Buybacks break the first commandment of capitalism

The stock markets have been propped up by a record amount of stock buybacks. That’s like peeing your pants to stay warm.

Stock buybacks break the first commandment of capitalism.

Israeli historian Yuval Noah Harari calls capitalism “the most successful religion of all time” and defines its first commandment as follows:

“In the new capitalist creed, the first and most sacred commandment is: ‘The profits of production must be reinvested in increasing production.’”

It’s Harari’s translation of Adam Smith’s golden rule on which he more or less founded free market capitalism.

Capitalism only works as long as profits are reinvested in order to increase output. That way the pie keeps growing and we can all get a bigger slice.

If that is indeed the foundation of capitalism, then tons of companies have been committing a sacrilegious offence this year.

The world’s biggest companies first hoarded their cash. Then, instead of reinvesting it in ways that would boost production, they played Santa Claus to their shareholders.

US companies are expected to spend $1 trillion on stock buybacks this year, an increase of 90% compared to last year when they spent $530 billion on buybacks.

With the market running out of steam, buybacks may have been the only thing that propped up the markets recently.

Sugar rush

Central bank quantitative easing and, more recently, stock buybacks have provided the market with lots of “free” money in the past nine-and-three-quarter years.

These giveaways have pushed stock markets to new highs with the Dow Jones and the S&P 500 breaking records in September. It’s led to the longest ever bull market. We started to believe that trees could grow to the sky.

But even the longest party in Wall Street history has to end sometime. At last, the corporate sugar rush has started to wear off.

While it’s true that this bull market has broken Wall Street records, you might wonder how much of this bull market has been based on genuine growth.

First central banks flooded the system with a shedload of money.

Stock markets got a huge lift because all the money that was meant to trickle down into the wider economy failed to spill from the big glass standing on top of the champagne tower.

The money that was earmarked for the real economy ended up in the stock markets. The economy didn’t benefit much from the stimulus, but stock markets sure did.

Just as the bankers’ bankers stopped giving out free money, a new Santa Claus came to town. President Donald Trump awarded US corporations tax breaks that translated into lots of spare cash.

US companies paid 33% less tax in the second quarter compared to the year before. After-tax profits rose 16.1% over the same period.

Another truckload of free money donated to the private sector, no strings attached, with compliments from the Treasury.

But that’s OK. Because in the big book of capitalism, The Wealth of Nations, Adam Smith wrote that companies would reinvest their profits to achieve more growth.

Profits are meant to be used to expand production and hire more workers. That way the gift to corporations would still boost the economy in a big way.

Unfortunately, that’s not what’s been happening.

Corporate hubris

Companies apparently can think of no better way to spend their new-found riches than to buy back their own shares.

In June, a grand total of 31 companies announced they’d splash over $1 billion on stock buybacks. Apple outdid them all with a planned $100 billion stock repurchasing programme.

“Buybacks are often a sign that the markets (and investors) are overconfident,” writes Forbes columnist John E. Girouard.

In other words, stock buybacks are a form of corporate hubris.

Still, every analyst on the planet is convinced this year’s round of buybacks will shatter the previous record of $589 billion, which was set in 2007. Estimates have only gone up, from $650 billion to $800 billion to $1 trillion.

“It’s so extreme that the largest share of US equity demand in 2018 will be the buyback of common stocks.”

Companies obviously can’t keep buying back their own shares forever. What happens when the appetite for buybacks dries up or companies run out of spare cash? Will investors swoop back in?

Don’t count on it. Just as a record amount of corporate buyback money hit the markets, investors set their own record for selling stock-based funds.

The sheer volume of stock buybacks plastered over the fact that many investors had already quietly headed for the exits.

Companies could come to regret not spending their resources more wisely, writes Niels C. Jensen on Seeking Alpha:

“US corporates have underinvested in physical assets in the post-crisis environment – i.e. they have invested less than depreciation – [returns on equity (ROE) and earnings per share (EPS)] have benefitted, but only because the free cash-flow has been spent on buybacks instead.

“As an old Danish saying goes, that’s like peeing your pants to stay warm.”

Stock market valuations shooting higher this year on the back of corporate buybacks may have been the pride that came before the fall.

Sir John Templeton said that bull markets are born on pessimism, grow on scepticism, mature on optimism and die on euphoria.

This particular bull market may have ended on corporate euphoria rather than investor euphoria.

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