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It's nearly inevitable that Wall Street's addiction to share buybacks will cause a stock market crash - and the 2020 election could be the spark that makes it happen.
The curbing - or banning - of stock buybacks will almost certainly be on the agenda should the Democrats win control of both houses of Congress and the White House in 2020.
But as you'll see shortly, stock buybacks have fueled much of the gains in the bull market of the past decade. New restrictions on them would slash demand for stocks, virtually assuring a stock market crash.
Such restrictions are becoming increasingly likely.
Several prominent candidates seeking the 2020 Democratic presidential nomination have voiced a desire to rein in Wall Street excesses.
Even a mainstream Democrat like former Vice President Joe Biden - who at the moment has a huge lead in the polls over his 21 rivals - has suggested the government "take a look at regulations that promote stock buybacks."
And the topic is a favorite of well-known progressives such as Sen. Elizabeth Warren (D-MA) and Sen. Bernie Sanders (I-VT)...
Stock Buybacks in the Crosshairs
Sanders has been a longtime critic of the practice. In a February op-ed piece in The New York Times, co-written with Sen. Chuck Schumer (D-NY), Sanders derided buybacks as "corporate self-indulgence."
Warren has also long criticized stock buybacks as part of her frequent broadsides on a range of Wall Street practices she sees as greedy and harmful.
"These buybacks were treated as stock manipulation for decades because that is exactly what they are. The SEC needs to recognize that," Warren said in 2015, referencing the 1982 rule change that permitted share buybacks.
She co-sponsored a bill in 2018 that would have limited share buybacks to tender offers, which have more restrictions and require more transparency. Such restrictions would no doubt dampen enthusiasm for buybacks.
In their New York Times piece, Sanders and Schumer proposed a bill that would "prohibit a corporation from buying back its own stock unless it invests in workers and communities first," which would include paying employees at least $15 an hour, among other benefits.
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But more recent proposals would go a step further...
In March, Warren, Sanders, and fellow candidate Sen. Kirsten Gillibrand (D-NY), signed on as co-sponsors of a bill called the Reward Work Act that would repeal the 1982 rule - and ban share buybacks outright.
This is the sort of "stick it to Wall Street" issue that could gather widespread support among Democrats in the wake of the 2020 election, particularly if they make significant gains.
And bipartisan support for at least some curbs on stock buybacks is not out of the question, either.
In February, Sen. Marco Rubio (R-FL), proposed ending preferential tax treatment for the practice, instead taxing buybacks like dividends in the hope of reducing the practice.
The fact is, any restrictions on buybacks will harm stock prices. A full ban would be disastrous.
You see, the stock market is hopelessly addicted to stock buybacks...
Why a Buyback Ban Would Trigger a Stock Market Crash
While the abundant use of share buybacks is no secret, few investors realize how vital they have been to the stock market rally that started in 2009.
Each year, Goldman Sachs Group Inc. (NYSE: GS) creates a report documenting the annual net demand for stocks from every major category of investor. Net demand means the total shares sold are subtracted from the total shares purchased. The categories include corporations - the source of the buybacks - as well as pension funds, foreign investors, mutual funds, and households (you and me).
The data from the past decade paints a stark picture. Goldman's numbers show that since 2009, corporations are responsible for more than 90% of the net purchases of stocks.
Since 2014, buybacks have accounted for a staggering 120% of net demand. In other words, without buybacks, there would have been net selling in the markets over the past five years - a recipe for a bear market if not a full-blown stock market crash.
Just as ominously, the nearly $5 trillion spent on buybacks since 2009 has artificially inflated earnings per share, making soaring stock prices appear justified.
The website Advisor Perspectives did the math on the impact of buybacks on earnings over the past decade. While sales increased just 53%, earnings zoomed 380%.
And the dependency has grown deeper over the past couple of years. The annual spend on share buybacks has increased from about $400 billion in 2012 to $806 billion last year. When companies are suddenly forced to go cold turkey, a stock market crash is practically unavoidable.
But even if the Republicans manage to block any political action against stock buybacks, another issue looms as a threat. It would have just as negative of an impact, too, severely reducing the ability of companies to buy back their shares.
And the chances of it happening are even higher...
This Ticking Time Bomb Will Blow Up Share Buybacks
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The only thing worse than buying back shares to inflate stock prices was buying back shares with borrowed money.
Yes, many companies have gone deep into debt to repurchase shares, enticed by the cheap money made possible by the Fed's near-zero interest rate policy.
According to a report released in April by Bank of America Corp. (NYSE: BAC), U.S. corporations have borrowed $2.5 trillion over the past five years while buying up $2.7 trillion worth of their own shares.
From 2011 to 2015, about a quarter of stock buybacks were financed with debt. In 2016 and 2017, the percentage shot up to about one-third. Last year, rising interest rates pushed the proportion down to 14%.
But all that debt continues to weigh down corporate balance sheets, and investors aren't happy about it.
"Today, the game has changed," the Bank of America analysts wrote. "Three times as many investors want companies to pay down debt than to buy back stocks."
So while companies are expected to have sufficient cash to buy back stocks even without borrowing over the next couple of years, the overhang of existing debt will pressure CEOs to adjust their allocation policies accordingly.
"After years of transferring value from bondholders to shareholders, companies may now be forced to instead defend their balance sheets at the expense of shareholders," the analysts said.
You also have the specter of rising interest rates that would make paying down debt preferable to buying back shares. While the Federal Reserve has "paused" rate hikes for now, a persistently robust economy could force a shift to a more hawkish policy.
But one way or another, the days of massive stock buybacks are coming to an end - and that will pop the stock market bubble.
Be Prepared for a Market Crash
The truth is, allowing massive stock buybacks was a bad idea. The SEC screwed up.
But all we can do now is deal with consequences. The addiction is real. And the market's withdrawal symptoms will be especially ugly.
Sure, stocks may well keep climbing higher... for a while. But with the bull market built on sand, it won't take much to topple it. So you definitely need to have a plan in place.
"There are a TON of ways to make money - and keep the money you have - in a downturn," said Money Morning Macro Signal Strategist Matt Piepenburg, who recommends three basic strategies for hedging against a crash.
"Strategies for hedging portfolios, and to just flat-out make money when markets tank, include short selling, buying put options, and using inverse ETFs," Piepenburg said.
One of the most basic ways to hedge is with inverse exchange-traded funds (ETFs). These funds move in the opposite direction of the markets. Among his favorites are the ProShares Short S&P 500 ETF (NYSEArca: SH), the ProShares Short Dow 30 ETF (NYSEArca: DOG), and the ProShares Short QQQ (NYSEArca: PSQ) which tracks the inverse of the Nasdaq Composite.
With short selling, you borrow a stock with the intent of buying it back at a future, lower price. So you make money if the stock falls, but lose if it rises. Piepenburg recommends shorting only for experienced investors.
Instead, he prefers using put options as a way to short with less risk. Instead of borrowing the stock, you buy an option contract. If the trade goes against you, you're only out the cost of the contract - a fraction of the loss you'd have if you shorted the stock itself.
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About the Author
David Zeiler, Associate Editor for Money Morning at Money Map Press, has been a journalist for more than 35 years, including 18 spent at The Baltimore Sun. He has worked as a writer, editor, and page designer at different times in his career. He's interviewed a number of well-known personalities - ranging from punk rock icon Joey Ramone to Apple Inc. co-founder Steve Wozniak.
Over the course of his journalistic career, Dave has covered many diverse subjects. Since arriving at Money Morning in 2011, he has focused primarily on technology. He's an expert on both Apple and cryptocurrencies. He started writing about Apple for The Sun in the mid-1990s, and had an Apple blog on The Sun's web site from 2007-2009. Dave's been writing about Bitcoin since 2011 - long before most people had even heard of it. He even mined it for a short time.
Dave has a BA in English and Mass Communications from Loyola University Maryland.