By Dillon Yeh
Correspondent, Economics Undergraduate Student

Imagine a lizard without means of nourish in a vast desert. In order to survive the lizard begins eating its own tail, with the ability to regenerate the part again. However, with each consumption, the tail returns ever diminishing in size. The lizard is forced to mutilate itself in order to survive, being pushed to the edge of absurdity.

Yet such a situation is as desperate as what corporations are practicing right now with asset selling and share buybacks.

Today’s situation is reminiscent of Japan in the late 1980’s and early 1990’s. Because balance sheets were used as an indicator of the health of a firm, corporations used inflated asset prices in order to entice investors with superficially healthy sheets. Investors mostly responded by accepting the artificially high prices as reflective of a roaring multi-decade long bull market.

The problem arose though when balance sheets began to deteriorate because of a fall in their asset-backed prices which inevitably led to a spike in debt ratios. Each corporation responded in a logical manner by selling their assets to clean their sheets. However the culmination of individual actions transpired into a Balance Sheet Mechanism, with subsequent margin and loss spirals. In simpler terms, the quiet asset sales by corporations across the board amplified into a cascade of sell-offs and further asset price volatility. Liquidation to pay off debt resulted in a capitulation of the market.

The situation is desperate as corporations sell assets and share buybacks.

The name of the game for the past seven-year bull market has been central bank stimuli and corporate share buybacks. However, the Federal Reserve raise in interest rates for the first time in almost a decade has tightened borrowing. The era of cheap debt finance has come to an end. And indeed balance sheets have alarmingly deteriorated in the previous months. Michelle Davis of Bloomberg News notes of the total debt excess has blossomed into the highest interest expense and the lowest capacity to service these obligations. Indeed Deutsche Bank’s Chief US Economist Joseph LaVorgna concurs stating that the balance sheets of corporations are worse than household balance sheets, pushing levels reminiscent of the past three recessions.

Yet this would not be an issue were these debts going to expansionary corporate growth development. But for the most part they were not, instead being designated to share buybacks. Thanks to the era of post-crash cheap credit, corporations have been able to cook the books to their advantage. By decreasing the supply of their shares outstanding through buybacks, corporations have been able to proportionally increase the slice of the pie each share accrues. With executives are mainly fixated on the short-term health of their firms by enticing investors with artificially supported Q/Q earnings, the reality of stagnant growth has largely gone unnoticed.

The problem is when that this behavior becomes taken for granted and priced into the shares, as is happening.

According to Reuters, “among the 1,900 companies that have repurchased their shares since 2010, buybacks and dividends amounted to 113% of their capital spending, compared with 60% in 2000 and 38% in 1990.” This behavior is systemic, with such iconic firms as IBM and HP exemplifying this trend, with the former spending $157bn on buybacks and dividends, far higher than the $111bn dedicated to research and development. And while the defense of using share buybacks as a mean of further spreading the profits of the company to stockholders when R&D spending is not unwarranted, it should not come at the expense of long-term growth. The problem is when that this behavior becomes taken for granted and priced into the shares, as is happening. Simply put: eventually the chickens will come home to roost.

Corporations will meet a difficult dilemma. They must either float debt in order to continue their buyback programs or face the music and cut back on their purchasing. The deterioration of balance-sheet health is becoming alarming as organic earnings growth continues to stall and dip as the Generally Accepted Accounting Practice (GAAP) and non-(GAAP) statistics continue to polarize, a behavior reminiscent of Spring 2000 and Summer of 2008. Looking forward, it is essential to monitor asset price levels as firms battle corporate debt, rising interest rates and stagnant growth. Because once asset price levels begin to fall, that initial quiet sell-off will fall into a loss spiral on a cataclysmic scale akin to Japan 1990’s.

Looking forward, it is essential to monitor asset price levels as firms battle corporate debt, rising interest rates and stagnant growth.

The lizard has ran out of the nourishment of cheap credit and is finding itself in the desert without a means of sustaining itself. Eventually that tail will look appetizing.

Featured image courtesy of Mayeesherr.