Financial Engineering Backfires
Something that happened just before the prior two market crashes, and the recessions that accompanied them, including the Great Recession, is happening again: the boom in financial engineering is starting to backfire against the companies doing it.
Their credit ratings are getting slashed, and their borrowing costs are therefore rising, even while they need newly borrowed money to buy back even more shares to keep the charade going. Until the music stops.
Downgrades ascribed to “shareholder compensation,” as Moody’s calls share buybacks and dividends, have been soaring, according to John Lonski, Chief Economist at Moody’s Capital Markets Research. The moving 12-month sum of Moody’s credit rating downgrades of US companies, jumped from 32 in March 2015, to 48 in December 2015, and to 61 in March 2016, nearly doubling within a year.
The last time the number of downgrades attributed to financial engineering reached 61 was in early 2007. It would hit its peak of 79 in mid- 2007, a few months before the beginning of the Great Recession in Q4 2007. At the time, stocks were on the verge of commencing their epic crash.
And there’s a reason for the link.
Companies buying back their own shares, often with borrowed money, are a big force in pushing up stock prices. Unlike other buyers, whether humans or algorithms, corporations are trying to be the high bidder. Their goal is not to buy low and sell high. Their goal is to push up their share prices. In this ingenious manner, they have become the relentless and dumb bid with near limitless means (borrowed money) – exactly what a stock market needs in order to soar beyond all reason.
Buying back shares also helps prop up stocks because it reduces the number of shares outstanding or at least it reduces the dilution that existing shareholders experience when companies award their executives and employees stock-based compensation or when companies buy other companies by issuing new shares. By reducing the share count, buy backs increase earnings per share, and particularly ex-bad-items earnings per share, which is the metric Wall Street analysts and corporate chieftains want everyone to look at.
Share buybacks have some big advantages: they are not accounted for as an “expense” on the income statement though they suck up huge amounts of mostly borrowed cash. So from an income point-of-view, share buybacks are free. But from a cash and leverage point-of-view, they’re very expensive.
When a company borrows money to buy back its own shares, the borrowed money doesn’t get invested in productive activities that would help service that debt in the future. All the company ends up with is a pile of additional debt that might cause all sorts of havoc when the multi-year credit boom – the “credit cycle,” as it’s called – ends. And that is now happening.
There is another element. According to Moody’s, upgrades attributed to common equity capital infusions are plunging. These include IPOs if they raise cash and lower debt for the company, and thus do the opposite of share buybacks (but many IPOs just raise capital for the investors exiting their deal). The moving 12-month sum of these upgrades peaked in the current cycle in September 2010 at 48. For the 12-month span ended in March, it plunged to just 14.
In the cycle before the Great Recession, the moving 12-month sum of upgrades attributed to equity infusions fell to 31 in December 2007.
Both – the soaring downgrades attributed to financial engineering and the plunging upgrades attributed to common equity capital infusions – speak volumes. Moody’s:
The climb by shareholder compensation downgrades suggests corporations are increasingly compelled to take extraordinary measures in order to support equity prices. When companies are willing to return capital to shareholders even at the cost of a credit rating downgrade, managements implicitly admit to the difficulty of achieving a satisfactory return from business assets.
Similarly, the much diminished incidence of upgrades from infusions of common equity capital reflects the now high cost of equity capital that stems from the more uncertain outlook for profits at this late stage of the business cycle.
And the gap between the 61 downgrades attributed to financial engineering and the 14 upgrades attributed to common equity capital infusions – at 47 – is now the highest since mid-2007, when it peaked at 49. Just after that, things began to unravel.
A similar gap built up just before the 2000 recession, but on a smaller scale.
This metric doesn’t cause markets to unravel. But it shows how late in the boom cycle we are today. It shows that the costs of financial engineering are starting to gnaw on stock prices. As at the end of the prior two cycles, companies see this too. Eventually, they curtail their share buybacks, or they’re forced by the credit markets to abandon them altogether. And when that relentless and dumb bid weakens, it pulls a big prop out from under the stock market.
The Fed heard the screaming from Wall Street earlier this year about the chaos in the markets, and it brushed rate hikes off the table. What ensued was a marvelous rally all around, particularly in bonds. But Moody’s pours some cold water over it. Read… OK, I Get it, this Junk-Bond Miracle-Rally Is Doomed
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When the music’s over…
When the music’s over…
When the music’s over, turn out the lights, turn out the lights, turn out the lights.
I think you are definitely one of the more informed and insightful in a sea of the confused lately. But I am afraid I’d have to be the devil’s advocate to the premise of this article,–that financial engineering eventually backfires.
Let’s face it, analysts, reporters, and strategists of all stripes are puzzled by a U.S. equity market that magically reverses back up every time it attempts a correction. Neither bottoms-up data (earnings, valuation, etc.), top-down data (GDP, PPI etc.), nor global funds-flow data (currencies, interest rates and carry-trades) can explain this. Unspoken, everyone is scratching his/her head, in search of that “magic button” being pushed by TPTB (we all know to whom this refers).
So let me propose a not-so-crazy idea.
There are actually two “magic buttons”: Overnight Futures manipulation and SPX options manipulation during the trading day. This combination is so powerful TPTB can make any downside market volatility go away. It’s the TPTB’s “magic hand” that keeps Wyle E Coyote suspended in mid air and levitating every time he steps off a cliff.
Take April 18, 2016 (Monday) for example. On the previous day (Sunday), news came out that the Doha talks ended without an oil-freeze deal. U.S. equity index Future promptly plunged 100 Dow points (SPX Futures down 14). By 3AM April 18, Futures were manipulated up to being essentially flat (down only 24 Dow points). Somebody was doing a lot of buying! A sharply lower opening on Monday that would have gathered momentum was totally averted.
The other “magic button” would be deployed should the market go down during the trading day. You see, in a world almost completely dominated by Algo-trading, funds are automatically re-balanced on a predefined interval, keying on a single common variable: Implied volatility (VIX). Selling causes buying of puts, elevates VIX, inducing buying of more puts, causing a vicious circle (which is why Algos are inherently trend following and self-fulfilling).
To prevent a sharp market drop, all TPTB has to do is to buy SPX calls, thus suppress the VIX. Then the algos take over the heavy-lifting (lower VIX induces VIX Targeting algos buying more stocks and Voila–yet another short squeeze!). As long as TPTB keeps the market on a short leash (not letting downward momentum gather steam), it can keep the market in constant sedation with minimum capital (leveraging off algo-trading). And that’s all TPTB needs and wants to do–to prevent a sharp market drop; there is really no desire or need to keep driving it to stratospheric heights.
Except for the Dec 2015 to Feb 2016 drop (maybe TPTB momentarily took its eye off on how long the leash was), TPTB seems to be extremely successful in doing just that, thank you very much. Absent a LTCM scale Black Swan that sends Algos spiraling out of control, it can do this all day long (i.e. forever), to the chagrin of the logically-inclined who expect a pullback. (And we all know waiting for Black Swan is neither a fruitful strategy nor much of a talking point.)
Therefore, my conclusion as a devil’s advocate is: There is indeed no betting against TPTB. There is only submitting to it. I’d dearly love to hear your rebuttal to this.
No need to rebut your scenario. I think it’s well thought-out and could be the scenario going forward… until it isn’t.
The key is finding the point when it no longer works.
But if you think it will ALWAYS work, you will learn the same lesson some of us learned in the past.
Thanks, Wolf, for your speedy response.
. Agreed. Do you sense that point is near and have a candidate for catalyst? (The last catalyst for the TPTB losing control back in Dec-Feb was, of course, the rate normalization brouhaha, which is completely off the table now. I am at a loss for a new and imminent catalyst myself…)
“finding the point when it no longer works” is what I agreed with.
The point where it breaks down is when any large player decides to take their chips off the table. This can happen at any time for any reason. In a market with so much fake volume and low liquidity the impact of a large player withdrawing is huge.
The plunge protection team may not be able to handle what could be a prolonged and deliberate withdrawal of liquidity, in time to stop the market from unwinding rapidly.
Market power rules, they make price. Lax lending/writing standards tell us where it’s going to end up. The crash point is political, market power decides. At some point the big boys decide to go into naked short fail to deliver operations, just like ’08, and other crash years. Over-leverage meets the giant sucking sound of capital destruction/wealth transfer.
We’re going Japanese! When the the world start dumping US tresuries and dollar the music will stop.
For some of us the Black Swan has arrived twice in the past 16 years. 60% drops are frightening. In ivory tower hindsight one can say that prices recovered in aggregate but in practical terms many smaller investors were ruined. These silly investors weren’t bold enough to just abide the losses. I’m not sure I trust any investor to tell me a 60% drop is readily ignored.
All is fine in the world of commerce. The Dow at 18000, property prices booming, no worrying inflation to eat away at your income, baby boomers (myself included) with lots of cash and freehold assets, millions of Chinese with billions of $ to spend (in foreign lands), and central banks (FED, BOJ, ECB etc) ready at the drop of a pin to pour money onto any indication of trouble. life is great what could possible go wrong?
In my home country (NZ) the economy is booming. I see some small issues around the world but nothing the FEDs cant manage. Time to enjoy life and forget about all this negativity. Whats the worst that can happen? Maybe a short recession where a few investors will lose a bit of equity but a couple of years latter new investors will take up the slack and the world economy will continue as it has for a thousand years. Our financial turmoil is only a very short space on a long time line so stop the short sighted thinking. Consider the price of land, equities etc one hundred years ago and look at them now. Over a long time period everything goes up. Just make sure you planned for financial security over a long time line not for a short period big gain. Those looking for the short period big gain will suffer if there is another financial meltdown. eg people with too much money in over priced stocks. But as a financial adviser once told me, his firm looked 30 years ahead when buying stocks etc. I was sceptical of his system but I have to admit it appears to work. Although I never used him, I prefer to control my own finances.
Time to head off for my third cruise in 4 years (two Alaska north trips and now a 14 day Baltic) At 62 (and self made financially independent by working hard) this is what you can do if you keep your nerve and don’t give in to pessimism.
Cheers from the land down under
Are you the poster on Zerohedge that goes by the name:
I know many in NZ….builders, developers, businessman… you must be living in your own bubble.
As many of us over the age of 50 have discovered, our assets have ballooned in value over circa 20 years beyond our wildest dreams. But don’t kid yourself that you’ve been ahead of the curve, or that you’ve beaten the game, or that you’ve skilfully earned your lifetime bonus, you haven’t.
Your gains have been down to luck primarily; being born in one of the sweetest spots financially we’ve known, has enabled you to enjoy a comfortable retirement.
In 2008 – 2009 you were probably standing at the side of the road as the car crash unwound thinking; “wtf, where do we go from here? I’m broke.” And if you’ve lived in NZ you’ve simply gained from Chinese investors and the dairy export market to China, leading to exponential house price increases creating a bubble environment.
The Frankenstein monetary policy that’s been created since 2008-2009 by unified central bank action is insane, NIRP plus QE to infinity is not a solution.
I’m into my fifth decade now and certain sayings have stayed with me throughout life: “pride always comes before a fall, nobody likes a smart arse.” You might want to think on that. In the meantime stay in your “everything is awesome” bubble if it makes you happy.
That point could be a LONG way off. Also let’s say the point arrives, I actually think you might not be able to cash out your winnings, because either the markets have to be closed or the brokerages will be so inundated with sell orders that their systems crash.
I just don’t dabble in the market anymore. Just like some people here, I focus on the neccesities AFTER the crash.
An important element missing from the article is that buybacks are essentially a way to loot the treasury at shareholders’ expense by mopping up optioned shares of insiders. Michael Brush did a story on this many years ago, and others have also commented on it more recently.
Even before buybacks became the epidemic of recent years, some companies had spent their whole profits for 10 years buying back shares, had borrowed more money to continue the programs, never paying a dividend, and yet had ended up with more shares issued and with a share price just a fraction of what it was before the buybacks began.
Anyway, when a company announces a buyback, head for the exit, because they don’t know what to do productively with their (your) money.
Share buybacks should be illegal (they used to be). The price of a share is not a direct function of the number of shares issued. Buybacks serve no purpose, and if a company wishes to see its share price rise it would be just as easy to consolidate shares, which costs nothing. Of course, the inverse analog to this fraud is the company that splits shares because investors have bid up the value for good reasons, i.e. the company has increased profits, paid dividends, and invested capital to build the business further.
And I’ve been writing about this a number of times, for years, including in 2013 with IBM as an example, using its own numbers.
I just don’t want to sound like a broken record.
I think the holding pattern is being driven by concern about the parlous state of *certain* Eurobanks, credit constraints, Zombie Asian economics, combined with the need to keep a steadying hand given the uncertainty afoot in the market thanks to Brexit and Trump. There are simply too many moving parts and keeping a nice upside on the market, however artificial, is convenient for TPTB at the moment.
What do you think about the USA housing market? Is it still keep going up or there will be price correction. If so when will it happen? Thanks!
It depends … on where you are. Housing markets are local. Once enough local housing markets start skidding, the national averages follow. For now we watch local markets. A price correction will show up there first.
I keep my eyes on San Francisco where I live, and on a few other places. All articles on the housing topic are under the “Housing Bubble 2” tab in the navigation bar.
Average price in San Fran is $1,000,000.
Average household income in San Fran is $75,000.
IMHO that’s the most insane property price metric in relation to income I’ve ever heard of. Where and how does it end? Answers on a postcard to Pluto.
Condos have already tuned the corner. Huge condo supply coming on the market in historic construction boom (high-rises), just as demand is waning.
I like that Flying All Black’s comment. Life does seem to proceed in a positive manner as long as one keeps to the straight and narrow: Don’t drink and drive, keep faithful with your wife, your best friend and biggest asset and do not spend more than you earn.
Have a good one Kiwi!
We know what must be done, but nobody [that counts] is willing to to it.
* Prohibit dividend payments with borrowed money. [GMC is poster child for this] The rule should be”no profits = no dividends”
* Tax investor profits from stock buy-backs at ordinary rather than capital gains rates to discourage avoidance/evasion.
* Impose a high per share tax on the corporations buying back their stock, to offset the tax avoidance/evasion.
IIUC the rationale for having a capital gains tax preference is to encourage investment in productive activities which generates more than enough jobs and additional tax revenue to offset the lost in revenue. Clearly this is no longer the case, and this preference is now is used mainly as a means of tax avoidance/evasion.
I guess China Politburo will double-down on the printing presses, let it ride? If so, no crash.