Fed Study Sees Stock Prices Slumping Once Buybacks Wane
By Joseph Rebello
WASHINGTON (Dow Jones)--U.S. companies have been pumping up the price of their stocks by spending less on dividends and more to buy back shares, but the habit is becoming so costly that the spending is bound to slow, a Federal Reserve study has concluded.
When it does, likely in the "near term," U.S. stock prices could fall as much as 38%, says the study, one of several the Fed has undertaken to examine how changes in U.S. compensation practices have affected the economic outlook. A draft of the study was circulated within the Fed last week.
The study, by Fed researchers J. Nellie Liang and Steven A. Sharpe, highlights a key fear of Fed policymakers: that the rapid rise of U.S. stock prices in the last five years, which has fueled the economic boom, has made the economy vulnerable to a sharp and sudden downturn. Fed Chairman Alan Greenspan has said the central bank is paying increasing attention to developments on Wall Street as a result.
Corporate Stk Options Boost Incentive For Repurchases
Fed researchers have concluded, in previous studies, that the tendency of U.S. companies to dole out stock options to top executives has changed the way companies view the payment of dividends. Because option holders typically aren't entitled to dividend payments, corporate managers prefer to buy back stock rather than pay dividends. Dividend payments, moreover, often reduce the per-share price of a stock while buybacks usually increase that price.
As a result, share repurchases by non-bank companies on the Standard & Poor's 500 have outstripped dividend payments for two consecutive years. Repurchases more than tripled between 1994 and 1998, soaring to nearly $150 billion. In the same period, the companies' dividend payments rose just 35% to about $115 billion.
The Fed study circulated last week says repurchases have reduced the outstanding shares of large S&P 500 companies by an average of 2% a year, although the retirement rate has been just 1%. Liang and Sharpe didn't assess the effect of those retirements on stock prices, but they said the repurchases have increased average per-share earnings by about one percentage point a year since 1994.
Repurchase Costs May Rise To 90% Of Corporate Earnings
That benefit has come at a high price: as price-to-earnings ratios have soared on Wall Street, so has the cost of stock repurchases. Liang and Sharpe estimate that S&P companies on average would have to spend as much as 90% of their earnings on repurchases to maintain the 1% retirement rate that has helped bolster stock prices so far. That will be difficult, they say, because companies typically need as much as 50% of their earnings for investment outlays.
Already, the companies are borrowing heavily to pay for the repurchases. The researchers say that in 1997, 144 of the 150 largest S&P firms they studied spent 125% of their earnings on stockholder payouts and investment outlays.
For now, the borrowing poses no difficulty for U.S. companies, largely because U.S. interest rates remain low. Although their debt burden has increased since the 1990 recession, their debt-servicing burden has actually declined. In 1998, the ratio of corporate interest expenses to operating cash flow was 19%, down from 24% in 1991.
"We don't see anything immediate that says companies can't continue to raise debt," Liang said in an interview Monday. But her study argues that the retirement rate of stocks is bound to slow in the "near term," which economists usually define as no more than two years.
Fed Policymakers Fear Sudden Slump Could Hurt Economy
The study envisions two scenarios: in the "optimistic" one, the annual share retirement rate would drop in half to 0.5%, causing a 32% drop in average stock prices. In the "pessimistic" scenario, the retirement rate would drop to 0.2%, causing a 38% drop in stock prices.
The possibility of a sudden slump in stock prices has become a growing preoccupation at the Fed, particularly because the run-up in prices over the last five years encouraged a consumer spending spree upon which the overall economy has become dependent. It has, as a result, become a constraint in the conduct of monetary policy.
The Fed, for example, has fretted since May that the country's torrid economy may be inflationary. But it has been reluctant to raise U.S. interest rates too quickly - at least partly because it fears triggering a slump in stock prices that would be large enough to stall the economy.
The Fed raised its key Funds rate twice over the summer, by a total of half a percentage point. That helped start a decline in stock prices that brought the Dow Jones Industrial Average down about 1,000 points, or 9%, from its 1999 peak. The central bank isn't expected to raise rates again when its policymakers meet next week.
"As the value of assets and liabilities have risen relative to our income, we have been confronted with the potential for our economies to exhibit larger and perhaps more abrupt responses to changes" in interest rates, Greenspan said in a speech last month. "As a result our analytic tools are going to have to increasingly focus on changes in asset values and resulting balance-sheet variations."