Trump’s cher­ished wealth ef­fect may soon be re­vealed as a mi­rage

The Globe and Mail Metro (Ontario Edition) - - COVER STORY - ERIC REGULY

The Don­ald Trump-in­spired wealth ef­fect is work­ing like a charm, in spite of the re­cent stock mar­ket wob­ble. The S&P 500 is up about 22 per cent since he stepped into the White House al­most two years ago, un­em­ploy­ment is at record lows and wages are grow­ing at their fastest pace in nine years. What’s not to like?

Noth­ing, so far; the wealth ef­fect may have pre­vented this week’s midterm elec­tions, which saw the Repub­li­cans lose con­trol of the House of Rep­re­sen­ta­tives, but gain two seats in the Se­nate, from turn­ing into a rout for the pro-Trump forces. The Repub­li­cans who lost their jobs weren’t sent pack­ing be­cause of an ail­ing econ­omy; they were pun­ished for other rea­sons.

But watch out – there is a lot less to the stock mar­ket than meets the eye. Mr. Trump must know this and is no doubt gam­bling that the lights won’t go out on the mar­ket party be­fore the 2020 elec­tion. What’s driv­ing stocks to pos­si­bly wild val­u­a­tions is not surg­ing growth and prof­its in Cor­po­rate Amer­ica. The rea­son is more mun­dane: It’s share buy­backs, and lots of them.

Mr. Trump’s tax re­forms, which kicked in early this year, were a god­send to in­vestors, es­pe­cially the wealth­i­est 10 per cent of Amer­i­cans, who own 80 per cent of to­tal stock-mar­ket eq­uity. The re­forms cut the cor­po­rate-tax rate to 21 per cent from 25 per cent and gave for­eign prof­its an ex­ceed­ingly light tax touch. Amer­i­can cor­po­ra­tions had parked some US$2.1tril­lion in cash over­seas.

Now, thanks to the tax re­duc­tions, hun­dreds of bil­lions of those off­shore dol­lars are be­ing repa­tri­ated. If you thought they were go­ing to good causes, such as bulked-up re­search-and-devel­op­ment bud­gets or ran­dom acts of cor­po­rate al­tru­ism, you’d be wrong. Those for­tunes in­stead are go­ing into buy­backs like never be­fore.

The to­tal value of buy­backs by S&P 500 com­pa­nies keeps set­ting records. In 2016, the fig­ure came to US$529-bil­lion. Last year, it was US$550-bil­lion. The 2018 amount will make those buy­backs look par­si­mo­nious. So far this year, ac­cord­ing to Gold­man Sachs, the au­tho­rized buy­back tally is al­most US$750-bil­lion. The fi­nal tally for 2018 could come close to US$1-tril­lion, de­pend­ing on how much more over­seas cash sloshes onto Amer­i­can shores.

There was a time when share buy­backs were vir­tu­ally non-ex­is­tent be­cause, un­der U.S. Se­cu­ri­ties and Ex­change Com­mis­sion rules, they were con­sid­ered du­bi­ous forms of stock ma­nip­u­la­tion. The rules changed in 1982, when the dereg­u­la­tion-mad Rea­gan ad­min­is­tra­tion opened up the mar­ket to vir­tu­ally un­lim­ited buy­backs. At first, they were used rather spar­ingly by com­pa­nies that con­sid­ered their shares il­log­i­cally un­der­val­ued.

To­day, buy­backs are used with aban­don to in­flate al­ready over­in­flated shares – shares which in­ci­den­tally make up the bulk of any ex­ec­u­tive’s com­pen­sa­tion pack­age. Buy­backs are so pro­lific that they now ex­ceed the is­suance of new shares. The re­sult is an ev­er­shrink­ing base of eq­uity, push­ing up the value of the sur­viv­ing pub­licly traded shares. Ac­cord­ing to Forbes mag­a­zine, the price-to-earn­ings ra­tio of the S&P 500 is cur­rently 40 per cent higher than its his­tor­i­cal aver­age.

Ev­ery­one’s play­ing the buy­back game. War­ren Buf­fett’s Berk­shire Hath­away dis­closed this month that it is buy­ing back al­most US$1bil­lion of its own shares. Ditto for Spo­tify, the mu­sic stream­ing com­pany. Ap­ple, which rarely launched buy­backs in the Steve Jobs era, has spent US$73-bil­lion on buy­backs in the past year alone (the Fi­nan­cial Times cal­cu­lated that the amount was enough to fund the salaries of 311,000 teach­ers for four years, or half of global in­fra­struc­ture spend­ing re­quired by 2030). The lav­ish buy­backs helped to pro­pel Ap­ple’s value to US$1-tril­lion at one point (the com­pany’s mar­ket cap has since fallen to about US$962-bil­lion). Buy­backs, not new prod­ucts, ap­pear to be sus­tain­ing Ap­ple’s lofty share price – the com­pany has not launched a block­buster new prod­uct since the iPhone ap­peared in 2007.

And that’s the point. The mar­ket is on a sugar high fu­elled by tax cuts and their off­spring, the buy­back bo­nanza. The fat price-to-earn­ings premium on the S&P 500 In­dex is just one in­di­ca­tion of dan­ger ahead. An­other is what is known as the Buf­fett In­di­ca­tor, which Mr. Buf­fett once called “the best sin­gle mea­sure of where val­u­a­tions stand at any given mo­ment.”

It’s a sim­ple cal­cu­la­tion, achieved by di­vid­ing the to­tal mar­ket value of all U.S. shares by the lat­est gross do­mes­tic prod­uct fig­ure. If the fig­ure falls be­low 90 per cent, stocks are con­sid­ered cheap. Any­thing north of 100 per cent in­di­cates the op­po­site. The Buf­fett In­di­ca­tor hit 145 per cent just be­fore the dot­com bub­ble burst in 2000. Last year, the in­di­ca­tor reached 130 per cent, and kept ris­ing to al­most 150 per cent in July.

What could cause the mar­ket bub­ble to burst? It’s im­pos­si­ble to iden­tify the trig­ger, but JPMor­gan notes that the pace of buy­backs, while up a lot over last year, slowed con­sid­er­ably in Septem­ber and Oc­to­ber, as less over­seas cash is repa­tri­ated. If buy­backs are the mar­ket’s main sup­port mech­a­nism, any slow­down in buy­backs could have dire con­se­quences. Ris­ing in­ter­est rates will hurt.

Mr. Trump is ev­i­dently wor­ried about the pos­si­ble va­por­iza­tion of the wealth ef­fect.

Last month, af­ter the mar­ket fell fast and hard be­fore re­cov­er­ing, he said the head of the U.S. Fed­eral Re­serve was mak­ing a “big mis­take” by rais­ing in­ter­est rates. The stock mar­ket is weaker than it ap­pears. Cor­po­ra­tions loved the tax cuts, which fi­nanced a tsunami wave of buy­backs, ar­ti­fi­cially prop­ping up eq­uity prices. That game can’t last for­ever. .

Mr. Trump’s great give­away may come back to haunt him, along with his re-elec­tion prospects.

What’s driv­ing stocks to pos­si­bly wild val­u­a­tions is not surg­ing growth and prof­its in Cor­po­rate Amer­ica. The rea­son is more mun­dane: It’s share buy­backs, and lots of them.

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