An Unpriced Risk For Equities?

Make it eight weeks of gains for U.S. stocks. No one foresaw more than a short-covering rally in December. When everyone thinks the same way, the market will go the other way. The rally since December 24 is more amazing than the rally to start 2018 on news of the Trump tax cut. Nothing has changed on the political / macroeconomic landscape this time around (either to explain the fall in December or the rally in January and February). The only thing that has changed are the trading algos going from sell programs back to buy programs. We really have no special insight on what is happening. The +3% jump in equities this week was pinned upon the usual suspects: optimism over the Trade War and relief over another stop-gap measure to reopen the Federal government. Our best bet is that the trading algos will push equity indexes above some resistance level, such as the November swing highs (around 2830 on the S&P 500) before flipping into profit-taking mode.

Macro data this week was not great, showing again that the equity rally is detached from economic news/fundamentals. The January small-business optimism index of the National Federation of Independent Business fell 3.2 points to a seasonally adjusted reading of 101.2, the worst reading since the election of President Donald Trump in Nov. 2016. We can’t put a positive spin on falling business confidence. Next, household debt rose for the 18th straight period in the fourth quarter, edging up 0.2% to $13.54 trillion. Household debt is now 21% above the trough following the credit crisis. Whenever the next crisis hits, we can be almost certain the underlying factor will be excessive (corporate) debt levels. The biggest surprise in terms of data this past week came from retail sales. Retail sales sank -1.2% in December, the largest drop since September 2009, a few months after the end of the Great Recession. Retailers faced plenty of headwinds in December, including a stock-market meltdown, sudden talk of recession, the start of the partial government shutdown and a bout of unusually poor weather. Yet the large decline in sales appears to go beyond that and offers more proof the economy slowed toward the end of 2018. Sales fell in every retail category except auto dealers and home centers. Finally, industrial production sank -0.6% in January, the first drop in eight months. Adding to a sense of weakness in the report, industrial production in December was cut to a +0.1% gain from the initial estimate of a +0.3% gain. Perhaps the market is over-looking temporary weak data points as equities keep rallying? But that maybe attributing too much foresight to what we believe to be pure technical trading by algorithmic traders.

What if Marco Gets His Way?

Nothing has been able to derail the equity bull market that started in 2009. Aside a couple bad months in the summer of 2011 and the end of 2018, closing your eyes and buying a 2% to 4% dip in the equity indexes would have made you money. The “Powers That Be” (the Federal Reserve and major Wall Street banks) want the markets to rise. The Fed uses rising asset prices as a policy tool, while Wall Street prefers rising prices as most products make money as equity go up. In sum, the structure in place is designed to encourage equities to rise.

A mostly over-looked news item this week is worth a bit more reflection. Clearly corporations buying back their shares on the open market has created a major source of demand, bidding up equity prices. So Florida Senator Marco Rubio’s proposal to treat corporate buy-backs the way as dividends could create a structural shift in the markets. Recall that corporations have a tax advantage for buybacks over dividends, which explains why companies have been using their Trump tax cut windfall to return money to shareholders in the form of stock repurchases and not dividend distributions. Last year saw a record $1.1 trillion in stock buybacks, the precursor of which was Republican tax bill.

The fact that Rubio, a Republican, is proposing an anti-business (or rather anti-Wall Street) measure is surprising. Perhaps Rubio, who was reticent about the tax bill, yet voted in favour, is now trying to distance himself from the debacle. The new law lowered the corporate tax rate from 35 percent to 21 percent, and many economists predicted it would go toward stock buybacks, and not necessarily an investment in growth or wages like Republican leaders promised. Those economists were largely right as the impact of the cuts have been much more mixed than the administration promised. The Federal budget deficit continued to rise in the first quarter of fiscal 2019 and is on pace to top $1 trillion for the year, as President Trump’s signature tax cuts continue to reduce corporate tax revenue. Wages and household income have not increased as hoped for. And by all accounts, companies poured a hefty portion of the tax windfall into buying back shares, a move designed to at least temporarily boost stock prices, which benefits executives and other large stockholders.

Below is the “tweet storm” sent out by Rubio this week.

The justification for corporate buybacks is company has no better investment available. This may be true for any company from time to time. But what does it say when it is true for many companies year after year?

Since 1980 have steady trend of corporate profits flowing back into financial markets & less of these profits invested in increasing productivity through innovation, technology, equipment etc. The result is not enough increase in productivity, growth or widespread prosperity.

Why are profits not being invested into company or new companies? Because our economy driven by large & active investors who pressure for increase earnings per share. Investment pools that prefer safe returns over long term investment & executive compensation based on stock.

This is evidenced by fact that over the last 4 years our largest corporations borrowed money in order to fund buybacks & dividends. This money they borrowed did nothing to make company more profitable or productive. And they have to pay interest on the money!

The argument buybacks are good because frees up $ to reinvest in other businesses growth isn’t backed up by the facts.

Over last 40 years money back to shareholders has tripled as a % of our GDP, but investment into business dropped by 20%.

I support free market over socialism b/c market better than govt at encouraging investment & innovation needed for widespread prosperity. But tax code discourages best aspect of free market by giving buybacks a deferral advantage over dividends or investment.

The irony is many businesses, if they could make own choice, would rather reinvest profits in improving their product & improving workers’ skills than return it to shareholders.

Right now don’t have a “free market”. We have tax code which engineers economy in favor of inflating prices of shares at the expense of future productivity & job creation. If we are going to use tax code to incentivize behavior, it should be investing in productivity & jobs.

Will soon file bill making immediate expensing permanent & tax corporate buybacks same way as dividends. No tax advantage for buybacks over dividends. But we’re going to give permanent preference to investments that will drive the creation of jobs & increase in wages.

This does not sound like a Republican senator but rather a Bernie Sanders. Whatever the agenda of Rubio, if he is able to sponsor a bill that ends the tax advantage of corporate share buy-backs, economic theory would suggest that corporate cash returned in the form of dividends will increase and cash returned vis share buybacks will fall. Our speculation is that such a bill will adversely affect share prices, eroding a major source of buying in the market. For the moment, this risk is still below investors/traders’ radar screen.

Clearly Democrats will go along with such a bill. We would guess enough progressive Republicans would join in, allowing this bill to pass. While the impact of a buy-back tax bill on the markets, in isolation, would not bring down equity markets, reducing a marginal buyer of equities could held tip the balance in favor of lower equity prices as the risk of recession gets priced in.

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