For years, net demand for US equities has been supported by corporate buybacks.
This is a real simple dynamic. Central banks instigate a desperate hunt for yield, driving investors down the quality ladder thus driving down the cost of borrowing for corporate citizens.
Those corporate citizens take advantage of the appetite for corporate supply by issuing debt at artificially low borrowing costs then use the proceeds to fund buybacks which themselves artificially inflate corporate bottom lines. That has the happy knock-on effect of bolstering management’s equity-linked compensation. Of course all this financial engineering also leads to higher corporate leverage which will be a veritable nightmare when the cycle turns, but hey, live for the moment, right?
Well on Friday afternoon, Goldman was out with their weekly note documenting conversations with clients and guess what? It looks like the buyback party is over. Here’s more…
Infatuation with buybacks has ended for both companies and investors.
Following years of prioritizing repurchases as a use of cash, corporations actually cut annual spending on buybacks by 11% in 2016 and executions YTD have plunged by 20% vs. last year. Meanwhile, authorizations YTD for new programs are proceeding at the slowest pace in five years.
Experience shows that firms repurchasing shares at extremely high valuations regret those actions when the stock price inevitably de-rates. The median S&P 500 constituent currently trades at the 98th percentile of historical valuation across a variety of metrics. Strategically, within the intermediate term we expect firms will have the opportunity to repurchase shares at a lower multiple than today. Trends in the use of corporate cash suggest that managements increasingly embrace this view.
Investors are also attuned to the situation and have started to penalize the share prices of companies that emphasize repurchases, reversing the pattern in recent years of rewarding firms that prioritized buybacks. Our sector-neutral basket of stocks with the highest buyback yields (GSTHREPO) is trailing the S&P 500 by 250 bp YTD (5% vs. 7%). Similarly, our basket of the 50 stocks with the highest combined buyback and dividend yields (GSTHCASH) has lagged by 280 bp.
While buyback-oriented stocks have fallen out of favor, fund managers have embraced stocks that are growing dividends. Firms with the highest expected dividend growth have outperformed their peers who continue to prioritize repurchasing shares at elevated valuations. Our sector-neutral basket of high dividend growth (GSTHDIVG) stocks has outperformed S&P 500 YTD by 200 bp (9% vs. 7%).
The GS Securities Division reports that buyback executions YTD have plunged by more than 20% compared with the similar year-ago period. Information Technology, Financials, and Consumer Discretionary have led the decline.
Looking forward, repurchase authorizations also suggest that buyback growth will decelerate. S&P 500 firms have authorized $146 billion in share repurchases YTD, a 15% drop from the comparable point last year and the slowest pace since 2012 (see Exhibit 1).
Our baseline S&P 500 repurchase forecast assumes an increase of 2% to $510 billion. Annual S&P 500 gross repurchases nearly doubled in five years from $290 billion in 2010 to $564 billion in 2015. However, buyback spending slumped by 11% to $500 billion last year.
Despite weak repurchase activity YTD, we expect annual S&P 500 buybacks will climb by a slight 2% during 2017 for five reasons: (1) Companies will be reluctant to shift capital use plans dramatically from current allocations until clarity on tax reform emerges later this year or early in 2018; (2) We forecast adjusted EPS will grow by 3% and cash usage will increase by 5% to $2.3 trillion; (3) S&P 500 cash-to-assets stands at 12%, the highest level since at least 1978, so most firms will be disinclined to accumulate still more cash; (4) Capacity utilization equals 76%, below the long-term average of 80%, so firms are unlikely to boost capex by more than our forecast 6% growth to $685 billion (the largest share of forecast cash use at 29%); and (5) Dividends are unlikely to grow faster than our forecast of 6%, which is in line with the dividend swap market. Our buyback forecast of $510 billion represents 22% of projected cash use, the lowest share in five years.
We previously forecast buybacks would jump by 30% in 2017 to $780 billion. Our prior estimate assumed S&P 500 firms would repatriate $200 billion of overseas cash in 2017 and spend $150 billion of the repatriated funds on share repurchases. Excluding repatriation, our prior estimate assumed 5% buyback growth in 2017. The delay in tax legislation means firms will not augment cash allocated to buybacks until reforms are clear.
Our buyback and total cash return baskets face a host of near-term risks given our forecast of a flatter trajectory for S&P 500 buyback growth. Goldman Sachs Economics expects the 10-year US Treasury yield will rise to 3% by year-end. They also expect an increase in inflationary pressures with core PCE surpassing the Fed’s 2% benchmark by 2Q 2018.