Archive for February 14th, 2007

The Market – The Fed and Buffer Inflation

Here is a conspiracy theory for you.  Perhaps the Fed benefits by not releasing / utilizing the inflation numbers that are often higher than the Consumer Price Index (CPI) measure.  The Dallas Fed tracks inflation with a trimmed mean PCE rate and the Cleveland Fed uses a weighted median CPI, both of which usually show inflation as higher than the standard CPI measure.  By using the officially accepted CPI, which also has the benefit of usually showing a lower inflation amount when food and energy are stripped out (two things a human being really doesn’t need anyway, let alone the American consumer), the Fed is able to quietly let higher inflation flow through the economy and thus not be forced by an inflation-wary market to raise rates to combat inflation.  Raising rates would likely have a negative correlation on asset prices (real estate and the stock market) and also the unemployment rate. 

Ever since the Volker Fed in the 1970s, it has been the Fed’s objective to prevent run-away inflation, or the ‘expectation’ of higher inflation by the market and the average consumer.  But current economic theory suggests that in containing inflation, the Fed may counter economic growth and thus job growth, causing the unemployment rate to rise.  Thus, the Fed somewhat delicately has to choose between containing inflation to foster an economy based on worthless pieces of paper (the dollar) or risk raising the unemployment rate and the resulting ire of politicians.  The important concept here is that as long as the market and consumers believe that inflation is contained around 2%, then inflation will not lead to run-away inflation.  If the Fed could have an official and generally accepted inflation index that the market and the consumer have faith in, and this index just happens to track inflation at a lower rate than the actual inflation pressures in our economy, then I am sure this index would work to their benefit.  The Fed would be able to create the ‘expectation’ that inflation was contained at the unofficial sub-2% rate target, and yet let the true inflation amount act as a support to spur economic growth.  The Fed would not be forced to raise rates on a more hawkish basis because the artificial inflation number gives them some buffer, and thus the Fed prevents higher rates from potentially undermining the economy, asset prices, and job growth.  Of course, the index that helps them do this is the CPI. 

The current economic fundamentals are quite spectacular: the unemployment rate is exceptionally low, market liquidity is exceptionally high, asset prices are still high, high consumer spending is still making my jaw drop, commodity prices are high, and yet all of this is occurring with inflation somewhere around 2.4%?  I have to think that our current economy is not been sustained by 2.4% inflation but a much higher rate, perhaps around 3.0-3.5%.  This higher rate of inflation may be acceptable to the Fed, but so long as only they know it and not the market / consumer, because as I said earlier, inflation expectations can lead to higher inflation.  So perhaps we should name the CPI the “Buffer Index: Helping the Fed keep inflation expectations low when real inflation is actually higher.”

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The Market – Stock Buybacks

Stock buybacks were recently reported as $325b in 2006 vs $200b in 2004.  If you assume total market capitalization was $11 trillion in 2006, stock buybacks would represents around 2.955% of the total market value.  As I don’t have data on 2006 total share count, let’s simply assume $10 per share, or 1.1 trillion shares in the market.  Buying back $325 billion would represent 32.5 billion shares or naturally 2.95% of the share count. If you assume that the market does not increase its earnings but they keep constant at say $1.00 earnings per share before the buyback, effectively representing $1.1 trillion in earnings, once that share count falls after the buyback, you now have earnings of $1.03 per share, or an increase of around 3.04%.  So potentially more than 3% of the markets earnings growth in 2006 came simply from share buybacks and all those double-digit earnings growth rates the market has consecutively hit quarter after quarter may be more ephemeral than solid organic growth.

I think stock buybacks are a poor means of returning shareholder value.  The old argument that it spreads earnings amongst fewer shares and theoretically leads to a higher share price thus benefiting shareholders is misleading in the fact that a higher share price can quickly be lost in an irrational market or a market reacting to external circumstances such as economic and geopolitical risk (something that may be happening fairly soon).  And as an investor, I know I would prefer the cold hard feeling of cash to the feeling of the wealth effect.  I can spend $1 in cash dividend (naturally before taxes) for $1 in goods.  The wealth effect only theoretically gives me about $0.40 on that $1.00. 

The problem is, companies like stock buybacks as it improves their EPS growth rates and justifies their rampant stock option pools.  Furthermore, many companies fear that a dividend payment will create expectations of future consistent dividend payments that the company may be forced to reduce during adverse business conditions, thus engendering a public image black eye.  Frankly, I don’t believe in that theory.  I think it would be an excellent idea if more companies started adopting more dividend payment mechanisms, perhaps something like a special dividend that investors may not expect on the typical quarterly or semi-annual basis.  A special dividend might keep more investors in a stock for the long term knowing that management is going to efficiently return capital to the shareholders when the balance sheet of the company is healthy enough to do so.  Microsoft is a perfect example of a company with ample cash that decided to have a special dividend.  They may not want a regular dividend mechanism because they may not want to create an ‘income investor’ perception and risk losing their ‘growth stock’ profile.  Thus, the company could continue to manage its cash flow as needed for capex and acquisitions without having to worry about a ‘mandatory’ consistent dividend payment, and they return cash to shareholders to are patient enough to stick with the stock (thus providing a consisten and stable investor base).  That sounds so much better than a stock buyback program in which shareholder return is simply put off until tomorrow during which it will face price volatility and stock dilution (many stock buybacks are simply buying back dilutive stock options – hello Cisco).  More on that crazy charade at a later date. 

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