Shareholders rewarded with bondholder cash
The credit bull market is helping to push stock prices higher via share buybacks.
With a big bull market underway in the credit markets, corporations are easily raising capital. But instead of using the money to fund new projects, executives are increasingly using the funds to reward shareholders and repurchase stock at the expense of bondholders.
According to UBS strategist Thomas Doerflinger, the bank's U.S. clients have started buying equities again after 16 straight weeks of selling thanks to the efforts of corporate clients. The buying is concentrated in the technology and materials. (Hedge funds -- who tend to be very short-term oriented -- continue to sell and sell-short, and are focused on the industrial and financial sectors. )
Analysts at Merrill Lynch note that the cost of debt is now below earnings yield -- which is the inverse of the price/earnings multiple. Historically, when this has happened, he said, executives "become more aggressive and reward shareholders at the expense of bondholders."
That sounds pretty arcane so let me just put it plainly: It's great news. It will result in share repurchases, mergers, and acquisitions -- all providing more support for earnings multiples and stock prices.
The supply of funds is certainly there: Merrill Lynch reports that new borrowing by high-grade issuers has matched the record annual volume of $960 billion set in 2007. And we still have one more month to go in the year! This sets the stage for a $1 trillion year for 2009. Amazing.
A few companies that have issued new debt have gone as far as to mention share buybacks as a possible use of the money. These include Cisco (CSCO), Praxair (PX), Quest Diagnostics (DGX), IBM (IBM) and Zimmer Holdings (ZMH). This is quite a cross section of the market. We've got a network hardware maker, an industrial gas supplier, a provider of healthcare testing services, and a medical device manufacturer.
Keep in mind that much of the entire 2003-2007 bull cycle was fueled by buybacks and mergers, as the public was still largely in shock over the 2000-2002 bear market. Buybacks are no joke, as they really help push prices higher by reducing the supply of shares.
Cheap credit is thus one hidden reason that stocks can keep moving higher even if the economy seems to be lousy. Buybacks react to a totally different dynamic than equity investors are accustomed to seeing and understanding. Keep an ear out for that word, and smile when you hear it.
Disclosure: The author does not own or control a position in any of the funds or companies mentioned.
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