Minutes and buybacks

Today we get one of the Fed's last chances to slam on the brakes before next month's FOMC decision, where the market is currently pricing a 2/3 chance of lift-off.  Although Fed governors and regional presidents would never say so explicitly, much of the rhetoric since last month's surprisingly "hawkish" statement has seemed to take the stance of putting their collective hand in the air and saying, "Yeah, we over-reacted to the whole equity sell-off thing."

How much of that tone is retained in today's minutes will help shape implied market probabilities; it's difficult to expect pricing to exceed more than a 75% chance of tightening until you see the red headline saying "Fed hikes rates for first time in nine and a half years"; after all, the Pavlovian impulse is a strong one.

Other markets, of course, continue to adjust in expectation of imminent Fed lift-off.   Gold is the latest one to cross an important threshold, breaking and closing below the 1080 level that marked the lows over the summer.   There's nothing but fresh air between here and 1000, and below there....who knows?  One of Macro Man's mates suggested that the UK stick a bid in to "take profit" on Gordon Brown's ill-timed golds sales of nearly two decades ago.

Elsewhere, Reuters ran a nice story on buybacks yesterday that was linked in the comments section yesterday.  It's certainly an interesting topic of debate;  while companies should generally be allowed to make decisions as they see fit, it's hard to escape the notion that issuing debt to buy back stock on the scale that corporate America has done achieves little in terms of improving the overall well-being of society while potentially posing financial stability risks.  As the financial sector has found to its sorrow, the umbrella of "financial stability" permits regulators to exercise fairly autocratic powers to rein in behaviour of which they don't approve.

And what has it all achieved?  Obviously there are always sob stories of individual buybacks that don't work out, but the slow and steady success stories usually don't merit a mention.  Macro Man does not possess an exhaustive database of share buybacks and subsequent performance, so he used a little shortcut to perform a small analysis.

He looked at the total return of the Powershares Buyback Achievers ETF (PKW) and compared it with that of the SPY.  For those not in the know, PKW tracks a basket of companies that have repurchased 5% or more of their outstanding shares over the past year.   Although it's not a perfect vehicle, it's close enough that it's useful to judge the relative performance trend of heavy buyers of stock.

On the surface, the return profile looks decent  with an aggregate 15% outperformance versus the SPY since the inauguration of the PKW ETF in late 2006.  Maybe corporate America is doing the right thing after all!

When you run the numbers, however, it's not so impressive.  It's easy to overlook the fact in the first year of the ETF, late in the last credit cycle, buyback firms underperformed by 10%.   Taking the full sample, the PKW outperformance has averaged 1.78% per year.   Not bad, perhaps, but is that really worth taking out record amounts of corporate debt for?  It seems dubious.  Moreover, a strategy of capturing the alpha of buybacks by going long PKW and short SPY offers pretty paltry reward for the amount of risk being taken; to earn that 1.77%, the spread incurs 5.11% annualized volatility, for an information ratio of 0.34.

Moreover, the penny hasn't even really dropped yet on the debt side of the equation.  If it does....well, let's just say that the Little Lebowski Urban Achievers might be a better investment.
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Thought4TheDay
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November 18, 2015 at 10:30 AM ×

USD approaching yearly highs, a more hawkish Fed, monetary policy divergence between Fed & ECB/BOJ... need we say more?
(Our view: USD Idx targeting 120 in 2016).

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November 18, 2015 at 11:54 AM ×

welcome to the most crowded trade (http://www.valuewalk.com/wp-content/uploads/2015/11/Screenshot_17-1024x650.png)

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Celeriac1972
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November 18, 2015 at 12:41 PM ×

The US buyback phenomenon has intrigued me for a year or more. I last updated my stats a couple of months back. PKW had outperformed SPX by 42% from 01/01/07, by 27% from 01/01/11 and by 10% from 01/01/13. More recent periods suggest that the magic is ebbing away: -2.8% over 12 months, -3.6% over 6m. I backtested the pair back to 01/01/07. Early April 2008 and early April 2015 would have been interesting periods (I haven't thought through why that is..?) but otherwise long PKW/short SPX would have been a steady accumulator. So I am running short PKW/long SPX in the hope of capturing some mean reversion as buybacks become (a) more questioned and (b) more expensive/difficult to finance. It is also often true that differentials are corrected far more quickly than they are created...

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Polemic
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November 18, 2015 at 12:43 PM ×

We all focus on big business. But with etc growing trend in swarm economics with small businesses proliferating we must underestimate their impact this BoAML Small Business Owner Report is fascinating in its optimism and hiring intentions

http://newsroom.bankofamerica.com/files/press_kit/additional/Small_Business_Owner_Report_-_Fall_2015.pdf

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washedup
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November 18, 2015 at 1:11 PM ×

I don't think buybacks have been the big contributor to the equity bull run that some would have you believe - they have been a coincident indicator for a decade, kind of like margin debt. Narrowly rational and perfectly understandable strategy in a world where setting up a factory or hundreds of restaurants in Peoria or Evansville is quite simply not a positive IRR exercise, and management does report to shareholders, remember.
What brings bull markets to a halt is what I dub a 'factor re-allocation' - capital, no soup for you, labor, here is some bisque, umm, not that much.
The anger against wealth inequality (justified) will keep picking up pace and lots of harebrained ideas to cure it (unjustified) will be suggested - ultimately, the inequality will be brought down by equities going down and not by labor's allocation going up, and it will be rinse and repeat time.
I am told we have a lots of time before that happens.

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Anonymous
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November 18, 2015 at 2:38 PM ×

Buybacks are a scam:

http://www.financialsense.com/contributors/danielle-park/executives-using-buybacks-exit-stage-left

Rossmorguy

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November 18, 2015 at 2:59 PM ×

Could you say firms that buyback 5% of shares are more likely to be having financial success in the first place... so buybacks would be positively correlated with stock performance to begin with?

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Anonymous
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November 18, 2015 at 4:45 PM ×

Looks like Fed are leaking info to the markets ahead of FOMC

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Anonymous
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November 18, 2015 at 4:52 PM ×

Note the ramp in equities and collapse in Oil after that last post about Fed leaks

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EschewObfuscation
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November 18, 2015 at 5:00 PM ×

(long-time lurker)

Hey MM, I usually enjoy your analyses, but this one seems kind of silly.

OF COURSE borrowing money to buy stocks has been a winning trade for the past seven years. Whether it's your own company's stock or some other company's stock hardly matters, does it?

It seems that few people view stock buybacks as equity investments, but it seems to me that is precisely what they are. You buy your shares in the open market; you "collect" any dividends by paying them to yourself (i.e. doing nothing); you sell those shares again via a rights offering... Buying and selling your own stock is indistinguishable from buying or selling stock in any business with identical economics. It's a smart move when the stock is cheap and a dumb move when the stock is expensive, as always.

So the real question is: Had those same companies used that borrowed money to buy (say) an index fund instead, how would they have done?

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Macro Man
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November 18, 2015 at 5:08 PM ×

Ummmm....Eschew, that's exactly the question that the post answers. You've made 1.77% more per year owning the 'buyback' stocks versus the index at large (which also includes the buyback stocks, so the actual outperformance versus non buybackers is probably somewhat larger.)

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washedup
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November 18, 2015 at 5:16 PM ×

That exchange was kind of funny - Eschew, nice way to break the ice with the moderator after 'lurking' for a long time.
The reason these companies outperform is because 65-70% of them they are companies that are the targets for private equity and activist investors, the premium for which is well known - I would add the measurement period needs to be a lot longer than a decade if you were trying to determine whether this strategy adds value to the world - spoiler alert - it does not - it was also, best I can see, not the question that MM was trying to address.

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EschewObfuscation
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November 18, 2015 at 5:34 PM ×

Hey, MM.

Sorry, but either I am misunderstanding you or vice-versa.

Some companies borrowed money and bought stock (their own, as it happens). Other companies did not.

By analogy, some investors borrowed money to buy the index. If you compare their returns to the index (or to other investors who did not lever up), of course those returns are higher, simply because they used leverage and the index rose.

Put another way... The average company generated the same return as the index. Any companies that borrowed money and bought the index would have outperformed just because the index went up.

On average, borrowing money and buying your own stock is probably a worse investment than borrowing money and buying the index, simply because it is not so easy to beat the index. But I do not think your analysis answers this.

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Anonymous
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November 18, 2015 at 5:53 PM ×

@Eschew,

I try to understand your logic here. Borrowing money to buy back its own stocks, shareholders would have capital gains. CEOs would have a great bonus. But how does a company entity realize the gain from this trade? If a company borrows money to buy other stocks and it can realize gains and repay the debt. How does buying back its own stock work? Issuaing more shares after buying back?

Buying back is basically a cash distribution event, unlike buying other stocks which is an investment event.

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Celeriac1972
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November 18, 2015 at 6:29 PM ×

EschewObfuscation said...

So the real question is: Had those same companies used that borrowed money to buy (say) an index fund instead, how would they have done?

I don't think so - for the reasons already pointed out. The real real question here is whether an unholy alignment of EPS based executive incentivisation programs and easy credit has led to a misallocation of capital.

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EschewObfuscation
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November 18, 2015 at 6:38 PM ×

@Anon 5:53

"How does a company entity realize a gain from this trade? ... Issuing more shares after buying back?"

Yes, exactly. Issuing stock is just selling it. Whether you call that action "selling treasury stock" or "issuing a secondary", the economic effect is identical.

A gedankenexperiment might help. Imagine two companies A and B that are nearly indistinguishable: Equivalent balance sheets, operating in the same market, commanding the same margins, etc. Imagine they each repurchase 10% of their own shares, operate for a few years, and then issue a secondary for the same number of shares.

Next, imagine instead that each had bought 10% of the shares of the other, operated for a few years, and then sold those shares again.

No matter what you look at, whether capital gains, dividends, stock splits, divestments... The final returns will be the identical in both cases.

Buying your own stock really is just buying stock in a company that happens to be your own. Good idea if the stock is cheap; bad idea if it is expensive. In theory, for your own company, you should be able to determine this better than most people and act accordingly. In practice, perverse incentives tend to cause precisely the opposite.

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abee crombie
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November 18, 2015 at 7:36 PM ×

Companies buy back their stock bc it helps HF managers know there is a buyer of last resort in that market. Without that, fast money doesnt want to play, but when you know there is a sucker out there willing to back you up if you messed up your analysis wrong, well it helps with the market dynamics, which cant be ignored nowadays... thats my 2 cents.

CCC and B HY markets are not cooperating and continue to sit at lows. Dumpster diving strategy is very cautious at this point. We will need commodities to rally for the animal spirits to come alive and touch anything that has a "resource" in its name

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Leftback
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November 18, 2015 at 8:44 PM ×

Options tail wagging the index dog here? Vol sellers continue to eviscerate shorts into Friday's expiration as USDJPY drifts higher. Abee is right, credit is not participating in this risk-on move, and that's a concern for bullish punters. The SPX 2075 gap has now been filled as we predicted.... Bucky kissed 99.85, still time for him to complete the century before the week ends.

US fixed income hanging tough this week in the face of Hawk Talk... we are tempted to add to our long position on weakness.

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Anonymous
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November 18, 2015 at 9:05 PM ×

One man's opinion:

A market that can rally despite a Fed hike will continue to rally. Fed liftoff is one of the most over-hyped events in Wall Street history. It's so bad that the Fed has virtually promised to only hike two or three more times in the following year and only if everything is going swimmingly. The party isn't going to stop because they cut the alcohol content of the vodka to 39.75% from 40.00%. The stock market is screaming that loud and clear. Support came in right around the 38.2% retracement and it was followed by a bullish reversal candle that's been validated by the monster rally today.

There's no fear of the Fed in the stock market, the Santa Claus rally is already underway.

http://technical-analysis.forexlive.com/!/sp-500-rises-30-points-all-signs-point-to-higher-20151118

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Anonymous
admin
November 18, 2015 at 9:46 PM ×

@Eschew,

In theory you are probably right. Then maybe I am ignorant, but I do not think there are many companies issued shares after (1-2 years?) they bought back their own shares.

It is option expiration day and the last full work week before Thanksgiving so "do not stand in front of the silly move" is a top priority for me. I hope that there will be some nice shorting opportunity next week. Right now, FX seems to present a much better risk/reward opportunity.

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Leftback
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November 18, 2015 at 10:12 PM ×

Yes, clearly this is a Silly Week into OpEx. Thanksgiving week is also often a Very Silly Week, and the short session on Friday after Thanksgiving can be one of the Silliest Sessions of the year. The Monday following Thanksgiving week is often one of the worst days of the year, however.

We are going to pass on equities completely for the time being and keep a sharp eye on FX and fixed income. Both Dollar Longs and US10y Shorts are clearly on the verge of becoming Lazy Sunbathers, if not Pink Flamingoes*.

* Regular readers will remember the fate of both flamingoes and sunbathers...

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Leftback
admin
November 18, 2015 at 10:25 PM ×

We are agnostic about US equities, but would point out that small caps (IWM) and high yield (HYG) still look decidedly sickly. Which is not to say that a Silly Rally in large cap tech etc.. might not continue for some time - but overall, with small caps and credit lagging and the dollar crushing smaller US energy companies, this is a market picture that makes one look more favorably for the time being at US Treasuries, at least as long as the US10y spread to bunds remains at such incredible wides. "Everyone" thinks that yields are going higher, which is usually when yields end up, you know, going lower. Right, Mr Gundlach?

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washedup
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November 18, 2015 at 10:34 PM ×

LB - with u on the us treasuries call, but I doubt it rallies appreciably without a risk off sentiment in equities.

Have a feeling king dollar did a 'sell the news' top today - I think if it turns around equities could lose USD/JPY as the patron saint of stop runners - if it goes on to make new highs, then, well, there are other implications.

Todays price action was the Goldman APPL call (where have I heard that before) and plenty of algo fodder in fed minutes - could have gone either way, but it was wedgie time for the shorts, so be it. We will see what happens next 6 weeks - there will be a santa claus rally of course, but there is santa, and then there is bad santa.

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EschewObfuscation
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November 18, 2015 at 10:38 PM ×

@Anon --

"I do not think there are many companies issued shares after (1-2 years?) they bought back their own shares"

Steve Wynn has a long history of buying his stock when he thinks it's cheap and selling when he thinks it's expensive:

http://www.vuru.co/analysis/WYNN/dividendsBuybacks

...but you are right that this is rare. It should not be -- "buy low, sell high" is a rule without exceptions -- but this just shows that maximizing the long-term value of the enterprise is not the incentive at most companies.

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Anonymous
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November 18, 2015 at 11:49 PM ×

Equities are going much higher. They remain the only game in town and every Central Bank is supporting them.

SP target: 2200-2300 by Q2 2016.

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Leftback
admin
November 19, 2015 at 3:21 AM ×

washed - I do think King Dollar is now near the top for 2015, and I agree on USDJPY as the carry trade engine, but with this being an expiration week, and then Thanksgiving ahead, we may see a Happy Clappy market for 5-6 more trading sessions.

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