Wednesday, February 4, 2015

We are the 100%...

I really want to get back to the housing stuff, but I just have to rant a little more about the current self-destructive mood of this country.  I'm getting myself a little worked up.  I want to go back to William Dudley's speech from yesterday's post:
The expectation of [a "Fed put"] is dangerous because if investors believe it exists they will view the equity market as less risky.  This will cause investors to push equity market values higher, increasing the likelihood of an equity market bubble and, when such a bubble bursts, the potential for a sharp shock that could threaten financial stability and the economy.
Look, lazy cynics (which, frankly, on the topic of finance covers a lot of people) think the Fed sits around watching the ticker tape every day to cover the backsides of Wall Street cronies.  Which, just right off the bat should strike everyone as a %*#($ing stupid thing to believe, coming out of a decade that saw two separate equity market contractions of 50%.  If they are trying to cover the butts of Wall Street cronies, they are pretty freaking bad at it.  So, as one fledging member of "Wall Street", let me go on record and say to the FOMC, if the last 15 years have been a secret attempt by you to line my pockets, please, for the love of Pete, stop.

But, I don't think any serious people think they do this, or that they should do this.  In fact, I don't even think they can  do it.  When you think about it, the inflation hawks are haunted by a spectre of the high inflation of the 1970's because excessively loose monetary policy was not good for capital.

ERP Source
Look at this graph of the unemployment rate and the equity risk premium.  William Dudley thinks it's a real problem if equity holders start investing more in at-risk ventures.  We need to be risk averse, to be saved from ourselves.  He is literally describing a policy where if the equity risk premium falls too low (which apparently is anywhere close to the historic average), it is his job to push the risk premium back up!  Because when prices are high, he says, why that could be a bubble!  He is literally treating one of the clearest signals of optimal Fed policy as a contra-indicator.

But, why stop here.  So many people think we have a bubble now and think the Fed is too loose now.  Maybe we need an equity risk premium of 10%.  Who says that 5% is safe enough?  The S&P500 is up to 2000 points.  That means it has 2000 points to fall.  Maybe we should get that risk premium up to 10%, then the S&P 500 would only have 1000 points to fall.  There would be a lot less bubble risk.

For that matter, we're in the range of full employment.  People could get too used to having plentiful work.  They'll start spending all their wages like the proverbial grasshopper.  It's a labor bubble.  Better to get unemployment back up to 9% or 10%.  It builds character.  You let people see a little sunlight and they just get soft.  They've got no sense.  Save them from themselves.  You've heard of people who grew up in the Great Depression, and to their dying days they hid all their savings under the mattress and refused to spend money on trifles?  That's what a good monetary policy can do.  It's like a structural reform that is built in for a generation.

Even many people who are calling for more Fed accommodation bemoan the booming stock market.  All the gains are going to Wall Street, they moan.  It seems that 90%+ of this country is convinced that success is failure.  Those bemoaning Wall Street's success are wrong in about 1,000 ways.  I will describe two.

First, in an age of heavy share buybacks (which is not a problem), using the published stock market indexes is not a good measure of equity market growth over time.  Buybacks are a return of capital, like dividends, but over time they are accounted for as capital gains, not capital income.  So, historically, equities tended to throw off about 5% annually in dividends, but today, only about 2% is paid as dividends, and the rest goes to buybacks.  (And, no, this doesn't somehow secretly line the pockets of the CEO.  If that's what you think, you've been listening to lazy cynics.)  So, that 2-3% adds to the level of the index, whereas dividends do not.  Here is a graph showing what the S&P 500 index would look like if all cash was still returned to shareholders via dividends.  These are annual numbers, ending in 2013.  At the current level, just above 2000, the adjusted S&P 500 level would be just over 1200, about where it was at the peak 14 years ago.  So, subtracting out the return of capital, which was not significantly different, in total, than its century-long total level, equity owners have not seen any nominal capital appreciation in 14 years!  (But, all the gains in this economy are going to Wall Street!  Right?)

And, secondly, if the stock market is rising because of falling equity risk premiums, then that is literally the result of capital owners demanding less cash in return for their investment.  It's not "trickle down".  It's math.  A low equity risk premium means that the stock market will be higher and that more corporate returns will be going to laborers and creditors.  When (if) the equity risk premium falls, real wages will be rising when it does.  This is true even over the longer term, shown in this graph, which is kind of another version of the first graph, above.

In fact, this graph will probably show up in one of the upcoming housing posts, because this issue with risk premiums gets tied up in home values in an interesting way.  I'm still working out exactly how.  But, clearly homes have pricing behavior similar to low risk, inflation-protected securities.  Home prices have been high when the risk premium has been high.  And, the Fed is treating high home prices as a sign of risk taking!

But, maybe I'm being too hard on the Fed and Mr. Dudley.  These nutty positions are basically consensus positions right now.


  1. Buybacks should not generally add to the level of stock indices. Here is why.

    For simplicity's sake, let's say that there is a corporation that has $1,000 of cash as its only asset, and it currently has 100 shares. Therefore the value of each share is $10.

    For whatever reason, the market is overvaluing the stock at $20 per share, but the corporation decides to to buy back 10 shares. Now the value of the corporation is $800 because that is the value of remaining assets ($1,000 - (10 x $20)). There are now 90 shares outstanding, so the per share value is $8.89. Each share is now worth less due to the buyback.

    Let's say the stock was trading at $5 when the buyback was done. The value of the company would instead be $950 ($1,000 - (10 x $5)). Now the remaining 90 shares are each worth $10.56.

    The third and final possibility is a buyback at $10, which doesn't change the value per share. The new value of the corporation is $900, and the remaining 90 shares are each worth $10, same as before the buyback.

    So buying back overvalued stock reduces stock values and buying back undervalued stock increases stock values. Warren Buffett has talked about this in some of his letters to Berkshire Hathaway shareholders.

    The question is, what is the relative valuation when companies do buybacks? I'm pessimistic enough to believe that they buy back stock when the shares are overvalued more than undervalued. But that may be because I have seen so many companies, especially technology companies, maintain their buyback programs despite absurdly overvalued shares in order to reduce the exploding number of shares outstanding due to employee stock options.

    So of a company's three options:
    1) Dividends - should definitely reduce the value of a share by reducing the net assets per share,
    2) Buybacks - may increase or decrease the value of a share, depending on the size of reduction in net assets to achieve the reduction in shares, and
    3) Retained earnings - should definitely increase the value of a share by increasing the net assets per share.

    1. Mark, think of it this way. The market owns the productive capacity to make 1 million widgets, worth $1 million. During the year, they can invest in capacity to make 50,000 more widgets, or they can receive $50,000 in dividends, or $50,000 in exchange for shares. Let's say that management decides that, on the margin, new widget capacity is not worth $50,000, so they return the capital. It doesn't matter whether the capital is issued through dividends or buybacks, or how many shares the buybacks bought. At the end of the year, the market owns the productive capacity for 1 million widgets and they also have $50,000. Either way.

      Where the cost of the shares at the time of the buybacks comes into play is just a matter of how much the share count was reduced, to arrive at the arbitrary value of a remaining share. This has already been accounted for by accounting for the buyback as a percentage of market value.

      But, to the extent that buybacks are done at suboptimal prices, this reflects a suboptimal use of capital for the remaining shareholders, not the shareholders who sold their shares to the company. So, the adjusted S&P 500 index value (tracking the value of the index after accounting for returned capital) remains the same, regardless of the price paid for the shares. If the company paid too much, the result is that the nominal value of the index, before the adjustment, will be lower than it would have been if the buybacks had been perfectly timed.

  2. TravisV here.

    I thought Damodaran's cost of capital by sector in this new post was interesting stuff........

    1. Thanks Travis. That was a good overview of the issue.

  3. Ouch! Here is how some people are responding to an artificial normalization:

    1. Becky, thanks for that interesting article. My thoughts while reading it were, (1) wow, the confidence with which everyone now blames the victim regarding the institutions who were exposed to risk when the bottom fell out is astounding. (2) The skeptics say, "You can't get rid of risk, you can only move it around." So, I guess we shouldn't have any fixed income or fixed wage contracts? How exactly does their critique not apply to every single financial transaction ever engaged in?

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  5. Great article! Thanks for telling all this important stuff! My uncle Dr. Aloke Ghosh is very much concerned about all these issues. You know he is planning to publish a book on “rental income”.

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