Stock Buybacks Are Nothing but Margin Speculation

Not only individual speculators are all-in the stock market; companies are, too

Crowds gather outside the Sub-Treasury Building (now Federal Hall National Memorial) opposite of the New York Stock Exchange at the time of the Wall Street crash in October 1929. KEYSTONE/GETTY IMAGES

Buying stocks on margin is buying stocks with money you don’t have. Usually, it’s speculators who engage in this risky practice that can be profitable as long as the market keeps going up.

Let’s say you have $10,000 in an account with your stockbroker. Under normal circumstances, you could buy up to $30,000 worth of stock with a $20,000 loan from the broker. Let’s assume you are lucky and the stock goes up 50 percent. The position is now worth $45,000, and your equity has increased by $15,000 to $25,000. This means you can increase your position size again to $75,000 and buy more stock, because most brokers only require you to keep 30 percent of cash or stock as collateral.

This is why using margin is so powerful in a rising market and why margin debt in the accounts of the New York Stock Exchange (NYSE) has kept pace with the records in the S&P 500 and the Dow Jones industrial average, reaching an all-time high of $581 billion in November 2017.

In a falling market, the whole exercise becomes less fun, and speculators trading on margin were one of the reasons behind the vicious crash of 1929.

The biggest companies in the United States run the risk of ending up like speculators caught in a margin call.

Let’s assume you just bought more stocks and your total position in company A was $75,000 with your initial cash outlay, with profits totaling $25,000, as in the example above.

If the market moves 10 percent against you, your position is worth $67,500 and your equity is worth $18,500, but the loan is still worth $50,000 and you are supposed to keep $20,250 as collateral. In order to make up the difference between your collateral value ($18,500) and the margin requirement ($20,250) of $1,750, you can either deposit more cash or sell some securities to decrease the margin position.

Most people will sell some of their position, which puts further pressure on stock prices. Sometimes brokers do this without asking their customers; this is the infamous “margin call.” This leads to an avalanche of selling in a market that has borrowed too much.

The selling leads to further price declines, which lead to more margin calls, which leads to more selling. This is what caused the relentless decline in prices on Black Monday (-12.81 percent) and Black Tuesday (-11.73 percent) in October 1929, as there weren’t any buyers with cash left to step in when everybody who borrowed to buy stocks had to sell.

The Everything Bubble

In 2018, it’s no secret that this market runs on leverage and borrowing. And although the percentage of NYSE margin debt compared to the total stock market capitalization of the Wilshire 5000 is not at the all-time high seen in 2007 (2.5 percent), it sits just a tad below, at 2.2 percent.

The U.S. government is all-in on debt, with a record debt-to-GDP ratio of 104 percent, and it’s only the household sector that lowered debt because it refused to go all-in on mortgages again.

Instead, this time around, it’s the U.S. nonfinancial corporate sector that boosted its debt outstanding to a record of $13.7 trillion. And it is using part of it for buying its own stocks on margin, although it is called by a different name this time: “share buybacks.”

In the third quarter of 2017 alone, S&P 500 companies bought back $129.2 billion of their own stocks. The biggest spenders were Apple Inc. ($7.8 billion) , Citigroup Inc. ($5.4 billion), and JPMorgan Chase & Co. ($4.8 billion).

Since the second quarter of 2012, S&P 500 companies bought back $2.7 trillion of their own shares, according to S&P data. At the same time, their outstanding debt securities have risen by $1.7 trillion.

Of course, companies have borrowed for other reasons and have also financed the share buybacks with generally good earnings. However, the increase in debt together with the share buybacks is not coincidental.

“International Monetary Fund estimates suggest that large U.S. corporations have experienced a negative net equity issuance of $3 trillion since 2009 due to share buybacks, thus significantly boosting their equity leverage ratio,” notes the Institute of International Finance. In other words, corporates have less equity and more debt now—exactly what one should expect if companies issue debt and buy back equity.

Apple, which previously did not have any long-term debt, has issued more than $100 billion to buy-back shares as it waits to repatriate $269 billion in cash sitting abroad. Microsoft borrowed $17 billion in a single bond issue in January 2017. IBM boosted its long-term debt from $42 billion to $45 billion in 2017 but added $3 billion to its share repurchase program.

The whole process is convenient for companies because equity is more expensive to finance than debt in a zero interest environment, and it artificially boosts earnings per share by keeping earnings the same but reducing the number of shares.

At the end of the day, however, this is nothing but margin speculation.

Company Margin Speculation

Similar to the individual stock speculator in the example above, a company has a certain amount of equity it can leverage. Of course, with big companies, there is not one number like the 30 percent margin requirement for the individual. However, the dynamics are similar.

As long as the total value of the equity of a company keeps going up in a rising market, the company can keep issuing bonds against ever-rising equity values. Nevertheless, the total debt-to-equity ratio for large companies has increased from 50 percent in 2007 to a record high of 83 percent in spite of the rising market.

In a low-interest rate environment and a functioning economy, the companies can easily pay the interest on the bonds they issue out of the cash flow, as the total interest payments are low. Refinancing is also not a problem.

However, what happens if the market starts falling because interest rates rise or there is a recession, or both? No, companies won’t receive a margin call—there is no such provision in most company debt.

If equity values fall by half, and the debt stays the same, the debt-to-equity ratio will double—too much for the bond market to roll over the loans at the same low-interest rates. So either the company pays back the loans—which it can’t because it spent the money on shares that are now only worth half as much—or it refinances against a much higher interest rate.

This will squeeze cash flows, especially in a tight economic environment, and it won’t be long until companies start selling shares again—at much lower prices this time—just to survive. The biggest companies in the United States run the risk of ending up like speculators caught in a margin call.