The Donald Trump-inspired wealth effect is working like a charm, in spite of the recent stock market wobble. The S&P 500 is up about 22 per cent since he stepped into the White House almost two years ago, unemployment is at record lows and wages are growing at their fastest pace in nine years. What’s not to like?
Nothing, so far; the wealth effect may have prevented this week’s midterm elections, which saw the Republicans lose control of the House of Representatives, but gain two seats in the Senate, from turning into a rout for the pro-Trump forces. The Republicans who lost their jobs weren’t sent packing because of an ailing economy; they were punished for other reasons.
But watch out – there is a lot less to the stock market than meets the eye. Mr. Trump must know this and is no doubt gambling that the lights won’t go out on the market party before the 2020 election. What’s driving stocks to possibly wild valuations is not surging growth and profits in Corporate America. The reason is more mundane: It’s share buybacks, and lots of them.
Mr. Trump’s tax reforms, which kicked in early this year, were a godsend to investors, especially the wealthiest 10 per cent of Americans, who own 80 per cent of total stock-market equity. The reforms cut the corporate-tax rate to 21 per cent from 25 per cent and gave foreign profits an exceedingly light tax touch. American corporations had parked some US$2.1-trillion in cash overseas.
Now, thanks to the tax reductions, hundreds of billions of those offshore dollars are being repatriated. If you thought they were going to good causes, such as bulked-up research-and-development budgets or random acts of corporate altruism, you’d be wrong. Those fortunes instead are going into buybacks like never before.
The total value of buybacks by S&P 500 companies keeps setting records. In 2016, the figure came to US$529-billion. Last year, it was US$550-billion. The 2018 amount will make those buybacks look parsimonious. So far this year, according to Goldman Sachs, the authorized buyback tally is almost US$750-billion. The final tally for 2018 could come close to US$1-trillion, depending on how much more overseas cash sloshes onto American shores.
There was a time when share buybacks were virtually non-existent because, under U.S. Securities and Exchange Commission rules, they were considered dubious forms of stock manipulation. The rules changed in 1982, when the deregulation-mad Reagan administration opened up the market to virtually unlimited buybacks. At first, they were used rather sparingly by companies that considered their shares illogically undervalued.
Today, buybacks are used with abandon to inflate already overinflated shares – shares which incidentally make up the bulk of any executive’s compensation package. Buybacks are so prolific that they now exceed the issuance of new shares. The result is an ever-shrinking base of equity, pushing up the value of the surviving publicly traded shares. According to Forbes magazine, the price-to-earnings ratio of the S&P 500 is currently 40 per cent higher than its historical average.
Everyone’s playing the buyback game. Warren Buffett’s Berkshire Hathaway disclosed this month that it is buying back almost US$1-billion of its own shares. Ditto for Spotify, the music streaming company. Apple, which rarely launched buybacks in the Steve Jobs era, has spent US$73-billion on buybacks in the past year alone (The Financial Times calculated that the amount was enough to fund the salaries of 311,000 teachers for four years, or half of global infrastructure spending required by 2030). The lavish buybacks helped to propel Apple’s value to US$1-trillion at one point (the company’s market cap has since fallen to about US$962-billion). Buybacks, not new products, appear to be sustaining Apple’s lofty share price – the company has not launched a blockbuster new product since the iPhone appeared in 2007.
And that’s the point. The market is on a sugar high fuelled by tax cuts and their offspring, the buyback bonanza. The fat price-to-earnings premium on the S&P 500 Index is just one indication of danger ahead. Another is what is known as the Buffett Indicator, which Mr. Buffett once called “the best single measure of where valuations stand at any given moment.”
It’s a simple calculation, achieved by dividing the total market value of all U.S. shares by the latest gross domestic product figure. If the figure falls below 90 per cent, stocks are considered cheap. Anything north of 100 per cent indicates the opposite. The Buffett Indicator hit 145 per cent just before the dot-com bubble burst in 2000. Last year, the indicator reached 130 per cent, and kept rising to almost 150 per cent in July.
What could cause the market bubble to burst? It’s impossible to identify the trigger, but JPMorgan notes that the pace of buybacks, while up a lot over last year, slowed considerably in September and October, as less overseas cash is repatriated. If buybacks are the market’s main support mechanism, any slowdown in buybacks could have dire consequences. Rising interest rates will hurt.
Mr. Trump is evidently worried about the possible vaporization of the wealth effect. Last month, after the market fell fast and hard before recovering, he said the head of the U.S. Federal Reserve was making a “big mistake” by raising interest rates. The stock market is weaker than it appears. Corporations loved the tax cuts, which financed a tsunami wave of buybacks, artificially propping up equity prices. That game can’t last forever. Mr. Trump’s great giveaway may come back to haunt him, along with his re-election prospects.