Stock Market Highs And Corporate Financial Engineering – Seeking Alpha

All major stock indexes in the United States have hit historical highs this year within the last two months.

The movements in stock prices have been attributed to the “Trump talk” and the belief that President Trump will be able to pass economic policies and change regulations in a way that will be very favorable to the performance of United States corporations.

In terms of stock valuations, Robert Shiller’s Cyclically Adjusted Price Earnings ratio is now at 28.46, the highest level achieved since the year 2000 just before the stock market collapse.

FactSet data report that the 12-month price-to-earnings ratio for the S&P 500 index achieved a value of 17.6 times yesterday, around the highest levels for this measure since 2004.

Whatever caused the movement, whether it was the “Trump talk” or something else, investors have moved into stocks in a very aggressive way. The market expectations must be for higher future corporate profits, for the current earnings results do not seem to be consistent with such high valuations.

And, the high price earnings ratios are not now being achieved with corporations buying back their stock.

Data released by Goldman Sachs (NYSE:GS) indicate that the share buyback plans of US corporations have fallen to their lowest level since 2012.

According to Goldman, “Companies on the S&P 500 index have authorized $146 billion in share buybacks this year, down 15 percent from a year ago.”

Furthermore, “Executives have also been reluctant to pull the trigger on already-approved plans, with buyback executions 20 percent lower in 2017 compared with last year.”

Note that there was a drop in corporate stock repurchases last year of 6.3 percent from the year earlier. One should note, however, that buybacks declined substantially in the last two months of 2017 after the results of the presidential election came in.

Even with the last year’s decline, “US buybacks have totaled more than $2.0 trillion over the past five years, according to Absolute Strategy Research, a research company.”

Stock buybacks have been a major tool of US corporations during “the almost decade-long bull market” as the Federal Reserve System has tried to stimulate higher stock prices in order to create a wealth effect that would result in more consumer spending and faster economic growth.

The historically low interest rates maintained since the Great Recession have been a gift to corporations in that they can borrow money at extremely low costs and use the funds to buy back their stock and help generate higher and higher stock prices.

This picture is all a part of the growing impact of financial engineering in the corporate world. In fact, the growth of financial engineering and of financial innovation over the past forty-five years or so have completely changed the dynamics of the US economy where governmental efforts to stimulate the economy, either through monetary policy or fiscal policy, often end up driving the financial circuit of the economy and not the industrial circuit.

In this scenario, the influence of the government dominates markets and creates expectations that drive decisions, corporate and otherwise.

Corporate buybacks have contributed in a major way to the buoyancy of the US stock market over the past decade or so, as the Fed’s three rounds of quantitative easing underwrote the low interest rates that accompanied the laxity. This was not totally unlike the “Greenspan Put” in which former Fed-Chair Alan Greenspan basically put a floor under stock market prices.

Now, the Trump administration has created an investor euphoria connected with (possible) future tax cuts, infrastructure spending and deregulation that has, once again, resulted in buoyant stock prices.

With this kind of environment, there is little need for corporate stock buybacks. So, managements have backed off on the stock buybacks.

The question now is, what will these corporations do with all the cash lying around the shop?

Will these corporations use the cash to buy physical capital that might help them become more productive and hire more people?

Or, will these corporations use the cash to buy assets and keep the money within the financial circuit.

If the past twenty years or so is any guide to the corporate behavior, the managements of these corporations will follow the latter path and we will get more financial movement in asset prices with little spill-over to physical investment expenditures.

Then again, President Trump and his administration could fail in their efforts to get tax relief, infrastructure spending and deregulation. If Trump fails in this way, then one might expect the stock market to fall back to lower levels as the “Trump reflation” goes away.

In this case, the corporations would need the cash to go back into the buyback business.

To me, this is what we need to look for going forward. Just how much will financial engineering and financialization dominate the future, given the environment government creates for economic decision-making. There is no doubt in my mind that the federal government will control the environment we all have to work within. How corporations and investors respond to the incentives set up by the government, how corporations and investors will direct their financial decisions, that will determine where the stock market goes.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.