Another Sign of a Weak Economy: Stock Buy Backs?

Over the past year or so, I have been arguing that the substantial build up in the cash balances of many large United States corporations has been for the purpose of merger and acquisition activity.   And, earlier this year, M&A activity seemed to be proceeding aggressively. (See my post “The Latest Merger Binge and the Economy,” http://seekingalpha.com/article/269056-the-latest-merger-binge-and-the-economy.)

Now, it seems as if these cash balances may be trending into more stock buy-backs than into the buying of other companies, at least in a relative sense. “US companies are buying back their own stock at the fastest pace since 2007…” (http://www.ft.com/intl/cms/s/0/381e8c26-9c14-11e0-bef9-00144feabdc0.html#axzz1Q0PX4bjp)  

Today’s attention on stock buy-backs has been caused by the announcement made yesterday by electronics retailer Best Buy of a proposed $5 billion buyback program. (http://professional.wsj.com/article/SB10001424052702304070104576400062744226034.html?mod=ITP_moneyandinvesting_10&mg=reno-secaucus-wsj)

Analysts have been wondering what these large corporations were going to do with the huge cash balances on their balance sheets.  These companies were producing profits, they were able to borrow at ridiculously low interest rates, and ample liquidity seemed to be available to them around the world.  Also, there were a lot of other companies or divisions of companies “out there” that were really struggling and seemed to be possible “sitting ducks” for growth hungry large corporations. 

Of course, one of the reasons for the build up of cash in some of these companies was the tax implications associated with bringing monies earned around the world back into the United States.  But, this was not really the major reason.  For example, Microsoft, a cash rich company, did not have to go out and borrow more than $10 billion in the United States, the first time Microsoft has even made use of the bond markets in its history. 

Many economists were hoping that this build up of cash would result in a boom in corporate investment in physical capital, a stimulus to further economic spending and subsequent economic growth.

This physical investment has not yet surfaced. 

My belief has been that this cash build up was for acquisition purposes.  The companies that had the cash were strong and were “on the hunt” for their weaker brothers and sisters hoping to build their economic base by acquiring companies that were not in good positions, had too much debt, and were struggling to make ends meet.  What a way to build markets and enlarge the company’s footprint!

This seemed to be happening…and I believe will continue to go forward.

However, the world economy seems to be stalling.  Perhaps economic growth will not be as robust as originally thought…even three months ago.  Thus, even though the merger binge may continue to some degree, the pickings may not be as lush as once thought. 

And, the stock markets seem to have reached a near term peak.  All the major indices, the Dow, the S&P 500, and the NASDAQ, peaked at the end of April.  Many analysts are saying that with the stagnant economy and the high levels of under-employment, the chances are not very great that the stock market will show much resilience in an upward direction. 

Thus, there is some drop off in the corporate enthusiasm for more and more acquisitions.

So, what does a company with a lot of cash on hand and with dwindling appetite for acquisitions do with all their loot?  Managements with so much cash around and with very little hope that the economy will become more robust, just does not see these excess balances as a good use of resources.

The only viable alternative is to buy back their stock.  They see this as the “best” investment available to them.  And, so they buy back their stock.

Neither one of the latter two uses of the cash really do anything for the economy and the acquisition path could even result in worse economic results…at least in the short run.

Acquisitions, of course, can lead to plant closings, layoffs, and other efforts to combine firms, which increase productivity in the longer run, but does not contribute to capital investment or human employment in the short run.  Obviously, these outcomes are not what the policymakers are looking for.

Stock buy-backs also do not stimulate capital investment or a reduction in unemployment in the short run and may not achieve either of these goals in the longer-run.

Therefore, if the economy is weak and more and more corporations seem to believe that the “best” investment of the cash they have accumulated is to buy back their own stock.  it would seem that this is evidence that more and more corporations are not seeing a very bright economic future ahead of them.  In my mind, this is not very good news. 

The Short Term Myopia of the United States

Working in urban neighborhoods can be a very disheartening experience. There are so many problems that at times they can seem overwhelming.

One of the most discouraging problems that one runs into over and over again is the myopia that exists within some of these communities, a myopia that results in people making decisions as if there is no tomorrow.

Often these decisions can be captured within the context of game theory, specifically the “Prisoner’s Dilemma” game. The solution to a one-shot, simultaneous Prisoner’s Dilemma is for all players to default to the action that results in the worst decision for each player.

Researchers will explain the deterioration of housing within certain neighborhoods in terms of this kind of Prisoner’s Dilemma game. No one maintains, or “keeps up” their house because that is not the best decision given how they expect everyone else to act. And, there is no communication between actors so that people fail to “co-operate.”

People within the United States, as a whole, have become very myopic. This myopia grew in the latter part of the 20^th century and stands behind many of the problems we face today. We constantly read about two areas that have produced damaging results in the United States, yet, as with most one-shot, simultaneous Prisoner’s Dilemma games, most are barely aware of the role that this myopia plays. I would contend that these two major areas have to do with employment and the environment.

The United States has such a short-run view of employment that its governments throw billions of dollars into efforts to put people to work “right now” or to put people back to work “right now”. The emphasis on achieving “full employment” in the United States going back into the 1930s and 1940s has tended to get people employed as early in their lives as possible and to keep them in their same jobs throughout their working careers.

The consequence of this emphasis is that unemployment and underemployment have trended upwards in the latter half of the last century. Now, roughly one out of every ten individuals of working age are unemployed and one out of every four is underemployed.

The current solutions for reducing this unemployment and underemployment just advise “more of the same.” That is, more fiscal stimulus and printing more money.

These are just myopic attempts at resolving employment problems, myopic attempts that result from the myopic behavior of the politicians. After-all they have to get re-elected every two years…or every four years. So they must continue to pump up the economy.

But, this behavior just exacerbates the problem. And, it creates massive amounts of debt or money for the economy to absorb.

It has taken us a long time to get where we are and it will take a long time to get us out of this mind-set and out of this situation. A lot of what needs to be done relates to education and to everything that surrounds education…parents and teachers…and society itself.

Thomas Friedman has written several columns in the New York Times about the situation that exists in the education front in the United States and how it not only impacts us internally but how it impacts of relative to other nations. (His latest can be found here: http://www.nytimes.com/2010/11/21/opinion/21friedman.html?partner=rssnyt&emc=rss.)

Friedman reports of a speech from the secretary of education Arne Duncan: “One-quarter of U. S. high school students drop out or fail to graduate on time. Almost one million students leave our schools for the streets each year.” And Duncan comments on a report from a group of retired generals: “75% of young Americans, between the ages of 17 to 24, are unable to enlist in the military today because they have failed to graduate from high school, have a criminal record, or are physically unfit.”

America’s youth are now tied for ninth in the world in college attainment.

How are these young people going to fill jobs in companies that must face competitors that draw from a better prepared and better educated body of potential employees? How are companies going to develop and train people throughout their careers that do not have the appropriate base of skills? And, if these people do not seem to be coming along the pipeline, why shouldn’t the companies “outsource” to other countries where they have the educated workforce and will even have a more prepared workforce in the future?

Continual efforts to re-stimulate the economy and put under-employed people back into the jobs they formerly held is no solution to either the employment problem or the happiness of the worker. Unfortunately, the solution is a longer-run solution. For another look at the situation see “The Baseline Scenario” https://mail.gv.psu.edu/exchange/jmm27/Inbox/[BULK]%20%20The%20Baseline%20Scenario.EML?Cmd=open.

And, the same myopia applies to treatment of the environment and the efforts to develop sustainable business practices. Businesses are forced to focus just on the near-term, on their ability to grow and produce continually increasing profits. And, in doing so these businesses “mortgage” the future. Again, we have another one-shot, simultaneous Prisoner’s Dilemma game where most of the players default to the actions that will produce the worst results for all.

A great deal of the effort to produce a “green” outcome also, in my mind, tends to produce short-term fixes and look as if they just add costs to the accounting for the firm.

Again, education is crucial in environmental understanding. We are not talking here about knowing what the ecological problems are. We are talking about understanding what decisions are available and the externalities and network effects that surround the decisions we make.

But, as with the education, the consequences of our actions extend over many years and our decisions must take this future into account.

It is my experience that the decisions and actions surrounding these longer term decisions produce better results over time and also produce better managements because they take more factors into the making of decisions and the taking of actions.

In both of these cases, the emphasis on the “short-run” end up hurting individuals as well as hurting the economy. We get into situations like the one surrounding the resolution of the government debt problem. The argument is made that we need to spend more creating more debt so as to put people back to work. Yet, the additional deficits just create a “debt crisis” that interferes with putting people back to work.

Speeded up spending on solutions to ecological problems is a top-down approach that seems to substitute for companies changing their own behavior and decision-making processes.

Short-run America is losing out on the longer-term competitive battle. As Friedman continually reminds us, we continue to slide in all the measures of what makes a modern economy more competitive and live-able. The chances for becoming more competitive? Highly unlikely given the myopic behavior of our politicians.

The Long-Term Jobless in the Current Economic Malaise

I have been concerned for some time about the changing nature of the United States economy and the structure of the United States labor market. There seems to be a tremendous mis-match between the two and this portends an unhappy near term for economic growth and employment.

An article in the Monday New York Times by Peter Goodman, “After Job Training, Still Scrambling for a Job” captures the whole dilemma (http://www.nytimes.com/2010/07/19/business/19training.html?_r=1&scp=2&sq=peter%20goodman&st=cse). In this article, Mr. Goodman presents a well-developed argument that even after job training, many people in today’s economy cannot find jobs. One of the individuals Mr. Goodman interviewed stated in extreme frustration, “Training was fruitless. I’m not seeing the benefits. Training for what? No one’s hiring.”

Yet, Mr. Goodman argues that some industries are hiring. Some experts point out that “even with near double-digit unemployment, some jobs lie vacant, awaiting workers with adequate skills.”

“’There’s plenty of jobs in health care, in technology,’ said Fred Dedrick, executive director of the National Fund for Workforce Solutions.

Some of the aggregate figures point up this mis-match between labor and industry. First, the capacity utilization figures tell a dismal tale. Since the 1960s, capacity utilization in the United States has fallen. Every cyclical peak of capacity utilization over the past fifty years has been lower than the previous one. In the 1990s, capacity utilization reached a peak of around 85%; in the middle 2000s, the peak was around 82%; and currently it is languishing around 74%. United States industry does not seem to be “tooled-up” for the right output.

Second, the under-employment of the working-age labor force has grown constantly over the past thirty years or so. The “measured” rate of unemployment indicates that about one out of every ten workers is currently unemployed. My estimate for the under-employed is that about one out of every four workers is under-employed in today’s economy.

How did we get this way?

I believe that the economic policies of the United States government helped to create this employment situation!

The reason I give for this conclusion is that every time economic growth started to slow over the past fifty years, the federal government stepped in to stimulate the economy and put people back into the jobs they had just lost. This was the Keynesian approach to the problem of unemployment.

This approach to stimulating the economy worked well in the short-run but in the longer-run failed to take account of shifting technologies and the job skills of the work force. This mis-match did not show up so much in the short-run because, especially in the earlier years, technology was not changing rapidly. However, as the last fifty years moved along changes in technology occurred at a faster and faster pace. The dislocation between the new technology and the “legacy” industrial capacity in place grew, as did the chasm between many in the labor force and the skills needed to handle the new technology in the new industries being created.

This is an unusual happening for it is nothing more than the working out of Joseph Schumpeter’s concept of “Creative Destruction”.

Applying Keynesian fiscal stimulus to this problem over and over again just exacerbated the situation. Why? Because people were either put back into “legacy” jobs or were given minor training and shoved back into the job market. Goodman writes, “Most job training is financed through the federal Workforce Investment Act, which was written in 1998—a time when hiring was extraordinarily robust. Then simply teaching jobless people how to use computers and write résumés put them on a path to paychecks.”

Goodman quotes Labor economist Carl E. Van Horn: “A lot of the training programs that we have in this country were designed for a kind of quick turnaround economy, as opposed to the entrenched structural challenges of today.”

The conclusion to this story is that over time the continued application of these Keynesian stimulus efforts causes a loss in impact. Each cycle this policy prescription seems to be less and less effective as the cumulative effect on industrial capacity and human capital grows. Capacity utilization declines and more and more workers become under-employed.

Given this conclusion, one can ask whether or not there comes a time when the fiscal stimulus program becomes almost totally ineffective? Have we reached a point where the cost/benefit tradeoff of more fiscal stimulus becomes almost all cost and very little benefit?

This, however, is not the only point that needs to be mentioned at this time. Most of the advocates of Keynesian fiscal stimulus policies are very concerned about the growth in income and wealth inequality over the past thirty years or so. The continued application of Keynesian-type fiscal stimulus packages during the past fifty years, I believe, has contributed substantially to the greater inequality in income and wealth that has occurred in the United States.

There are three primary reasons for this growth in inequality. First, the fiscal stimulus programs put people back to work in the jobs that they formerly held. The largest number of the short-term unemployed came from large firms so that the stimulus had to encourage the growth of these companies so that the workers that were laid off could be re-hired. The fiscal stimulus packages “subsidized” the growth and wealth of the big, already implanted companies. Thus, the salaries and employment packages in these areas could continue to grow over time even as the capacity utilization in these industries continued to fall.

Second, as more and more people in these industries became under-employed, their incomes dropped relative to other sectors of the economy and their future prospects also fell. This, however, did not keep these people from piling up debts to buy cars and houses and other consumer items. These people felt confident that over time, they would continue to generate income, even if it might be somewhat sporadic. Furthermore, the inflationary environment of the past fifty years made it sensible for these people to go into debt for the inflation depreciated the value of their debt over time.

Third, the wealthier segment of the economy took advantage of the continued fiscal stimulus of the past fifty years (gross federal debt rose at a compound rate of seven percent every year) and the fact that, on average, inflation rose at a compound rate of more than four percent per year over this time period. Wealthier people have always been able to position themselves better than the less-wealthy, especially when macro-trends become as predictable as the economic policy proscriptions of the United States government, whether Republican or Democrat.

Furthermore, wealthier people have always been able to find their way into the professions that provide, over time, the greatest opportunities to earn income and create wealth. Certainly these professions would include medicine and health, legal, finance, and management some of the biggest gainers over the past fifty years.

Given these factors, how long will it take for the United States economy to re-structure itself? In the 1930s it took a long time. Will it take that long this time around?

Let's Look at the United States rather than Europe for a change

Durable goods orders are up 2.9% in April. New home sales rose last month. More and more statistical releases point to a continuing recovery. More and more it appears as if the Great Recession did end in July 2009 and we are, consequently, in the tenth month of the economic upturn.

However, it still doesn’t quite feel like much of an upturn. But, economic pundits contend that there is very little chance for a “double-dip” recession even with the financial turmoil rocking Europe. One analyst argued that with the European disorder the probability of having a “double-dip” recession has risen, but from about 5% a month earlier to around 20% now. In other words, he believed that it is highly unlikely that we will have a “double-dipper.”

My concern is still focused upon the long-term fact that there is so much un-used capacity in the United States. The efforts to stimulate the economy, as a consequence, represent efforts to put people back into “legacy” jobs (the jobs from which they were released) that will continue to thwart the competitiveness of the United States in world markets and put back to work “out-of-date” plant, machinery, and labor.

If we look at capacity utilization in the United States, we see that we are using more capacity now than we did in July 2009. For April the figure was below 73.7%. However, we are still substantially below the previous peak in capacity utilization, which came in at about 81.5% in 2006. And, the previous peak before that was below the previous high before that, 85% in 1997, which was lower than the previous peak and so forth for the whole post-World War II period.

Furthermore, industrial production remains depressed from the level it attained in early 2008 and also in 2000. Both series are making progress, but we are still running way below levels that were previously attained and although the “catch up” seems to be robust, the question remains as to whether or not these measures will exceed earlier highs in the near future.

Adding to this concern is the fact that the labor situation remains weak. Unemployment in April stayed just under 10%, but the number I am very concerned about is the total amount of workers that are under-employed. I am concerned, not only with those that are out-of-work, but those that are not fully employed but want to be fully employed, the discouraged who have left the workforce, and the people that have taken lower positions, positions that they can fill but are fully qualified to perform in other more challenging jobs. My estimate of these under-employed persons runs around 25%, about 1 out of every four people who could be considered to be in the labor force.

The fact that these factors are running so low relative to “capacity” employment raises concerns about the United States achieving its “potential” any time soon. To examine this possibility we look at a comparison between the estimates of the Congressional Budget Office of potential real Gross Domestic Product and the level that real Gross Domestic Product was actually attained. Not only was the United States economy producing at a level of output only 94% of potential, the rates of growth of actual real GDP seem to lie below the rate at which the CBO is estimating that potential real GDP should grow.

The economy of the United States is recovering, but one can understand why many people really do not seem to be experiencing it. Nothing in the previous stimulus plan, or in the one being developed, or in the current stance of monetary policy, gets the United States back on track. Different types of policies are needed to renew the productive capacity of the United States so that the U. S. can become fully competitive again and fully use its resources…both human and physical. Unfortunately no one seems to be working on these kinds of policies because they rely so heavily on the private sector. Also, these policies take too long to achieve results; politicians have a much shorter employment cycle.

A Quick Look at Profits

So far, two facts stand out to me in many of the current earnings releases. First, for many large financial firms, trading profits have provided almost all of the positive results that we have seen. Second, for many large non-financial firms, cost cutting has resulted in better-than-expected earnings.

Both of these lead me to the conclusion that the basic or fundamental businesses of the companies reporting are showing little or no life. In other words, the demand for the basic products or services they provide is listless, at best. And, results like these are not sustainable.

Yes, the results are encouraging. Profits are always better than losses. But, these profits are not connected with the core business of these companies and hence give no indication that either the financial firms or the non-financial firms have established some kind of competitive advantage that will last into an economic recovery.

In terms of the large financial firms, like Goldman Sachs and JPMorgan Chase, the trading profits have allowed them to post substantial earnings and get the government off their backs. Getting the government off their backs is important and will become more so in the future because these companies can pay to keep their top-flite executives or pay to attract other major talent to their organizations. They can buy time as their core businesses improve. However, trading profits are not sustainable and should not be counted over an extended period of time.

The large financial firms that have not produced, like Citigroup and Bank of America, will find themselves at a considerable competitive disadvantage, both in the United States and worldwide, as their competition can apply their strengths to continue to grow and increase market share. Plus, these non-producers are having to sell off assets like BOA’s sale of First Republic and Citigroup’s sale of Phibro even though both were profitable operations.

The last thing these organizations need is to have their pay the top officers receive drastically cut. Not only do troubled firms have problems hiring top talent, but to have the onus of the government hanging over the companies and controlling what top executives get paid is doubly bad. These financial institutions were too big to fail—immediately. But, they are not too big to fail a slow death. Certainly the government’s effort to impact the remuneration of the top executives at firms still receiving government help will skew the playing field to the Goldman’s and the JPMorgan’s.

One can understand in today’s environment that a lot of people are angry about big salaries and bonuses, especially to those that have been bailed out by the government. Certainly, the forthcoming big bonuses to be received by the executives at Goldman and JPMorgan do not help stem these populist attitudes about the pay at financial institutions. But, in this case, the response of the public is just helping the competitive position of Goldman and JPMorgan and hurting that of these other large banks because the actions on pay just makes Citi and BOA less competitive! Goldman and JPMorgan are smiling all the way to the bank!

The other banks, the regionals and the locals? They need time to continue to work out their loan and security portfolios. They need to regroup, get back to their core business and they will be fine. But, this is going to take time. Nothing substantial in profits here for a long time.

As far as the non-financial firms are concerned, their cost-cutting efforts are paying off. Their efforts to return to their core businesses are paying off. But, cost cutting alone does not produce sustainable exceptional returns. Cost cutting can be duplicated. And, as long as consumers stay on the sidelines and restructure their balance sheets and keep reducing their debt not increasing it, the final demand for goods and services will not show much bounce.

There is continued hope in one sector after another that sales will pick up. In computers. In retail sales. In food services. There is continued hope that sales will pick up during Thanksgiving, or Christmas, or at some other relevant time. But, these blips of hope seem to pass on as sales continue to disappoint. The hope is transferred to the next holiday.

Companies, for the past four or five months, have posted not-so-good earnings, but they raise their forecasts for the upcoming year.

There is nothing these companies are doing right now that produce sustainable results. Demand for their products and services must be forthcoming and, right now, there is little encouragement that this will happen any time soon.

All of these factors raise two concerns in my mind. First, what is the basis for the continued rise in stock prices. The profit results that have been achieved so far are not sustainable and point to no growth in earnings or cash flows for the time being. Furthermore, the cost cuts are great, they help companies get their focus back onto the right things. But, cost cutting does not result in a continued increase in earnings or cash flows. In addition, trading profits do not contribute to extended growth in earnings or cash flows. This is why I am concerned about the possibility that the rise in stock prices since March might just be a bubble. (See http://seekingalpha.com/article/167561-are-we-in-an-asset-bubble-or-not.)

Second, managements are refocusing their efforts and reducing inventories, labor, and other resources that they had accumulated during the go-go years. This restructuring, given past experience, will continue, even when the economy begins to recover again. These managements are not going to return to the same business practices as before. This will change the supply side of the economy and, as a consequence, full employment of resources will not be the same as it was earlier in this decade.

If this does occur, and I believe that it will, it will just be one more part of the trend that began in the 1970s. Through all the cyclical swings in the economy during the last forty years or so, the economy has never regained the height it had achieved in the previous upswing. That is, the next peak of employment, of capacity utilization, of industrial production, has never as high as it was at the previous peak.

This means that the economic policies of the last forty years or so have left more manufacturing capacity idle, more workers discouraged, and more resources wasted each cycle of the economy. The American economy is changing along with competition in the world. Artificial stimulus on the part of the United States government just tries to put people and other resources back into the jobs that they once held, like in autos and steel for example. And, such an economic policy only exacerbates the longer term trend. Furthermore, this is not helpful to the stock market.

It is easy to build a case that the rise in the stock market in the 1990s and the 2000s were asset bubbles created by easy credit. Given the performance of financial and non-financial firms at the present time could the Federal Reserve just be producing another one?