Are More Share Buybacks a Good Sign?

Share buybacks—companies using cash to buy stock in their own company—are becoming a more common way for American corporations to spend their money. In the first quarter of 2014 share buybacks from the largest US companies increased by 50% relative to the first quarter of last year, according to analysts at FactSet. Is such an increase a good sign or a bad sign for investors? The answer (perhaps unsurprisingly) is “it depends”.

First the positive aspects of share buybacks. They indicate that companies are confident about their future prospects, since otherwise they presumably wouldn’t be spending money to buy their own stock. They also are a way, like paying dividends, of returning cash to shareholders (when a company buys back its stock it reduces the total number of shares outstanding, increasing the remaining investors’ stakes in the company). Returning cash to shareholders is therefore a bullish sign for those who believe that companies would otherwise squander their excess cash by failing to invest it profitably. And share buybacks are more tax-friendly than dividends, since they don’t count as income for investors.

For each of these positives aspects, though, there is a negative side. Making substantial share buybacks may indicate a short-term focus on boosting earnings per share rather than trying to grow a business over the longer term. It can also increase vulnerability to an economic downturn: many companies that had repurchased shares in the mid-2000’s found themselves without enough spare cash when the financial crisis struck in 2008. And studies have shown that companies tend to destroy value for their investors by repurchasing shares when stock prices are high.

The bottom line: each company’s decision may be good or bad depending on why it’s doing the buyback and how good it is at predicting the future. Share buybacks can’t be universally categorized as “good” or “bad” for investors.

Q2 Recap: Stocks and Bonds Both Rise as Low Volatility Reigns

There were plenty of potential triggers that could have sent financial markets into a panic in the second quarter of the year: it was revealed that the economy contracted in the first quarter at an annualized rate of almost 3%, the Federal Reserve continued to scale back its monetary stimulus, and oil prices rose as Iraq was overrun by insurgents. But financial markets shrugged off these developments, and the quarter was characterized by low volatility (few large ups and downs in the markets).

Both stocks and bonds did well, with emerging markets in particular rebounding strongly after lagging last year and in the first quarter of this year. Cash, with its return of essentially 0% in the current low interest rate environment, was the worst-performing asset class.

Q22014 Asset Classes

Every sector of the stock market made gains in the second quarter. Energy stocks led the way, partly driven by increases in the price of energy commodities such as oil. For many sectors 2014 has so far been a reversal of the trends of the previous year. For the second straight quarter, utilities (the worst-performing sector in 2013) were near the top while consumer discretionary (the best-performing sector in 2013) was near the bottom.

Q22014 Stock Sectors

The top-performing countries in the second quarter were a potpourri of emerging markets, largely as a result of political developments. Turkish stock leapt following local elections at the end of March, although they lost some ground toward the end of the quarter as conditions in neighboring Iraq deteriorated. Indian stocks surged as Narendra Modi was elected in the country’s May elections.

The worst-performing countries in the second quarter were Greece and Ireland, countries on the European periphery that had been central figures in the continent’s sovereign debt struggles. Not all such countries did poorly, however: Spanish stocks returned more than 6%.

Q22014 Countries

The outlook going forward depends on a few factors. Most economists expect the US economy to rebound strongly in the rest of the year after its negative growth rate in the first quarter (which has generally been blamed on rough winter weather), but any continued economic slowdown could cause stocks to give up their recent gains.

A second factor is inflation, which has ticked up recently. A continued rise in the inflation rate could lead to losses for bonds, which have benefited from an inflation rate below the Federal Reserve’s 2% target in recent years.

Lastly, the outlook for China continues to be a major influence on the global economy. So far the Chinese government has been able to manage a slowdown in the country’s growth rate without triggering a broader economic collapse, and the second quarter saw some encouraging data about the state of the Chinese economy. Continued success in avoiding a broad financial crisis would support stocks globally and in particular could boost Chinese stocks, which gained almost 5% in the second quarter.

Avoiding the Low Volatility Trap

Stock market volatility—how much the market goes up and down on a daily basis—has recently been unusually low. Since July of last year the S&P 500 index of large US stocks has gone either up or down by more than 1% on only about 12% of trading days, compared to a historical average of more than 20%.

Stock Market Volatility

Such low volatility isn’t necessarily good or bad, although most investors probably appreciate not having the value of their wealth swing wildly on a day-to-day basis. But low volatility can also trick investors into making bad decisions that damage their long-term performance.

One cause of these bad decisions is regret. Low volatility typically occurs as markets rise: the recent tranquility has occurred in the middle of an almost 40% rise in the S&P 500 index since the start of 2013. When these kinds of bull markets occur, a natural tendency is to wish you had allocated more of your portfolio to stocks.

The effect of regret is compounded by recency bias, the tendency for people to predict what’s going to happen in the future based on what’s happened in the recent past. During periods of low stock market volatility, it can be easy to forget that stocks often move up and down quite a bit (at the nadir of the financial crisis in late 2008 US stocks rose or fell by more than 5% in a single day numerous times).

Regret and recency bias are normal, so it’s not always easy to fight them off. The result can be a low-volatility trap, where calm markets lull you into taking too much risk. The key to avoiding this fate is to honestly assess your willingness and ability to take risk, and then stick to a long-term strategy aligned with that risk tolerance. Sticking to your strategy may not always be easy, but it will increase your chances of achieving your long-term financial goals.

Brazil’s Stock Market Struggles

Brazil Stock Returns

Emerging market stocks haven’t done particularly well in recent years, but Brazilian stocks have done especially poorly. From 2010 through 2013, Brazilian stocks substantially underperformed emerging markets as a whole in each calendar year. So far this year, however, Brazilian stocks have outpaced their emerging market peers. Does this reversal herald a comeback for Brazil’s stock market?

The struggles of Brazilian companies have a number of causes. The country has been battling persistently high inflation, currently above 6% per year. Worker productivity in Brazil has been weak due to factors such as poor infrastructure, a low-quality education system, and inefficient regulations. And declining commodity prices in recent years have hurt the country’s commodity producers.

Often times when a country’s stock market dramatically underperforms over a number of years, stock prices fall so far that they subsequently look cheap. By conventional valuation metrics such as price-to-earnings ratio and price-to-book ratio, however, the valuation of Brazil’s stocks isn’t much different from emerging markets overall. Other valuation measures, such as the ratio of the size of the country’s economy to the size of its stock market, suggest that Brazilian stocks may indeed be undervalued, but less so than other emerging markets such as China.

Since Brazilian valuations don’t seem especially attractive, the country’s stock market will likely need something else to provide a boost if it’s going to build on the gains achieved so far this year. Perhaps elections in October will provide the impetus for pro-growth economic reforms, or a stronger global economy will lead to higher commodity prices. If not, the stock market gains so far this year may be an aberration rather than the start of a trend.

Why Dividends Matter

In a recent post we discussed how taking a total return approach to investing can have benefits relative to focusing on dividends when trying to generate income from your portfolio. Does that mean dividends (and the numerous funds and commentators who focus on them) are irrelevant? Not exactly.

Historically, stocks that pay higher dividends have outperformed stocks that pay low dividends or no dividends at all. And contrary to the investing principle that higher returns should go along with higher risk, higher-dividend stocks on average have actually been less risky investments. They’ve historically outperformed lower-dividend stocks in both bull markets and bear markets.

Dividends
Source: BlackRock, via Business Insider

There are a number of possible explanations for this phenomenon. One hypothesis is that investors tend to overestimate that potential of high-growth companies, which also tend to be the companies that pay lower dividends (since the companies are choosing to use their money to try to grow their businesses rather than returning it to shareholders). As a result, the stocks of lower-dividend companies are often overvalued, so the subsequent returns are lower than for higher-dividend stocks.

Other possible explanations relate to how paying dividends affects companies’ decision-making. For example, it’s possible that having to consistently pay a dividend to shareholders keeps companies’ management more focused on only investing in profitable ventures.

That’s not to say that higher-dividend stocks always do better: there have been extended periods of time when they’ve underperformed lower-dividend stocks. And while some investors consider the collapse of internet stocks in the early 2000’s to be a warning against investing in high-flying stocks that don’t pay dividends, higher-dividend stocks are not immune from big declines of their own: banks were among the highest-dividend stocks in the US prior to the financial crisis in 2008.

So what’s the verdict? There’s no definitive explanation for why higher-dividend stocks have done well in the past, and there’s no guarantee that they’ll continue to outperform in the future. But there is compelling historical evidence that dividends do matter.

 

Should You Prepare for a Long Period of Slow Growth?

Larry Summers 2

More than 5 years after the most acute phase of America’s financial crisis, the US unemployment rate is still far above its pre-crisis level. In a series of articles during the past few months, former Treasury Secretary Larry Summers suggested that the economy may be in a persistently depressed state (a “secular stagnation” in the technical jargon). The article sparked renewed debate among economists about whether such a prolonged slump was theoretically possible, and if so, whether the economy was in one right now.

An extended period of slow economic growth should be good for bonds (due to low inflation and interest rates) and bad for stocks and commodities (because of weak demand for goods, services, and raw materials). Yet there are reasons to think that even if the pessimistic side of the secular stagnation debate is correct, trying to adjust your portfolio in response could be a mistake.

One reason is that there’s only a very weak link between economic growth and stock market returns. A long period of low economic growth and high unemployment would hurt companies’ ability to grow their revenues, but it would also keep a lid on how much they have to pay their employees. The lack of pressure to raise employees’ wages is part of the reason corporate profits in the US have been so high since the financial crisis.

A second reason is that Summers and the other proponents of his hypothesis aren’t arguing that a prolonged slump is inevitable, but rather than the government would simply have to use some different policies to overcome it. They argue that policy changes such as increasing government spending on infrastructure, raising the central bank’s inflation target, and allowing more immigration would help boost investment in the economy and reduce the unemployment rate.

Shifting your portfolio to prepare for an extended period of weak economic growth therefore wouldn’t just be a bet that the pessimists are correct; it would also be a bet that the government wouldn’t properly adapt and that no unforeseen occurrences lead to a surge in investment. The secular stagnation idea was previously peddled by an economist named Alvin Hansen in the 1930’s, when he argued that trends such as a declining population growth rate would lead to persistent high unemployment. The unexpected baby boom following World War II invalidated his prediction.

Q1 Recap: US Stocks Overcome Russia, China to Stay in Positive Territory

The first quarter of 2014 had a few bumps in store for financial markets, yet in the end almost every asset class ended up with positive returns. Bonds performed well as interest rates declined and the US inflation rate remained below the Federal Reserve’s 2% target. US stocks recovered from January jitters to end the quarter in positive territory. Even emerging market stocks, buffeted by fears of financial instability in countries such as Turkey, Russia’s military adventurism in Ukraine, and weak economic data from China, finished the quarter only slightly down.

Q12014 Asset Classes

Despite the continued US stock market gains in the first quarter, the economic optimism that fueled last year’s stock market surge showed signs of fading. Weak housing market data helped more defensive sectors such a utilities and health care outperform the broader market.

Q12014 Stock Sectors

The Russian stock market was pummeled in the first quarter as fears mounted that the country’s annexation of Crimea would crimp its economy and its ability to export natural resources. Russia’s troubles may have obscured a more important development, however: disappointing economic data in Japan and China led to a weak first quarter for Asian stocks.

Q12014 Countries

The outlook for the Chinese economy is likely to be one of the key drivers of financial markets for the rest of 2014. For years bearish analysts have been predicting a financial crisis in the world’s second-largest economy, and declining property prices in China could be the start of a broader collapse that finally validates these gloomy prognostications.

Yet so far the Chinese government has overseen a fairly orderly decline in the country’s economic growth rate, and it has the capacity to stimulate the economy if it fears that trouble in the real estate market is spreading. Success in containing the fallout from the economy’s slowing growth would provide a boost for stocks around the world, particularly in China itself where valuations are very low compared to other countries.

 

What the P-E Ratio Is Saying

P-E Ratio Graph

 

 

 

 

 

 

 

With the S&P 500 index of large US stocks having risen by close to 150% since its trough during the financial crisis, are US stocks now overvalued? One way to answer this question is by looking at the price-to-earnings ratio (or “P-E ratio”), which measures how high stock prices are relative to the profits that companies are generating. If the P-E ratio for the market as a whole is higher than its historical average, investors may be overvaluing stocks and the future returns from investing in the stock market may be below average.

The P-E ratio for the S&P 500 is currently about 19.5, above its historical average of around 15.5, suggesting that stocks are slightly overvalued. But one problem with using P-E ratios is that companies’ earnings can bounce around a lot, making historical comparisons difficult. In hindsight stocks were clearly overvalued in the late 1990’s, when euphoria about the prospects for technology companies pushed the P-E ratio for the S&P 500 above 30. But the market’s P-E ratio also surged in early 2009 as companies’ profits collapsed during the financial crisis, and that coincided with the start of the current bull market.

One way to get around this problem is to use the average of companies’ profits over a number of years. Robert Shiller, a professor at Yale University and recent recipient of the Nobel Prize in Economics, popularized a calculation that averages earnings over a 10-year period. According to his calculations, this 10-year P-E ratio is currently above 25, substantially higher than the long-term average of around 16.5. This metric has its critics as well: some argue that it puts too much weight on periods of abnormally low profits, such as the financial crisis. Proponents retort that historically it’s been one of the most accurate ways to predict future stock market returns.

So are US stocks currently overvalued? According to either of these measures of the P-E ratio, the answer is yes.

Record-High Profits May Not Last

Corporate Profits Graph

One factor that has buoyed U.S. stocks in recent years is high profit margins. Corporate profits as percent of the country’s total output reached a record level of 10.8% in the first quarter of 2012, and they’ve gone even higher since then. In the third quarter of 2013 (the last period for which numbers are available) they reached a new record of 11%.

Part of the reason for record-high profitability may be the weak jobs market. Higher levels of unemployment since the financial crisis have resulted in less pressure on companies to increase their employees’ wages, leading to lower costs and higher profits.

Some analysts suggest that record-setting profitability is a bearish sign for the stock market going forward, since profits presumably have nowhere to go but down (the long-term average for corporate profits as a percent of the country’s total output is around 6.5%).

This decline may begin as the unemployment rate declines toward more normal levels (it’s now 6.7%, down from a high of 10% in late 2009). That would serve as a headwind for stocks, offsetting some of the benefit from stronger economic growth.