(Note: I rarely post that kind of analyses but this time it is probably important to know about, and interesting to watch).
How to transfer cheap credit into fake profit and create an illusion of growth, simple:
- borrow a few billions of dollars at near zero interest rate
- buy your own corporate stock back, which allows the company to increases dividend per free trading share without incurring extra costs or improving anything nor adding anything of value. It also triggers a buying momentum on the stock market, which other "investors" tend to follow.
- wait until stock price increases due to higher dividend yield and due to momentum investing. This will also increase a value of the previously purchased corporate stock held as the asset, making it available to use as a collateral for future loans.
- repeat the above, roll-over the old loans if necessary.
In fact, one can argue that it makes no sense whatsoever to invest in production if stock buyback brings more return on “investment” and quicker since the lag is much shorter then a new product development cycle.
What can go wrong?
- if interest rates go up too much then rolling over the old loans would drain the cash and bankrupt the companies. This is highly unlikely since the central banks are well aware of that kind of systemic risk and will not raise the interest rates substantially, any time soon.
- if the stock prices decline in spite of buybacks due to market correction or declining fundamentals (as in case of mining & energy sectors and some banks) , then the own corporate stock held as a collateral must also decline which may trigger the calls on the existing loans and may make it more difficult to borrow and to roll-over the old debt. This may potentially expose the company to a liquidity crisis. We will probably see some interesting examples of this phenomenon in 2016, beginning with the mining sector and some oil companies and then possibly some banks exposed to bad loans. Previously, the governments fought it by issuing another QE (“quantitative easing” of credit), will it work this time? We shall see. It will cause US dollar exchange rate to rapidly go down as it happened during 2008-9, which may trigger an outflow of capital out of the US stock and bond market, again as in 2008-9 (this time into the currencies of countries that are not exposed to deflationary risk of mining and energy markets). This will exacerbate the stock market rout in the US. Note that the above mechanisms are not self-correcting, they form a positive feedback loop, that is a movement in one direction, up or down tends to amplify itself reinforcing the trend.
Big companies have lost billions buying their own shares
And it's not just a few big corporate losers accounting for all the pain. The group includes 229 companies in the Standard and Poor's 500 index, nearly half of the companies in the study prepared by FactSet for The Associated Press. When a company shells out money to buy its own shares, Wall Street usually cheers. The move makes the company's profit per share look better, and many think buybacks have played a key role pushing stocks higher in the seven-year bull market.
Why Stock Buybacks Won’t Save The Market This Time
There's a reason investors have blindly trusted Wall Street's "buy the dips" mantra since 2009. In fact… there are 2.3 trillion reasons. That's because since 2009 U.S. companies spent more than $2.3 trillion buying back their own shares, according to a report by Aranca Investment Research Services. All that buying acted as a floor for stocks and launched the major indices to new heights.
Fundamentally, spending cash on or debt-financing buybacks is touted by management as "returning cash to shareholders" by reducing share count, which reduces the number of shares the company's earnings are divided across. So, by reducing shares through buybacks, earnings per share can rise even if actual earnings are flat or falling. And that's a source of positive sentiment for those holding those stocks.
There is only one buyer keeping S&P 500 bull alive
When The Prop Drops - Company Share Buybacks Accounted For 100% of New Stock Market Cash Since 2010