A Rally Without Investors And Other Musings
Over the course of the last two weeks, I attempted to explain to the general investing public how, thanks to the virtual impossibility of distinguising between 'legitimate' market making and 'illegitimate' prop trading, some of America's systemically important financial institutions are able to trade for their own accounts with the fungible cash so generously bestowed upon them by an unwitting multitude of depositors and an enabling Fed. Of course, as I noted recently, simply taking excess reserves and using them "to make big bets in the credit and equity markets would be too transparent even for U.S. regulators," so the banks do what any scandalous business worth its salt does -- they launder the money. The laundering services are provided by the Bank of New York Mellon, State Street, and JPMorgan -- in other words, the custodian banks. Through repo channels, banks are able to pledge the assets they purchased with deposits and excess reserves as collateral for 'clean' cash. The best part? The pledged assets stay on the books even as the cash loans are 'invested' in such bastions of capital preservation as Markit's CDS indices and, of course, equities.
As it turns out, the investing public doesn't take kindly to the idea that their deposits and their tax dollars (via the Fed's Treasury purchases) are being used as poker chips. Apparently, they have been slowly indoctrinated by the incremental doses of Keynesian propoganda they receive each time they turn on the TV or read the main stream financial press. As such, they are decidedly unwilling to admit that the glaring contradiction between ICI data which shows some $130 billion in net outflows from domestic equity funds in 2012 and an S&P 500 index hitting all time highs, might just signal that the market is being propped up by something other than good old, healthly grassroots demand from retail investors.
Commentators generally write-off the mutual fund flows data by asserting that the reason for the apparent exodus is retail investors' newfound preference for ETFs. This is a nice thought but unfortunately, it isn't supported by the data. The following chart shows that even when ETF flows are taken into account, there was a net outflow of some $21 billion from U.S. equity funds in 2012:
So given this, where has the money come from that has sparked the rally? One answer is that excess liquidity pumped into the coffers of the primary dealers by the Fed combined with a historically low (72%) loan-to-deposit ratio has precipitated a prop trading field day at some big banks. This contention is supported by Goldman's latest quarter which showed that between prop trading (they call it 'principal transactions') and market making, the firm pulled in $4.7 billion in revenues in just three months.
But aside from this, there is another channel by which the Fed's actions have driven stocks higher. The magic of ZIRP has led to historically low corporate bond yields fueling a flood of corporate issuance in 2012. The problem? Corporations aren't borrowing to invest in their businesses per se, they are borrowing to buyback their own shares. Put simply, when you can borrow for less than the cost of paying dividends, why the hell not borrow and buyback some shares? Even the Wall Street Journal gets it:
Some of the spending on buybacks is just financial tinkering -- interest rates on borrowed money are cheaper than paying dividends, so companies take on more debt to eliminate some of their shares.
So just how much of the market's 2012 gains can be attributed to corporate buybacks fueled by ZIRP? Have a look at the following chart which shows that some $405 billion was spent in 2012 on buybacks, the most since 2011 which, in turn, was the most since 2007:
It would certainly seem then, that with retail investors being net sellers, the stock market rally can be entirely attributed to corporate share buybacks, in conjunction with prop trading at cash-flush, repo-pyramiding banks.
This isn't a good sign for two reasons. First, note the similarites in the following chart regarding the trend in the percentage of corporate cash spent on share buybacks in the years leading up to 2007 and in post crisis years:
A rising percentage of corporate cash usage devoted to share buybacks is not generally a good thing. In fact, it may well be appropriately viewed as a contrarian indicator given that corporations can sometimes be pitiful judges of value in terms of when the right time to buy is. Take Intel for instance which,
...over the last 10 years has spent about $56 billion to buy what is now $52.5 billion of stock. Counting the dividends Intel didn't have to pay, the company's return on investment from these purchases was roughly zero.
Furthermore, companies are fond of saying that buybacks are a way of returning cash to shareholders. Of course, if the buybacks are funded by the accumulation of debt (even at low interest rates) it isn't exactly accurate to say that any cash has been 'returned.' Take for instance, Herbalife who, in the second quarter of 2012 trumpeted a new 5-year, $1 billion share buyback program. The company said it would fund the program with future earnings if possible but suggested that it may fund the repurchases with a new credit facility. The new credit facility was necessary because the old revolving credit facility was used to...wait for it.... repurchase stock. As I noted at the time,
the new credit facility is being used to pay-off the revolver on the existing credit facility which was itself used to buy back shares. Essentially then, the company took out a loan to buy back the
shares, then took out another loan to pay off that loan, and now says it may ("if needed") use the remaining balance of the new loan to buy more shares. This doesn't sound like "returning excess cash flows to shareholders" to me. It sounds like returning other people's money to shareholders and incurring debt obligations along the way which, of course, the company must pay interest on in the mean time.
Aside from all of this, there is another problem. Corporations are so busy buying back shares in order to artificially boost earnings (remember, when shares are repurchased the denominator in the EPS calculation shrinks) they have neglected to make the requisite expenditures on that all-important source of productivity and efficiency: capital. If you're buying back shares you're not investing in productive capacity and while you may be helping to keep the stock market afloat with share repurchases, you're virtually assuring that your company will be less competitive in the long run. In short, it isn't any coincidence that share buybacks are up while capex is down or flat as a percentage of corporate cash usage.
So for those poor souls who have had their ability to connect the dots blunted by the deafening chorus of the Keynesian establishment, allow me to reiterate: there are no coincidences here. It isn't mere happenstance that stocks are somehow at five year highs despite net $21 billion in retail outflows from equity mutual funds and ETFs during the previous twelve months. ZIRP-fueled corporate borrowing has funded capex-killing share buybacks. Meanwhile, record deposits over loans combined with the endless stream of freshly printed dollars flowing into the accounts of primary dealers has meant a bonanza of fungible dry powder for big banks. Once this cash is recycled through repo channels, it finds its way into every corner of the market even as the repoed collateral sits on the books like trophies on a shelf waiting to be admired by regulators and clueless investors alike. A centrally planned market for a centrally planned world.
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