As you may have seen that worldwide stocks are falling as the COVID-19 fears have completely taken over the markets. The S&P500 index has fallen nearly 20% from it’s ATH. Asian and European stocks are also following suit.
When markets crash like that, Governments step in and offer certain incentives to businesses like tax-cuts and cheap credit / lower interest rates etc. The governments say that cheap credit will enable businesses to fuel growth with lower borrowing costs. However, there’s an interesting theory on why the Fed really offers cheap credit and what the businesses really do with that credit, read below.
TL;DR: Companies use cheap credit (e.g 0.5% interest rate) to buy back their own stocks which post 5-10% profits per year.
The evolution of the US stock market- A mini thread:
— The Crypto Fam (@TheCryptoFam) March 10, 2020
We are in uncharted territory. It has not even been fifty years that we have been off of the gold standard.
I believe that what happens next in the stock market will reshape our economy for decades, if not centuries.
This subject probably deserves a lot of supporting research and a deeper dive. For now, I wanted to point out some things I have noticed and hear what others think.
— The Crypto Fam (@TheCryptoFam) March 10, 2020
Pretty much everybody in the investing world is familiar with the feds go to play for boosting the market.
The Fed uses the federal funds rate to stimulate the market. When they see weakness, they can lower the rate to encourage cheap borrowing.
— The Crypto Fam (@TheCryptoFam) March 10, 2020
Banks and companies then buy their own stocks with the cheap money. Their return outpaces the rate, and it works.
If it sounds sketchy and stupid, it's because it is.
— The Crypto Fam (@TheCryptoFam) March 10, 2020
These companies are running up millions in debt on their balance sheets to buy their own stock to boost its price.
It's just now getting good. Stick around.
Buying your own stock with debt was not even legal until the mid 1980s. We barely have 30 years of data on what this type of risk-layering might do. And 2000 and 2008 were pretty bad! Again, uncharted territory.
— The Crypto Fam (@TheCryptoFam) March 10, 2020
This is all a result of the "Number Go Up" economy. Like one of my favorites Andrew Yang says, Trump is a symptom, not the cause.
— The Crypto Fam (@TheCryptoFam) March 10, 2020
Wall Street really thinks they designed an incredible, foolproof system. If stocks go down we can borrow money to buy them so they stop! Perfect!
Not so fast.
— The Crypto Fam (@TheCryptoFam) March 10, 2020
Before recently, take a guess when we set the record for most corporate stock buybacks.
Oh wow, who would have guessed that in 2007, we set a record with $600 billion of stock buybacks!
Generally, about 30% of buybacks have been financed by debt/corporate bonds.
— The Crypto Fam (@TheCryptoFam) March 10, 2020
Going into debt to buy your own stock so it's price goes higher. That's bad. But what if I told you we went one step further?
This is where it gets good.
We shattered the record for corporate buybacks in 2018, exceeding 2016 by over $200 billion.
— The Crypto Fam (@TheCryptoFam) March 10, 2020
However, the percentage of buybacks funded by debt dropped significantly to 14% according to a JPMorgan analysis.
That sounds like it would be good, right?
Wrong. Companies had more cash on hand for 1 reason – the 2017 corporate tax cut from 35% to 21%.
— The Crypto Fam (@TheCryptoFam) March 10, 2020
Lower taxes aren't inherently bad. Companies had on average 14% more income to allocate because of the cuts. So what did they do?
Pumped their stock!
In 2017 the US made $297 Billion in revenue from corporate income tax.
— The Crypto Fam (@TheCryptoFam) March 10, 2020
After the tax cuts, the US made $205 Billion from corporate income tax.
They lost revenue, but they didn't cut expenses.
They actually spent more!
— The Crypto Fam (@TheCryptoFam) March 10, 2020
In 2017 the deficit was $665B. In 2017, it grew $114B to $779B.
Seems like we needed that tax revenue, doesn't it? Seems like the market was doing okay before that, too. But wait!
So wrap your head around this.
— The Crypto Fam (@TheCryptoFam) March 10, 2020
We gave companies a tax cut and they pumped their stocks with it. Almost nobody invested in R&D or distributed a one-time dividend. All buybacks.
2018 began a US-subsidized 92 billion dollar stock market pump. Awesome.
Companies loved 2018 so much that they kept buying their stock in 2019 to inflate it.
— The Crypto Fam (@TheCryptoFam) March 10, 2020
However, the tax cuts were a one time thing. Back to going into debt as a strategy to increase your stock price! All this while making no changes to business operations themselves.
So in a time of economic turmoil, here's how it should happen.
— The Crypto Fam (@TheCryptoFam) March 10, 2020
The Fed lowers rates. Companies borrow cheaply to weather the storm during periods of decreased revenue. They pay it back easily because it was low interest. We bottom and resume growth.
We really messed up.
Companies are already over-levered because successful QE gave them the idea that the market can't fail
— The Crypto Fam (@TheCryptoFam) March 10, 2020
Meanwhile QE has shown diminishing returns since the first injection
We will see major firms default on debt that was only used to pump their stock. Book it.
After 2008, strict lending and credit rules were implemented to ensure we stopped giving bad loans. Even created a whole new agency, the CFPB, to protect consumers.
— The Crypto Fam (@TheCryptoFam) March 10, 2020
A banning of open-market share repurchases, at least those financed by debt, will be 2020/2021's CFPB.
This will help return our capitalist economy back to the incentive system it had when it functioned properly.
— The Crypto Fam (@TheCryptoFam) March 10, 2020
Companies don't try to produce income anymore. Their income is their stock price.
Startups never need to be profitable. Just get users and sell your stock!
I hope that the 2020s are the return of the dividend.
— The Crypto Fam (@TheCryptoFam) March 10, 2020
Buyback volume officially surpassed dividend payout volume in 1997. Strangely, we've had 2 (likely 3) significant crashes since.
Make companies make profit again!
Finally, we see absurd volatility because nobody trades anymore. It's all passive ETF investing.
— The Crypto Fam (@TheCryptoFam) March 10, 2020
The 2020s decade will look much, much different. We will constantly chop 10% up and down for a decade before making a new ATH.
It feels like there's no liquidity because of the passive investing phenomenon.
— The Crypto Fam (@TheCryptoFam) March 10, 2020
After we bottom, consistent buy-side pressure from buybacks (through cheap borrowing) and ETF investing will disappear, leading to the chop.
Trader's paradise, investor nightmare.
Good luck!
Some sources:
— The Crypto Fam (@TheCryptoFam) March 10, 2020
Deficit increase after 2017 tax cuts – https://t.co/tTGmdDymqE
2018 buybacks new all time high https://t.co/t9V7VQQnMf
Buybacks funded by debt, JPMorganhttps://t.co/VcIj56PA1n
How passive investing can cause a bubble https://t.co/ARpFRnp7hd