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Buybacks Drive Stocks Higher

This  post is written by Clif Jarvis an advisor at Ohanesian / Lecours.

 

The tax cuts that went into effect this year lowered the corporate tax rate from 35% to 21%.  Of course, most corporations were not paying that, the effective rate that was actually paid was much lower. However, the new lower 21% official rate allowed corporations to lower their effective rate even further and boost earnings.  Also of great importance, it allowed for bringing overseas earnings back home for a limited time at a substantially reduced tax rate. While the goal of this  ‘bring the money home’ legislation was to increase investments in plants, equipment, and jobs (which is happening) much of the cash is going to stock buybacks.

Stock buybacks are driving the stock market higher. Corporations are buying shares in the open market creating demand and driving prices higher. Additionally, when corporations buy their own shares they ‘retire’ these shares leaving fewer shares outstanding. Each remaining outstanding share then represents a larger piece of the corporation. Therefore, when total earnings are reported, a smaller number of shares are divided into them. This increases earnings per share and further boosts share price.

Unlike paying out dividends to shareholders, buybacks do not involve immediate taxation. Dividends are taxed up to 20% while buybacks can result in meaningful capital gains in share price which will only be taxed when they are eventually sold. Buybacks can be a very positive way to reward shareholders with earnings in excess of what the underlying corporation needs to finance ongoing business plans.

So far this year, buybacks are running at a record pace.

Furthermore, and not quite as positive, several years of ultra-low interest rates have encouraged corporations to borrow money to buy back shares. This has resulted in record levels of debt carried by U.S. corporations. While stock buybacks help boost share price in the short run, this incurred debt may be problematic over the long run as more and more money is going towards interest payments. This leaves less for ongoing business needs, especially in recessionary times.

While there is no equation to forecast the effect of buy backs on future share prices, it is continues to be a very strong positive in the short run.