The Federal Open Market Committee's (FOMC) November meeting will take place from Tuesday to Wednesday, with the high likelihood they'll announce formal plans to begin rolling back the quantitative easing program. For the past year-and-a-half, the Fed has been purchasing $120 billion per month in mortgage-backed securities and Treasuries, as one major tool to support the economy during the pandemic. The bond purchases have added more than $4 trillion to the Fed's balance sheet, which now stands at $8.5 trillion, about $7 trillion of which is the assets bought up through the Fed's quantitative easing programs. The purchases have helped keep interest rates low, provided support to markets which were collapsing at the start of the pandemic crisis, and coincided with a powerful run for the stock market. The upcoming FOMC meeting will be important for three reasons: 1) the announcement of tapering; 2) guidance around what tapering means for the path of hikes; and 3) nuanced changes in views around inflation risks given recent data.
None of this should be news however. The only real question is how will this known event affect the market short term and long term? That question really hinges on the answer to this one: How much of the stock market’s gain since QE was first started after the 2008 financial crisis is due to the Federal Reserve’s extraordinary monetary policy actions, particularly quantitative easing, or QE? Outside of this known benefit is there anything that might be going unnoticed as a result of QE that might soon become problematic?
One of the intended effects of QE is to flood the market with liquidity. The ability to find credit is crucial for companies to continue growing. By flooding the market with liquidity it becomes possible for companies to easily borrow money at extremely low rates. But what if that money wasn't being used to grow but instead being used on share repurchases aka buybacks? What If I told you that 40% of the bull market rally over the last decade was from buybacks alone?
The problem for companies in a weak economic environment is the lack of topline revenue growth. Given higher stock prices compensate corporate executives, it is not surprising to see companies opt for a short-term benefit of buybacks versus investment. Here's an example of how that can be misused.
• Company A earns $1 / share and there are 10 / shares outstanding. Earnings Per Share (EPS) = $0.10/share.
• Company A uses all of its cash to buy back 5 shares of stock.
• Next year, Company A earns $1 again, however, earnings are now $0.20/share ($1 / 5 shares)
• Stock price rises because EPS jumped by 100% on a year-over-year basis. However, since the company used all of its cash to buy back the shares, they had nothing left to grow their business.
• The next year Company A still earns $1/share and EPS remains at $0.20/share.
• Stock price falls because of 0% growth over the year.
With the ability to easily borrow money, many companies are using buybacks in a manner like this to give the appearance of growth without actually growing. Tapering bond purchases lessens the availability of credit. Eventual rate hikes will further dry up this easy money. For much of the last decade, companies buying their own shares have accounted for all net purchases. The total amount of stock bought back by companies since the 2008 crisis even exceeds the Federal Reserve’s spending on buying bonds over the same period as part of quantitative easing. Both pushed up asset prices. The decomposition of returns for the S&P 500 breaks down as follows:
• 21% from multiple expansion,
• 31.4% from earnings,
• 7.1% from dividends, and
• 40.5% from share buybacks.
In other words, in the absence of share repurchases, the stock market would not be pushing record highs of 4600 but instead levels closer to 2700.
To put that into context, the high water mark for the S&P 500 in October 2007 was 1556. In October 2021, after 14-years, the market would be 2700 without share buybacks. Such would mean that stocks returned a total of about 3% annually or 42% in total over those 14 years. This factor may be getting overlooked when pricing in fallout from tapering. As monetary policy tightens around the world we should expect to see this record pace of stock buybacks begin to slow as the cost of borrowing creeps up to a level that removes any benefits from using borrowed money for share repurchases. This will give an immediate appearance of significantly slower growth.
All in all the expectations of this meeting are that roughly $15 billion in purchases will be shaved off starting in December. This expectation could end up being very conservative. On Friday world renowned investor Bill Ackman gave a presentation to the NY Fed arguing that tapering wasn't enough and that a full stop to QE was necessary. It is always possible he made a big enough impact that enough governors vote for stricter measures. While a reasonable buffer has likely been priced in any significant deviation from the expected announcement could have very severe repercussions. If you're long term you might want to avoid checking things this week. If you're short term you should make all your decisions with that meeting in mind. It might not be a terrible idea to sell into some extra cash today to have the ability to react to whatever happens on Wednesday. This isn't financial advice merely me thinking out loud about the week ahead. If we make it through Wednesday unscathed the rest of the year shapes up very nicely. The NYSE Cumulative Advance/Decline Line, which tracks rising versus falling stocks in aggregate, finally hit a record high this past week, something it hadn’t done since June. When the A/D line has hit a new high after more than 90 days, the S&P 500 has been higher three months later 22 out of 25 times since 1935, while gaining a median 4.1%. Fingers crossed 🤞🤞
#tcardizzle #tapering #fomc
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