Courtesy of Doug Short.
Market commentators are at something of a loss to explain the stock market’s steady advance in 2012. Through January 26th, the S&P 500 Index is up 4.8 percent; this compares to its flat performance (0.0 percent) in 2011.
Some contend the heady start in the New Year is simply a reversion to the mean. The problem with this explanation is many of the issues which hampered the market in 2011 are still unresolved, and look to remain unresolved for the foreseeable future. True economic activity in the U.S. seems to have picked up its pace; but Europe looks likely to slip into a recession or, at best, to see barely positive growth in 2012. A solution for Greece and a resolution of the sovereign debt remain intractable. At the moment, no consensus has emerged in the U.S. for tackling the Federal deficit or debt. And, anecdotal reports suggest that the Chinese construction boom is nearing a pause. All-in-all, the individual strands do not present a terribly rosy picture for share prices.
Since there must be some explanation, commentators have cast about for a reason why share prices seem to be momentarily defying gravity. One idea involves share buybacks.
We are skeptical that corporate repurchases of their outstanding equity explains the New Year’s pleasant bounce in share prices. It is perhaps one factor of many. But researching the idea we have uncovered an interesting trend ? one which shows no sign of reversing and one which will have we are certain interesting unintended and unforeseen consequences. Although our imagination is rich with possibilities, space permits us to explore only one.
A not so obvious consequence is that corporations now are one of the largest owners of corporate equities in the United States. True, these shares are limited to treasury stock holdings in their own businesses. And, true, this ownership model is different from the now discredited Japanese keiretsu network of cross holdings by companies; or, the discarded German universal banking system in which financial institutions exercised sway over Germany’s industrial companies through share blocks which entitled the bank’s management to board seats.
No, the current pattern does not fit either model. But we cannot help thinking that, like with the keiretsu or universal banking models, issues of corporate control perhaps underlie the current mania for share buybacks. The agency problem is still with us. We have not come up with a solution to align the interest of management with those of its absentee owners.
Suppose management uses the annuity of a firm’s free cash flow to buy out all of the other shareholders. As an idea it is not as farfetched as it sounds. Taken to the logical extreme, management systematically retires all shares save one. That sole remaining share ? a golden share ? is the prize which confers unfettered control.
Notes:
“Net new equity issues” data sourced from the F.102 Table for Non-farm, Non-financial corporate businesses. Data presented on a seasonally adjusted basis.
Outstanding equity levels sourced from the L.213 Table for Corporate Equities, line 2. This is an estimate of the outstanding equity for non-financial corporate businesses valued at market prices. Data presented has not been seasonally adjusted.
Cumulative sum reflects the aggregation, year-by-year, of annual net issuance (retirement) activity. No attempt has been made to update prior year?s activity to current market prices. Accordingly stock retired in prior years at higher prices will overstate the cumulative net issuance (retirement) ratio. Conversely, stock retired in prior years at lower market prices will understate the ratio.
The ratio is computed by dividing the annual (or, cumulative) activity (from Table F.102) by the outstanding equity levels (from Table L.213).
Data for 2011 is an average of data for the first three calendar quarters.
(Sources: Federal Reserve Board, Z.1 Flow of Funds Accounts of the United States, December 8, 2011; AIFS estimates.)
Note from dshort: For some interesting historical context underlying Eric’s chart title, see the Wikipedia entry for Tontine.
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