Back in early 2014, we first explained [10]how it was possible that with the Fed's QE tapering, the S&P kept rising higher despite declining intervention by the Fed in capital markets: the answer was corporate buybacks, which had then soared to the highest level in history.
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This artificial stock-support by CFOs and Treasurers only increased in the subsequent year, with buyback announcements hitting a record high one year later, in May 2015, as also profiled previously [12].
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[14]
Then after the early euphoria of 2015, repurchase activity slowed down. As Factset observes in its just released quarterly buyback report, [15]the dollar-value of share repurchases amounted to $134.4 billion over the second quarter (July), which represented a 6.9% decline from the first quarter (April) and a 0.4% decline year-over-year. On a trailing twelve-month basis (TTM), dollar-value share repurchases totaled $555.5 billion, which was approximately flat with the first quarter.
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On the surface, this is good news, but, and here there is a huge "but"... because the reason for the drop off in buybacks has nothing to do with corporate executives reigning in their desires for higher stock prices and thus, higher equity-linked compensation, and everything to do with funding limits. Because while buyback activity may be slowing down it is only due to one thing: a collapse in free cash flow among S&P500 companies, with energy companies at the forefront, but increasingly all sectors being hit by a dramatic slow down in FCF creation. According to Factset while LTM buybacks declined by 1.3%, Free Cash Flow over the same period plunged by a whopping 29%!
In fact, as Factset notes, in the past 12 months, for the first time since October 2009 the amount spent by companies on buybacks has surpassed the Free Cash Flow of the S&P 500 itself! In other words, the only use of funds for the 500 or so companies in the biggest stock index in the world is to... push their stock even higher. It also means that any incremental "use of funds" such as M&A, dividends, capex or just plain organic growth, would have to be funded through issuance of debt.
From FactSet:
Although the aggregate dollar-value of share buybacks declined sequentially in the second quarter on a TTM basis, companies in the S&P 500 still spent more on buybacks than they generated in free cash flow. Free cash flow is defined as cash from operating activities minus capital expenditures from fixed assets and cash dividends paid. The aggregate Buybacks to Free Cash Flow ratio for the S&P 500 exceeded 100% for the first time since October 2009. The ratio hit 108% on a TTM basis at the end of Q2, which represented a 12.9% increase quarter-over-quarter and a 42% increase year-over-year. The 10-year median ratio was 72.2%. At the sector level, four out of the ten GICS sectors had a ratio greater than 100% at the end of Q2 (Consumer Discretionary, Consumer Staples, Industrials, and Materials).
What is driving this ratio to such high levels? As mentioned earlier in this report, the TTM dollar-value share repurchases in Q2 amounted to $555.5 billion, which was a 1.3% increase year-over-year. This partly contributed to the higher ratio, but the main driver was free cash flow. TTM free cash flow at the end of Q2 totaled $514.4 billion, which represented a 28.6% decline year-over-year. The aggregate FCF for Q2 was the lowest level for the S&P 500 since Q3 2009, when FCF amounted to $140.2 billion.
The sectors leading the decline in free cash flow were Energy and Financials. Financials saw a 50.2% decline in FCF year-over-year, with State Street Corporation heavily contributing to this decline. State Street reported cash flow from operations of -$5.1 billion in the TTM ending Q2 2015 after reporting a $907 million inflow in the TTM from the year ago quarter. The Energy sector, which typically has high levels of fixed capital expenditures, saw free cash outflows totaling -$65 billion in the TTM ending Q2. Free cash outflows amounted to -$7.1 billion in the TTM ending Q2 2014. Southwestern Energy was another large contributor, as it increased its fixed capital expenditures by almost 250%, leaving it with free cash outflows of -$5.7 billion in in the TTM ending Q2. The company reported free cash inflows of $4 billion in the TTM from the year ago quarter. Due to decreases in free cash flow, buyback spending for the S&P 500 is now 1.08 times TTM free cash flow, which has surpassed the 10-year average of 1.05 times free cash flow.
And voila:
[17]
And that, in a nutshell, is why the market is tumbling today: it is not so much longstanding fears of a Chinese collapse (although these are certainly relevant), nor the threat of a European recession due to the Volkswagen scandal (which is certainly an issue but will be resolved promptly once enough congressional palms are greased) nor the long-telegraphed plunge in Glencore and other miners (this too will get much worse before it gets better) - no, the catalyst for today's dump is that the biggest buyers of stock in the past 2 years, the corporations themselves, just priced themselves out of the market and no longer generate the cash needed to push their own stock to new all time high levels in a thin, illiquid market in which the orders from Goldman's buyback desk are the marginal price setter.
It is very possible that the current quarter may well be the last push to keep stocks levitated, and until and unless there is a substantial increase in free cash flow (unclear what would cause this), companies will slam shut the buyback spigot, especially when the vast majority of CFOs realize that the returns on the latest year of buybacks just turned negative and the board says "no more."
As for what happens when companies decide to proceed with buybacks anyway and issue billions in debt just to fund these and keep the party going a little longer (even if if means risking their Investment Grade rating in the process) look no further than IBM [18]and HP [19] for the outcome.
Source: FactSet [15] [15]
