks instead of capital investment is that companies were already spending too much on R&D. Companies typically plow a certain percentage of revenue back into R&D to grow profits in the future. The concept of diminishing marginal returns states that past a certain point, each additional dollar spent on R&D will begin to reduce profits. Estimates suggest that about 63% of companies are over-investing in R&D. If companies do not have profitable projects to pursue, it makes sense to use cheap debt financing and a tax windfall to repurchase shares.
If firms are already overspending on R&D, then increasing the money available to firms through fiscal and monetary policy can not be reasonably expected to stimulate economic growth. This phenomenon can be happening for two reasons: One, firms may have slipped with R&D efficiency. Two, firms may have bleak economic prospects. If companies manage to become more efficient with R&D, it will increase capital investment, and economic growth will follow. If economic prospects are bleak, it will take policy efforts aside from tax cuts and low interest rates to stimulate growth. Until companies have a reason to invest in capital, companies will continue to repurchase stock, and the economy will continue to lag.
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