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 U.S. – 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.”
Just like the yield of a bond is the income that an investor receives from cash, the most important component of the yield on a stock is the dividend that the investor receives as the company pays out cash dividends. The total yield from holding a stock is the sum of the dividend yield and the “buyback” yield. The buyback yield is simply the capital returned to investors divided by the market value of the stock. To compare the relative yield value of stocks and bonds, then, we should compare the yield on bonds and the total yield on stocks. What has been a direct consequence of the large buying of bonds by central banks until recently is that investors have been buying stocks for their total yield since this yield has been much higher than the comparable bond yields. One could also argue that investors have been buying bonds for capital appreciation, not yield. Otherwise why would one hold negatively yielding securities in Europe? Bonds for capital gains, equities for yield – very interesting!
Tech companies notoriously do not give back much in terms of dividends, recycling their earnings into either more investment or, recently, buying back more of their stock. Going back to the beginning of 2000, information technology sector has delivered a total yield of 3.27%. Today, the total yield is 1.72%. The dividend yield is close to its average of 1% for this sector, which just confirms that tech is returning money to its investors via a higher price, but not necessarily more cash. In fact investors buy tech for growth, not income, so this is perfectly rational behavior on the part of both corporations and investors.
Hence the Tech “yield” is mostly of the buyback kind. If we take a close look at the eleven sectors of the S&P 500, we find that buybacks, and the anticipation of these buybacks, has been the engine behind the rapid rally in Tech. Both have created euphoria, and a happy contagion has spilled over into other sectors as well. In a classic George Soros-style reflexivity, the phenomenon of rising stock prices created more market and economic optimism, better access to funds since the collateral is priced richly, M&A dollars, more buyback ammunition. This resulted in a virtuous cycle of rising asset prices and optimism.
The chatter in the market place is that the volume of buybacks in 2018 is likely to exceed $800 billion, which is significantly higher than the $500 billion or so in 2017. Much of this ($200 billion) might possibly be related to the tax repatriation. By our estimates, the early February hiccup in the equity markets resulted in $500-$750 billion of equity selling from various systematic strategies. A “buy the dip” from buybacks and other bargain hunters can then clearly be seen as a possible reason for the sharp bounce back that retraced half of the markets losses. The systematic selling from volatility contingent strategies was almost absorbed by the systematic buying of corporations of the market.
If a buy-and-hold investor receives anything higher than the yield on the corporate bonds of the same issuing authority and duration, theoretically he should opt for the equity. Similarly, if a corporation can issue debt and buy back its stock with a net positive carry, it should also do so, locking in its financing. The wrinkle here is that equity holders are more at risk if there is a catastrophic selloff in the markets, or if total uncertainty or volatility rises, since they are the first to lose their capital.
By my guess, anything below a 1.5% spread on equities vs. the equivalent credit is a fair tradeoff, or in other words, the equity risk premium relative to corporate bonds of 1.5% is about as close as one typically should get. We are within spitting distance of that spread. If the equity risk premium is about 3% vs. risk free assets, and as a whole corporate bonds across every economic sector yield about 1% more than treasuries over the long horizon, we are left with about 2% spread of equity “yield” to the corporate bond yield. Add another 0.5% for various risk premiums (equities are more risky), and we are right around that 1.5% level of “fair” carry from equities, unless there is no risk over the very long horizon.
In other words, we need to receive a total yield of at least 1.5% more than what we receive on the underlying bond of the same company to take the trade between equities and bonds. Given that almost 30% of the buybacks over the last three years have been funded by debt, clearly corporations “get” this arbitrage and are stepping up their issuance to buy back their equity before it’s too late. The risk, of course, is that yields on the corporate bond market rise too quickly from here on, either because of treasury yields rising, corporate spreads widening or both. In which case investors would likely find the bond markets more attractive, and issuers would probably not issue bonds to buy back more stock. The likelihood of another large pile of windfall cash like the one received from repatriation also seems unlikely in the short run.
So now what? What is an investor supposed to do? When a corporation is telling you that given the opportunities and current market pricing they would rather buy the stock back than spend it, invest it or save it in cash, the investor should take this signal and the gift, and take some of the money to the bank. In other words, they should sell the stock to the company and not buy it back until the company says it sees better opportunities. In the long run, owning stocks are really owning companies that build stuff, rather than a factory that produces financial alchemy. Other than dedicated financial sectors where the arbitrage on funding rates is actually the investment, betting on capital structure arbitrage in the broader stock market today is primarily a bet on the buybacks continuing beyond what is priced in.
Any views expressed by Dr. Bhansali are solely those of Dr. Bhansali and do not necessarily reflect the views of LongTail Alpha, LLC, its affiliates or other associated persons thereof.