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The S&P 500 is Booming, So Why Is the Stock Market Shrinking?

Last Updated September 23, 2020 12:45 PM
Ryan Smith
Last Updated September 23, 2020 12:45 PM

By CCN.com: The S&P 500 is having a blistering run in 2019. As of May 28, the large-cap stock market index is up 13.5 percent and shows minimal signs of slowing down.

One equity analyst, however, isn’t buying that the rise is organic. He believes the stock market is shrinking and has actually contracted by 2.3 percent since 2018.

S&P 500
The S&P 500’s year-to-date rally masks a concerning fact: The stock market is shrinking. | Source: Yahoo Finance

Citigroup’s Chief Global Equity Strategist, Robert Buckland, “crunched” the numbers and ultimately blames the decline on share buybacks and mergers and acquisitions (MA). Bloomberg’s Tracy Alloway fittingly describes the idea as the “incredibly shrinking stock market “:

“Share buybacks and MA are a really easy way for companies to boost earnings per share… If you can grow through organic growth and, you know, actually improve your company’s performance then why not do it through financial engineering and arbitraging equity versus debt yields.”

Stock Market Shrinkage Is Simple Economics

Buckland estimates that the cost of equity in the US currently sits around 6.7 percent while the cost of debt is considerably lower at 4.1 percent. That may not sound significant, but as Bloomberg points out, executives won’t hesitate to jump on an easy two-and-a-half percent arbitrage opportunity in a low-growth environment.

The easy money won’t last forever, though. Debt-to-equity levels are rising sharply for the S&P 500, leaving behind a rapidly closing window for this kind of financial engineering.

SP500 Debt to Equity Ratio
The cost of raising debt continues to rise for S&P 500 companies. | Source: Bloomberg 

Share Buybacks Were Once Outlawed

Stock buybacks have accelerated to record levels since the global financial crisis. Prior to the 1980s, however, company buybacks were illegal, outlawed for the same type of shenanigans that led to the Great Depression.

President Reagan repealed those laws in 1982, giving companies, for the first time in decades, the opportunity to buy back their own stock. That decision formed a major bottom in the S&P 500 and an epic run to this day.

S&P500 long term chart. Stock market is shrinking
A long-range view of the S&P500 since the 1930s. | Source: Macrotrends 

Coincidence? You decide, but it’s not that hard to make the connection. The practice also raises questions around company leadership.

In an interview with CNN Business , veteran hedge fund manager Mark Yusko lambasted buybacks as “stock price manipulation,” deftly observing:

“I find it absolutely mind-numbing that a company like Apple can sit on $260 billion of cash, you’re telling me that all these genius people can’t think of one intelligent thing to do with that capital?”

You Feeling Lucky, Punk?

Similar to the great Westerns of old, a new modern standoff is taking place. On one end of the street is management with their hand firmly on the buy trigger. On the other, politicians like Elizabeth Warren, gunning to be the new sheriff in town:

Executives have every reason to buy back their own stock. Who wouldn’t? Their performance bonuses are heavily tied to their share options. Problem is, this creates a scenario where management is more interested in juicing their own stock instead of growing the business organically.

Perhaps this new gunfight will be labeled as an “Eastern” in the years to come. This time around, the showdown may take place between Congress and Wall Street.