Thursday, December 8, 2011

A Leading Indicator: Corporate Stock Buy-Backs

I must admit to being wrong.  I believed that the big cash buildup at corporations would be used to fuel a mergers and acquisitions binge.  I thought that the economic recovery was strong enough that the “better off” corporations would “pick off” all the low-hanging fruit offered by the companies that were not in a very good position coming out of the Great Recession. 

I argued that this behavior would not accelerate economic recovery because the restructuring taking place would result in consolidations and debt reductions that would just make industry more productive somewhere down the line but add very little to economic growth and lower unemployment in the present.

Merger activity has been fairly high this past year but not as great as I thought it would be.    

Where I was wrong…was in the strength of the recovery.  The economic recovery is not strong enough to propel the M&A binge I expected. 

So, what are the cash accumulations and the low borrowing rates leading to? 

Corporations buying back their own stock.

“US companies are on pace to announce buy-backs of more than $500 billion worth of shares this year, according to stock research firm Birinyi Associates, the third biggest year on record.” (

The message is that the economy is not recovering sufficiently to warrant more acquisitions and the stock markets have not been robust enough to provide higher valuations for market shares, so, the companies with the cash or with access to the cash are buying back their stock at prices they believe to be ridiculously low. 

This can have some consequences for firms.  For example, Safeway, Inc., sold $800 million in bonds last week and, the same day, management disclosed that it was buying back $1 billion worth of its own common shares. 

The rating agency, Fitch Ratings, immediately dropped the company’s credit rating by one notch to triple B minus. 

A similar thing happened to Amgen and Lowe’s.  Last month, Amgen sold $6 billion worth of bonds to buy back its stock early in November…and Moody’s Investors Service cut Amgen’s bond rating by one notch while Fitch cut its rating by two notches.  Lowe’s sold bonds in November to buy back stock, which resulted in downgrades by Moody’s and Standard & Poor’s. 

That is, the debt issue followed by the stock buy back increased the financial leverage of these companies and hence make their debt riskier.

Stock buy backs, however, do not increase economic growth!

What is happening?

Long-term interest rates in the United States are being kept down by the actions of the Federal Reserve and the flight of money from Europe seeking a “safe haven” in United State Treasury bonds.  The Fed wants to get the economy going again and has said it will keep rates at historically low levels for another two years or so.  And, “with corporate bonds benchmarked to US Treasuries, whose yields have fallen to historic lows amid strong demand for havens, borrowing costs fro investment grade companies have also fallen.”

So what do we have…low economic growth and credit growth that exceeds the “productive” needs of the corporations. 

In essence this is a picture of credit inflation.  To be sure, we are not seeing the creation of credit raising consumer or wholesale prices at this stage…but, when credit expansion exceeds the real growth rate of the economic sector that the funds are going into we get a “dislocation” that can lead to problems in the future.

That is why, to me, the acceleration of corporate stock buy-backs in this instance seems to me to be a leading indicator of dislocations in the economy that will have to be dealt with at a later time.

“Although bondholders generally do not like these transactions (issuing bonds to buy back stock) because of the risk they pose to companies’ credit ratings, most of the groups buying back shares this year with debt have not seen too much fall-out from the bond markets or from credit rating agencies.”

This is always the case.  Those that move first and move rapidly get the most benefits from their actions.  Only later, when many others attempt the same thing, do markets…and credit rating agencies…move more…or produce greater “fall-out.”

“The deals, then, are likely to continue so long as investors keep buying bonds and pressuring rates.”

And, as the Fed works to keep interest rates so low.

The concern about corporate stock buy-backs being a leading indicator?

If economic growth does not pick up a greater speed ( and if the Fed continues to maintain the excess reserves it has pumped into the banking system and keep interest as low as it has promised to do, then we need to be aware of where the dislocations are forming in the economy. 

And, be assured, if this credit inflation begins to show up in some places…it will also begin to show up in other places as time passes.  That is, fault lines are created in the economy much as Raghuram Rajan has described in his award winning book called “Fault Lines: How Hidden Fractures Still Threaten the World Economy.”  And, fault lines make everything more fragile.   

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