My friend Brian Reynolds, chief market strategist at MS Howells & Co., has long said that Buybacks have been a driver of stock prices, with the shrinking float the key reason why. Econ 101 says that reduced supply with the same demand equals increased prices.
There are some caveats: Companies always could add shares back by new issuances, so equity is not quite like a commodity with a finite supply (Oil and Gold come to mind).
We were discussing this in the office yesterday, and the example I used was Paul Kasriel’s recent chart. It showed up in Barron’s today, with an interesting spin, and that’s kismet enough for me:
"THAT DANDY LITTLE CHART WITH THE HOPEFULLY
catchy head of "Off a Cliff" on this page comes to you courtesy of Paul
Kasriel, Northern Trust’s crack economy watcher. What it shows is the
dramatic shrinkage in the supply of equities; all told, a record $548
billion worth was "retired" in ’06. As Paul explains, rather than using
their vast profits to fund capital spending, corporations have been
buying in their own stock, hand over fist. Further soaking up the
supply of stocks has been the explosion in private equity. It’s hardly
a surprise, then, he says, that stock prices moved up as smartly as
Paul also points out that the massive corporate
buybacks and scarfing up of shares by the acquisition-hungry private-
equity types have had another effect: Together with mortgage-equity
withdrawal, they’ve helped fund the $503 billion deficit that
households ran last year. Said households, either directly or
indirectly via mutual funds or pension funds, he reckons, were net
sellers of stocks in 2006.
Which suggests, according to Paul, that unless
corporate buybacks or personal income steps up sharply, with
mortgage-equity withdrawal (MEW) likely to slow further this year, Jane and
John Q. will have to clamp down on their spending. The stage seems set,
in other words, for the end of the great consumer buying binge."
A few things worth pointing out:
• If MEW slows, that would potentially engender either more stock selling to fund a certain lifestyle — or decreased consumer spending.
• There is, according to Barron’s, a "sizable build-up in pending new issues. By one savvy estimate, the number of IPOs in ’07 could shoot up a formidable 50%."
• Share repurchases are heavily dependent on corporate profits. If the earnings deceleration trend continues, so too might buybacks.
One last thought: Late 1990s saw a similarly large net share decrease. As prices rallied to new highs, we saw a return to trend. Once the market cracked, buybacks went away.
In other words, the psychology of the financially engineered buyback is a double-edged sword. If either the market seriously corrects or the economy slows (or both), we should expect buybacks to drop too.
Barron’s, March 12, 2007
Corporate Equities: If the Supply goes down, the Price is Likely To Go Up (PDF)
Northern Trust Global Economic Research, March 8, 2007